“The designers of the good ship euro wanted to create the greatest liner of the age. But as everybody now knows, it was fit only for fair-weather sailing, with an anarchic crew and no lifeboat. Its rules of economic seamanship were rudimentary, and were broken anyway. When it struck a reef two years ago, the water flooded one compartment after another.. European officials now recognise the folly of creating the euro without preparing for trouble. It would be wise to be planning now for what to do if it sinks.. Even now, after decades of “European construction”, many Eurocrats cannot conceive of the euro as a wreck. Those who have worked hardest to keep it afloat are exhausted and know it is not in their power to save it anyway.”
- Charlemagne in ‘The Economist’, November 26th.
The business of investment for at least the past four years has been akin to conducting a detective inquiry: whodunit? Just how did we end up in this mess? To tackle one’s enemy, one first needs to identify it. In the popular conception, a myth gleefully adopted by politicians, it is all down to corrupt American investment banks, poisoning the collective well of global capital with subprime mortgage filth – what Professor Robert Vambery in this week’s Economist nicely if grimly refers to as adding three quarts of milk to a quart of sewage and creating four quarts of sewage in the process. And then the poison spread. It is a neat little tale but nowhere near sufficient to explain the extent of our current malaise. We can throw some mud in the direction of politicians, but that is a little like shooting the messenger; they have only been dispensing the bread and circuses and pension and welfare benefits on the never-never that everybody has been clamouring for. The culprit we find the most culpable, and which draws all these disparate threads of blame into one cohesive narrative, is a fundamentally corrupt money system.
At this point, Keynesians and other economically retarded or wilfully ignorant financial onlookers typically have their eyes glaze over. But the frequency of repetition of the Austrian perspective does not make it any less true. To have a properly sound economy, one needs sound money. Everyone is for the former, but few can see the essential requirement for the latter.
Jörg Guido Hülsmann in his masterful The Ethics of Money Production lays out the historical facts. Money is useful because it replaces the messy inconvenience of barter.
In the history of mankind, a great variety of commodities – cattle, shells, nails, tobacco, cotton, copper, silver, gold, and so on – have been used as media of exchange. In the most developed societies, the precious metals have eventually been preferred to all other goods because their physical characteristics (scarcity, durability, divisibility, distinct look and sound, homogeneity through space and time, malleability and beauty) make them particularly suitable to serve in this function.
When a medium of exchange is generally accepted in society, it is called “money”. How does a commodity such as gold or silver turn into money? This happens through a gradual process, in the course of which more and more market participants, each for himself, decide to use gold and silver rather than other commodities in their indirect exchanges. Thus the historical selection of gold, silver and copper was not made through some sort of a social contract or convention. Rather, it resulted from the spontaneous convergence of many individual choices, a convergence that was prompted through the objective physical characteristics of the precious metals.
At this point, politicians and bankers should already be cringing. Precious metals have throughout history been adopted as money through free choice. Their adoption has never required the coercion of the state. Hülsmann points out that in no period of human history has unbacked paper money ever spontaneously emerged on the free market.
In all known historical cases, paper money has come into existence through government-sponsored breach of contract and other violations of private-property rights. It has never been a creature of the free market.
Hülsmann also points out, and this could not be more topical, that in a truly free market, paper money could not withstand the competition from the monetary metals; paper currency would ultimately be completely eradicated.
Of course we now operate under a fiat money system, in which money is given the dubious legitimacy it possesses by means of the power of the state. It is merely worth making the non- trivial observation that no unbacked paper currency has ever lasted. This observation is, of course, more poignant given current events in Europe.
The problem is made more acute, and global, by the fact that, as Chris Martenson points out, we operate with debt-backed money. At the local bank level, all new money is loaned into existence. At the central bank level, money is simply created out of thin air and then exchanged for interest- paying government debt. This next sentence should be read aloud, in an ominous tone:
Perpetual economic expansion is a requirement of modern banking
Not least, so that existing debts can continue to be serviced.
The problem of our age is that the level of global accumulated debt is so huge that it can never be paid back. Certainly, the austerity now being pursued in varying degrees across the western economies ensures that we will have insufficient economic growth to maintain debt service costs. The only question now is in what form much of the unpayable debt is repudiated – explicitly by outright default, or implicitly, by further money printing that is likely to spiral out of control.
The adjective ‘iatrogenic’ comes from the Greek ‘iatro’ (healer) and ‘genic’ (caused by): it refers to an illness caused by the doctor himself. And this is surely the way to describe the current policy prescriptions of our current monetary Doctors Frankenstein: the best way to “cure” an ailing economy is simply to pump more money in. This prescription ended up killing the Weimar patient and there is no reason to believe the experience will be any less painful this time around. Unfortunately, in the mythology of our current overly politicised economy, there can be no hard choices, so a series of soft options continues to be pursued until – like now – we are left with the hardest choices of all.
Fund manager Doug Noland of the Federated Prudent Bear Fund summarises the situation well:
The global credit crisis took giant leaps forward this week. With even the euro region’s depleted “core” succumbing, crisis dynamics are now anything but isolated to “periphery” markets and economies.. Problems at Europe’s “periphery” will not be easily resolved by German and French guarantees, Eurobonds, a leveraged bailout fund, the ECB, or the Chinese. The markets recognize there will be no quick fix, while worries mount that global finance and economies may be much less sound than earlier believed.. I don’t believe that the expanding nature of global market illiquidity is garnering the attention it deserves. And it’s difficult to envisage a scenario where the liquidity backdrop doesn’t continue to deteriorate. European banks are likely still in the early innings of their historic retrenchment. With financial implosion risk seemingly growing by the day, I fear an escalating crisis of confidence with respect to derivatives and counterparty issues. This is a major issue for global financial institutions and the vulnerable global leveraged speculating community.. I would not be surprised by some announcement of concerted international policymaker measures to bolster confidence in global market liquidity. The financial breakdown scenario is no longer outrageous. The global crisis has afflicted the core, with literally tens of trillions of sovereign debt and banking system liabilities now in the markets’ bad graces.
All of which should serve to remind us that money is far too important to be left to politicians. As the financial world edges ever closer to the brink, desperate investors are fleeing to all sorts of things in a crazy delusion of apparent safety. That US Treasury bonds (issued by a country with a national debt of $15 trillion) are among those ‘safe havens’ is a sign of just how far down the rabbit hole we have fallen. In the short term, the last true safe haven will see even its price, as expressed in unbacked paper money, oscillate uncomfortably. But given the perhaps existential severity of the global challenge, the one true money is now the only logical choice. And given the role of the banks as global plague-carriers, and politicians as their wing-men, it should offer particular comfort to investors that physical gold comes with zero counterparty or political risk.
This is a statement that has no basis in fact. Any rational analysis will quickly expose it to be a fallacy. Economic theory, economic history, and plain good old horse sense can demonstrate effortlessly that this statement is an illusion. Yet, it is today a widely held and deeply cherished illusion in the world of finance (and, incidentally, the world of politics). In fact, it has become one of the defining myths of the modern fiat money era. It has for decades provided portfolio managers and bankers with an imaginary refuge from the turbulent world of capitalist “creative destruction”, a ‘safe haven’ where their nerves and capital could rest. The ‘free lunch’ might not have been a feast – only the ‘risk-free rate’ was to be had – but it was better than nothing and anyway a welcome break from capitalism and entrepreneurship. And by the way, if you leverage your government bond portfolio sufficiently with the help of central-bank-provided, zero-cost fiat money, the returns could still be quite handsome.
The fate of myths is that they sooner or later clash with reality. Then they are exposed as myths, which requires a painful giving-up of beloved certainties, a readjustment of paradigms and an abrupt change in behaviour. This is what we have been witnessing in European sovereign bond markets and will soon observe outside Europe as well. To believe that this process would stop with Greece or even Italy, as seemed to be the consensus in the summer of 2011, was naïve. That it would stop with France or even be contained within the European Monetary Union is the present hope of government bond investors and government-bond issuers, i.e. politicians. It is equally naïve and it received a meaningful dent last week in form of the worst auction result for German government debt (Bunds) ever.
When the irrational belief that the major governments – those of the U.S., Germany, U.K., France, Japan – can and will always pay, regardless of the size of their overall obligations, and that their bonds are therefore ‘risk-free’, is finally being questioned, we could witness a momentous change in market behaviour. That this moment will be reached at some point is beyond doubt. I would argue that this moment could be sooner than many think.
Before we look at present events more closely and risk a peek into the future, let us revisit some of the fundamental facts of government bond investing.
Some basic facts about lending to the state
Government bonds are not backed by productive capital and will not be repaid out of capitalist production, at least not directly. Those who lend to the state do so in the expectation that the state, after consuming what it has borrowed right away, will repay its creditors by either taxing the productive section of society (i.e. those who have not put their money into ‘safe’ government bonds but risked it in a competitive enterprise and managed to generate a return by providing something of value to the buying public) or by printing the money and thereby taxing the fiat-money users in society (i.e. everybody) via a declining purchasing power of the monetary unit. Government bonds channel savings back into consumption, and they shift scarce resources away from employment that is directed by markets (and thus ultimately consumers) and into employment that is directed by politics. The rising public debt levels of the modern fiat money era indicate substantial and growing waste of resources and misallocation of capital, and are harbingers of great social and economic upheaval.
That banks and portfolio managers lend so generously to the state is not surprising as the cost of error (over-lending and over-borrowing) is apparently easily socialized across the wider public, either via higher levels of taxation or faster paper money debasement. “The state can always pay.”
The game is now up. The accumulated debt load has become too big to be serviced or repaid in any stable manner out of taxation or fiat money creation. If these mechanisms are nevertheless still employed it must lead to chaos.
Fact is this: Around the world government spending, budget deficits and accumulated debt loads are unsustainable in light of real underlying economic strength and the true available pool of private savings. But the modern welfare state cannot shrink. Nobody in the political machinery has any idea how it should be done. The fiat money economy is not built for deleveraging and the welfare democracy not for downsizing.
If you needed any further evidence of this you got it in spades last week. In the U.S. the ‘super-committee’ failed to reach agreement on spending cuts, and in the UK the Prime Minister admitted that the government was failing in its effort to reduce the debt load and announced various subsidies for the housing market, tax-funded bribes for companies to hire unemployed teenagers, and New Deal-style infrastructure projects to ‘kick start’ the economy.
The confused and pointless “Occupy Wall Street” movement seems to have brought to the forefront of public discussion again the notion that all of this could be sorted by taxing the rich. That this is even debated shows how little the public appreciates the sheer mind-boggling extravagance of the modern welfare-warfare state: In 2011 the U.S. government will have spent at least $3,700 billion while taking in about $2,200 billion, thus running an eye-watering $1.5 trillion deficit. It collects less than $1 trillion in income tax. Thus, even if the government doubled its intake from income taxation instantly it could not close the budget gap. The situation is completely out of control, and to those who believe that this is no problem because the U.S. government can always print the money, I can only say: Be careful what you wish for.
Beyond repair
But back to Europe, which continues to get most attention at the moment: As I said, long-held and cherished myths are not abandoned easily. The investment community has for months demanded ever more urgently a policy ‘bazooka’ that would restore the old order. Of course, by this is meant again the established mechanisms for repaying the lenders to the state: tax somebody else or print money. If the taxes needed to repay Greek and Italian debt could not be had from Greeks and Italians, then the Germans should pay as part of ‘fiscal integration’ or communal bond issuance. Or, the bond investors get repaid out of printed money from the ECB. “Unlimited bond-buying” via the printing press was the other bazooka.
Such proposals are unoriginal and illustrate that the gravity of the situation is not fully appreciated. Germany and France simply lack the resources to bailout the others, or even their own banks. As to the ECB’s printing press, as I explained here, ‘unlimited’ bond buying cannot be limited to Italy, which in itself would pose an enormous challenge. The overall size of the operation would soon be such that concerns about inflation must rise, and once real interest rates begin to go up deficits will expand even faster, forcing the ECB to buy ever more bonds. A spiral of ever higher real rates, more central bank bond buying, and in turn rising inflation expectations and even higher real interest rates is the classic fiat money endgame.
(At this point I often get the following comment: But what about Japan? Have they not been conducting QE for many years without a rise in inflation? — No! The Bank of Japan’s balance sheet is roughly the same size today as it was ten years ago. By contrast, since 2008, the balance sheets of the Fed, the Bank of England and the ECB have roughly tripled in size. For numerous reasons, Japan is a gigantic accident waiting to happen but in terms of monetary sanity the Japanese are presently the least mad.)
The political class, the fiat money bureaucracy and their eager creditors in the financial community have collectively checkmated themselves. Dreams of the policy ‘bazooka’ and the helpless babbling about ‘lack of political leadership’ cannot mask that sinking feeling that a lot of the ‘risk-free assets’ that have been carelessly accumulated over recent decades now turn out to be toxic waste that could burn a sizable hole into investment portfolios. Hiking taxes or printing the money is not a sensible solution but that does not mean it won’t be tried – it most certainly will be, and with predictably disastrous results. But here is the funny bit: if these are the potential outcomes of the European debt crisis: defaults, fiscal integration, unlimited helicopter money – why would anybody buy German Bunds? Did anybody really think that the ECB could print the entire European sovereign bond market to a sustainable 2 percent communal interest rate, or that in a fiscal union everybody converges on Germany’s 2 percent rate? Yet, for months and months now (until last week), the investment community has happily piled into German debt as the alleged ‘safe haven’. Why?
Mass psychosis
To explain this we have to resort to psychology. As I explained here, amateur psychology has no place in economic theory but it is often useful when trying to make sense of short-term market phenomena. Traders, bankers and investors simply didn’t want to give up the myth of the safe asset. Although the problems are essentially the same almost everywhere, the investment community did not want to believe that government bonds as such were a dodgy investment but only that certain government bonds were dodgy investments. Bizarrely, the realization of acute fiscal predicament in one state thus led to massive inflows into the bonds of other, only slightly less fiscally challenged states, which were then prematurely declared ‘safe havens’ precisely until their predicament was exposed as well. It almost appeared as one only had to wait for the tidal wave of fiscal concern to take one state after another out of the safe-haven basket into the basket of basket cases.
Talks of contagion risk, despite having a brief respite earlier this year, are back stronger than ever. With Italy dominating the news, the new risk is that a new European domino is threatening to topple the others over.
The authors find that over 80 percent of the total variance in the Eurozone CDS market can be explained by general Eurozone risk. This is a sharp increase from less than 60 percent at the beginning of the year. Their conclusion: “once again markets are bundling EZ members as one in terms of risk.”
Despite an earlier uncoupling of country-specific risks – especially those of Greece, Portugal and Ireland – the markets are once again pricing in a convergence of these countries´ risks relative to general CDS spreads. Stated differently, over the summer months these countries accounted for only small statistical portions of total CDS spreads. The tides have turned of late, with the result that these countries are increasingly affecting the general risk of the Eurozone market. Their conclusion: the risk of systemic contagion is increasing.
Finally, the two authors look at the correlation between the new contagion culprit de jour – Italy – and other Eurozone member states. The bilateral correlation between Italy and all countries (save Germany) is between 0.99 and 1. In other words, 5-year CDS spreads are moving in almost perfect lockstep between the affected European countries. The authors’ conclusion: little diversification can be achieved by investing in different Eurozone countries.
By all three measures the authors make the claim or allude to the conclusion that because markets are moving with high degrees of correlation, the risk of contagion is high. Such an analysis ignores the definition of what “contagion” means.
As I pointed out previously, contagion in the general sense (and also the financial sense) only occurs when one event affects an otherwise innocent bystander. Two questions arise. How do we know that the innocent bystander was actually affected by the “contagious” party? What would it take to be considered fully “innocent”?
The two authors in question actually answer the first question, at least as it pertains to Italy, claiming “Italy’s problems are homemade – contagion is a sideshow.” Indeed, Italy’s problems are more the result of unsustainable domestic policies coupled with weak growth then they have to do with contagion from Greece (or elsewhere). This in part explains why markets gave only the weakest rally with the exit of Berlusconi. The problems are largely already sunk, and it is now difficult to quickly revive growth or limit promised expenditures.
On the other hand, what does it take for one to be innocent, and thus susceptible to contagion. If I walk down the street, and someone with a contagious disease sneezes on me, I am surely the object of contagion. I had no connection to the individual prior to the event. Indeed, there was no way that I could have known that they were to sneeze on me (perhaps they did so only accidentally, but it would make no difference). But what if my friend with a communicable disease is bed-ridden at home, and so I decide to pay him a visit. By entering his sickly house I knowingly place myself at risk. When I return home and get sick there is no use in blaming my sick friend for my unfortunate health. I did it to myself.
The countries of Europe are sick, and the Eurozone as a whole is highly contagious. But there is no way that we can say that those parties inside the system are innocent. Holding Greek debt, or Italian debt, or bonds of a bank that holds these debts, these are all acts that remove your supposed ¨innocence¨. These are all activities that put you at risk because of the connection between the risky activity that you are undertaking, and the party that you are undertaking it with.
If I don’t want to get sick, I don’t enter my sick friend’s house. If I don’t want to be affected by the Eurozone’s sickness, I don’t invest in the guilty parties’ bonds. I also don’t associate with people who do so – banks, insurance companies, or investment funds.
By labeling the crisis as one of contagion, attention is drawn away from the real causes. Highly risky financing activities fueled by an easy-money credit policy over the last decade are now bearing their rotten fruits. Profligate European governments now find their revenues unable to cover their promised expenditures. There are specific causes to this crisis, and specific culpable parties. Chalking market misfortunes up to “contagion” risk obfuscates the true causes, and hinders meaningful analysis of workable solutions.
India in the last 20 years has started to reverse the Keynesian-inspired planning that clouded its growth since independence. A large part of this turnaround was driven by one of Hayek’s students at the LSE, B R Shenoy, whose ideas are now coming into fashion. It is interesting that as the West once more embraces the Keynesian policy options, the East is rejecting it.
This article in honour of Prof Shenoy was co-authored with B Chandrasekaran.
“An Indian will, on average, be twice as well off as his grandfather; a Korean 32 times” said Robert Lucas in a 1985 paper titled On the Mechanics of Economic Development. The Nobel laureate’s figures were based on the 1960-1980 period when India’s per capita income grew at 1.4% per year. In the period from 1992-2002, India’s per capita income grew at 3.7%, and from 2003 to 2010 it grew 6.9% – at this rate an Indian too will be 32 times better off than his grandfather.
August 2011 marks two decades since a high level committee—Narasimham Committee—was setup by government of India to initiate financial sector reforms. The deregulation recommendation by the Narasimham Committee went a long way in improving capital market efficiency – a key ingredient of economic growth. Ideas of free market economics, however, were not new to India. Long before 1991, Prof B R Shenoy had fought a lonely battle to promote free-exchange.
Shenoy warned India about the consequences of “central planning” twenty years before Jagdish Bhagwati and T N Srinivasan told us – in their 1975 book Foreign Trade Regimes and Economic Development: India – “that India’s foreign trade regime, in conjunction with domestic licensing policies in the industrial sector… impaired her economic performance”. Shenoy was the only Indian economist to write a Note of Dissent to the 2nd Nehru-Mahalanobis Five Year Plan (similar to the Soviet Gosplan). In the 1955 Note, Shenoy points out that the 2nd Plan “begins by prescribing the increase in national income which the Plan would set to achieve”. In other words, the plan begins with a certain growth rate and then goes about figuring out how to gather necessary savings. Shenoy says “the availability of real resources must be assessed first and the investment plan must match it”. This was at a time when Joan Robinson’s view that “It is the rate of investment which governs the rate of saving, and not vice versa” was in fashion.
The government of India and its economic advisors choose to reject Shenoy’s wise remarks. What followed was an unfortunate verification of Shenoy’s theoretical vision. The average per capita income growth for the first five 5-year plan periods was a meager 1.5%. Joseph Schumpeter in his 1910 essay on Leon Walras says “It has become long since manifest who was being judged when the Academie des Sciences Morales et Politiques rejected his work”. Perhaps the same can be said of the government of India’s rejection of Shenoy.
“Is there some action a government of India could take that would lead the Indian economy to grow like Indonesia’s or Egypt’s?” asked Robert Lucas in the mid 80s. In 1991 the government of India took some such actions. And the debate turned ideological, especially with the IMF’s condition-ridden package. Shenoy was the first economist of independent India to lucidly support free-market policies:
Efficient management of business and industrial concerns in a competitive market economy is a highly specialised function…best left to private entrepreneurs.
The reforms were greeted with skepticism at best and outright rejection at worst amongst India’s intellectual class. Arun Ghosh—in an August 1992 Economic and Political Weekly article titled One Year of Narasimha Rao Government: A Balance Sheet—declared “The Narasimha Rao government’s economic policies have not brought any promise of harmony and progress to the Indian economy.” Rather symbolically, the article was on the same page as an advertisement for the Hindi translation of a book titled The Russian Revolution by Rosa Luxemburg. Surprisingly, in the midst of the ideological battle of early 90s, Shenoy’s ideas were not resurrected for intellectual support. S B Mehta wrote in 2001 of events a decade earlier:
the then Finance Minister was criticized by many that we were mortgaging our sovereignty to IMF. This author wrote to him that he should declare that we were following the policy that Shenoy hinted for twenty long years…. No politician or economist, however, uttered the name of Shenoy… Thus, it seems, we neglected the sound advice of Shenoy during his life-time [and also] when our policies leaned more towards free market.
With his 1931 article in the Quarterly Journal of Economics, Shenoy became the first Indian economist to publish in leading scholarly journal. However, Shenoy is not just a scholar of the past; his ideas are of great relevance today. Take the debate on corruption, for instance. In February 1975, Shenoy delivered a lecture in Ahmedabad putting forward the thesis that interventionism is the root cause of corruption. And data backs his claim: Transparency International’s perception of corruption index and Heritage Foundation’s economic freedom index are strongly correlated. The 10 least corrupt countries have an average economic freedom index rank of 11, while the average for 10 most corrupt countries is 163!
Shenoy choose to be “right in a minority of one”. As India marks two decades of economic reforms, it is time classical liberals come forward to institutionalize B R Shenoy’s ideas. They say that VKRK Rao, a prominent post-independence Indian economist, “strode like a Colossus over the Social Science disciplines”. He established four institutions: the Delhi School of Economics, the Institute of Economic Growth, the Indian Council of Social Science Research, and the Institute for Social and Economic Change. Shenoy established none. The difference was at least partly because of their respective economic views. Rao was awarded his PhD in 1937 from Cambridge and was a student of Keynes. Shenoy was from the London School of Economics and was highly influenced by the then ‘new’ ideas of F A Hayek. Naturally the government of India loved Rao – a necessary prerequisite for establishing institutions in Gosplan India.
The first round of economic reforms was a matter of necessity, but India still ranks 124 in Heritage Foundation’s 2011 Economic Freedom Index. Hopefully the much-needed second round of reforms will be a matter of choice. And a reform by choice will come only if India has institutions promoting ideas of B R Shenoy. In the long run, ideas must either take the form of institutions or die. And as to the question of where to begin, a chair at the Delhi School of Economics might be a good place.
Britain’s economy is on the brink of recession after barely growing in the last year and it faces acute risks from the debt crisis in the eurozone, its biggest trading partner. Critics of the ruling coalition say budget restraint is to blame for the malaise but just how much spending has been cut?
Opposition leader Ed Miliband, suddenly concerned about the deficit, urged the government to change direction “for the sake of the country” last week. “Austerity at home, collective austerity abroad is no solution to the problems of jobs, growth or the deficit,” he said. To stir job creation, the socialist urged immediate stimulus measures, including tax cuts. Imagine that.
The reality is that Britain can’t afford it. Its deficit it still as big as Greece’s while government spending accounts for half of gross domestic product. Total public sector spending, in real terms, is almost 4 percent higher this year than it was in 2009, Labour’s final full year in power.
When the Conservatives and Liberal-Democrats engaged in a coalition last year, accountants at PricewaterhouseCoopers estimated that “Britain would have to make across the board budget cuts of 5 percent a year to come close to cutting the deficit in half by 2014.” They even assumed a slight economic upturn that’s unlikely to materialize due to Britain’s high energy costs and the spiraling debt crisis in Europe.
Prime Minister David Cameron recognizes that too often, government is what’s standing in the way between entrepreneurs and wealth growth. He has vowed to fight the “enemies of enterprise” and cut regulations but one out of five Britons is still employed by his government. The top income tax rate is 50 percent and the level of government debt, though ambiguous, is eye watering.
Officially, Britain’s debt stands at roughly 62 percent of GDP or nearly £1 trillion but that doesn’t include its huge pension liabilities. When factored in, according to the Treasury, Britain’s actual debt equals 173 percent of GDP. According to independent analysis, it could be double that number.
Meanwhile, the Bank of England has been injecting some £275 billion into the economy, corresponding to nearly 20 percent of GDP, in monetary stimulus. This policy David Cameron has explicitly endorsed. He ruled out fiscal stimulus this summer, saying that no country can afford it anymore. “They have all run out of money.” So the answer is printing more of it?
The only sensible policy is for the central bank to stop the printing presses—which not only undo the very modest pay increases that Britons still enjoy but exacerbate the credit dislocations that were at the heart of the financial crisis—and for the government to start cutting red tape as well as future pension commitments to simultaneously encourage private sector investment and shore up public sector finances.
That’s what austerity would look like. The half-hearted “conservative” policy that Britain has now is not enough.
Jan Skoyles recently brought our attention to an upcoming documentary called The Four Horsemen, which promises that 23 people will “break their silence and explain how the world really works”.
Cobden Centre readers will recognise many of the 23 (including some who haven’t exactly been reticent in the past):
Hugo Salinas-Price, James Turk and David Morgan are among the gold and silver bugs, whilst Gillian Tett and Max Keiser represent the market commentators and economists such as Joseph Stiglitz and Professor Michael Hudson represent the academia. But it is not just the ‘usual’ suspects who appear in this film; Noam Chomsky and Camila Batmangelidjh are examples of individuals whose viewpoints of the world from a social and human perspective are respected by governments and individuals all over the world.
Jan’s article highlights some memorable quotes from the trailer.
Gillian Tett, Assistant Editor at the FT, speaks candidly:
Most societies have an elite, and the elite try and stay in power. [They do this by] controlling the cognitive map – the way we think
Prof. Herman Daly, a former Senior Economist at the World Bank, says:
People are beginning to get angry, but not nearly angry enough
It’ll be interesting to see how it turns out, but this first glimpse looks promising.
I recently wrote about the inconsistency of the economic arguments for the formation of the Eurozone. The conclusion that the euro was oversold at inception leads us to conclude that calls to save it are also oversold. If the economic considerations for the Eurozone are misguided at best, let’s see if the political arguments fare any better.
The European monetary system existed in various forms for decades prior to the euro. It bred its own instabilities across the continent throughout these decades. Existing as a complex web of fixed exchange rates, continual readjustments caused an uncertainty as to what values one could expect their cross-border costs and benefits to be worth in the future. Germany, the largest and most fiscally conservative country in Europe, was long seen as overemphasized under these conditions – smaller and less fiscally and monetarily responsible countries were under constant subordination to a highly valued Deutschmark.
The creation of the Eurozone would serve four political ends:
The single currency would offer greater integration.
The increased mobility of capital removed most of the gains from pegging exchange rates (and that brought about many losses if these pegs were abandoned).
The Maastricht Treaty, that key Treaty governing debts and deficits, would promote political stability
Germany would no longer be overemphasized as an economy, and political rivalries of the past would be diminished.
It is difficult to see any of these political goals being achieved.
While the single currency may have promoted greater integration among goods transfers within Europe, there is no real evidence that this has resulted in greater integration where it really matters for most Europeans – in the labour market. Further goods market integration does not transfer immediately to labour market integration, and as this recession makes clear, the labour market is what the unemployed masses are most concerned with. (Indeed, as I made clear in my last article, labour market integration is a criterion for forming a currency union, not an expected result thereof.)
The Maastricht Treaty originally set limits on debts and deficits that European governments could incur – 60% of GDP for the former, and 3% of GDP for the latter. It also set strict inflation and exchange rate criteria for potential member countries to maintain prior to admission to the Eurozone. While these rules create political stability in the sense that they constrain the fiscal policies of the member countries, they have famously been abandoned. Indeed, Germany – the role model for European financial conservatism – was the first country to break the Maastricht Treaty. It has since become laughable. Ireland ran a budget deficit of over 30% of GDP last year. Several member states run public debt-to-GDP ratios of more than 100%. Only Finland continues to abide by these rules (with the Netherlands coming very close).
When rules are thrown out the window, discretion reigns. When discretion reigns – especially 17 different types of discretion, one for each country using the euro – the uncertainty inherent for the euro-using community soars. In a similar application, Bob Higgs famously argued that “regime uncertainty” prolonged America’s Great Depression. Many entrepreneurs and investors sat on the sidelines, unsure of the future state of the regulatory and tax environment of Depression-era America.
A similar atmosphere exists in the Eurozone today, except in a more extreme form. It is not only the business community that is hesitant to undertake new ventures; it is anyone using the euro as a currency. This includes not only European entrepreneurs, but also European consumers and interested foreign parties. Instead of providing the political stability promised by the euro promoters, we are now witnessing one of the most extreme periods of instability and uncertainty of the modern era.
Finally, the shift from the Exchange Rate Mechanism to the euro was supposed to end a period of German dominance. European countries – especially Southern European countries – were continually constrained in their fiscal and monetary policies under the ERM. As the continent was linked via a complex of fixed exchange rates, disparate inflation rates vis-à-vis the largest economy – Germany – resulted in continual strain on the individual central banks. Readjustments, commonly in the form of devaluations, became the norm. Germany implicitly set the interest rate and fiscal policy for Europe. If a European country veered from these norms, its exchange rate would come under pressure, and would have to be reset when the central bank was unable to defend it.
The European Central Bank was set up as an attempt to remove this German dominance. Now instead of being subordinate to the Bundesbank, European governments would have an equal say in how monetary affairs were to be run. For a period this was true. Indeed, one could argue that Germany became subordinate to the rest of Europe under the monetary regime of the ECB (as Philipp Bagus argues in his book The Tragedy of the Euro).
It is increasingly becoming clear that few member states are equals to Germany in the Eurozone. No good deed goes unpunished. The heavily German-funded bailouts of several Eurozone economies to date have been met with indignation. As the saying goes in Ireland, “We serve neither King nor Kaiser.”
To briefly recap, none of the four pre-euro arguments for the common currency stand the test of time. Two of them (greater capital and labour mobility, and increased integration) were actually criteria to be met prior to forming a currency union, not results to expect after. The other two – increased political stability and decreased German dominance – are being reversed with every passing day.
The great European experiment of currency integration has failed to meet any of the economic and political goals set prior to its formation. Perhaps it is time to admit the error, and stop trying to salvage a broken system.
I’m absolutely convinced that this system will collapse. Nobody can say when we will reach the endpoint, but I think in the next two to five years some big things will happen. That is a judgement call and needs to be distinguished from the fact that fully elastic fiat money is – on a conceptual level – suboptimal, inherently unstable and ultimately unsustainable.
Historically all paper money systems have collapsed. For 900 years they all ended in failure. There is either a voluntary return to commodity money, apolitical money that is not under government control (Britain in 1821, the US in 1879, the Ming dynasty in the fifteenth century), or you keep printing and ultimately suffer inflationary breakdown (US continentals in 1781, French assignats in 1803, German reichsmarks in 1923, and many others).
European monetary integration relies on the theory of the optimal currency area (OCA). Successful currency unions generally meet four criteria:
A high degree of economic integration exists within the region
Prices (and wages) are sufficiently flexible
Places within the region are exposed to symmetric shocks
There exists a risk-sharing agreement (i.e., directed fiscal policy) for the region
A region fulfilling these four criteria makes a prime candidate because one monetary policy will be able to combat the root shock affecting the economy, with factor mobility and price flexibility reallocating resources to where they can be more fully utilized. The cost of joining is the sacrifice of an independent monetary policy. Instead of the Bank of Spain or the Bundesbank directing monetary policy for Spain or Germany, the European Central Bank does so for all included countries. As long as all included countries face the same shock, or provided that factor mobility is sufficiently high to easily reallocate resources, this unique monetary policy should be (according to the theory) adequate to combat any ensuing crisis.
While the effectiveness of monetary policy in mitigating adverse shocks is certainly not without its own controversy, for our purposes we will take the theory on its own merits and judge its outcomes accordingly. Importantly, the fourth criterion becomes a caveat on the others – only in circumstances of low factor mobility, price rigidity or asymmetric shocks will fiscal agreements and transfers payments be necessary to stave off recession. Hence, OCA theory states that targeting fiscal policy will only be necessary if these criteria are not met. In other words, if a country is not an optimal currency area.
The euro was originally sold as an economic enhancement to certain European countries. The costs of trade (through direct exchange costs and uncertainties) of having multiple currencies across the continent made at least some European countries candidates for currency union inclusion. While this cost reduction would be beneficial, inclusion in the currency union would only be net beneficial if the cost of joining a currency union was lower than the resultant benefits.
Against these criteria, how does the Eurozone fare?
Cross-border trade is quite high within Europe, so capital mobility is consequently high. The Treaty of Rome was passed in 1957 to liberate the mobility of goods, services, labour and financial capital across European borders. One would consequently believe that capital flows within the European continent are high, and by and large they are.
Labour mobility is a different issue. While freedom to movement is a key principle of European integration, there are inherent features of the labour market that make it quite rigid. Language differences are the most obvious difficulty to labour reallocations, but cultural differences also abound. An unemployed Spaniard does not just move to the Netherlands to find work (an unemployed Spaniard might not even move from his home province to another region of Spain to find work, but that is another question).
Is the Eurozone exposed to similar shocks? In a broad sense one can say that today’s crisis has homogeneous roots across the continent. Yet with the Dutch economy still performing well with the PIIGS in full depression, it is difficult to say that this is the case. One significant factor is the euro itself. One currency for the zone implies one currency value for the whole zone. The euro trades for the same price in Germany as it does in Greece. This would not be problem if prices were flexible. If Greek prices (and especially wages) were sufficiently downward flexible, an overvalued euro would see real prices equilibrated with the rest of the zone through nominal Greek price declines. This is not the case.
Southern European economies famously suffer from an overvalued euro, inhibiting their abilities to create export growth to escape the crisis. Germany, in contrast, is quite possibly exposed to an undervalued euro, resulting in a large net export position. While the euro may be more or less fairly valued for the whole region – net exports for the euro zone are about zero – for any specific component country this may not be the case.
Having a risk-sharing agreement for a currency area is effectively a caveat for when asymmetric shocks occur. In the Eurozone, fiscal agreements were only loosely defined at the euro’s inception. While transfer payments from high to low income European countries were fairly noncontroversial during the boom, as budgets are strained during this recession there is considerably more animosity towards the idea. Indeed, given the perverse incentives facing transfer payment recipients, it is not clear that increased risk-sharing is a desirable alternative. Indeed, Germany pushed for the Stability and Growth Pact to diminish reliance on fiscal transfers for this very reason.
Lacking flexible prices and labor or symmetric shocks, it is difficult to make the case that Europe is an optimal currency area. While this is becoming apparent in this recession, a proper reassessment of the “optimality” of the currency union is hard to come by. In other words, maybe we should be asking if the Eurozone was oversold to us.
In response, calls for fiscal consolidation are becoming increasingly common. If Europe’s woes cannot be solved by one blanket monetary policy, and some countries lack the resources to enact appropriate fiscal responses to stave off recession, other member states should chip in to save their less-fortunate neighbours.
This approach confuses what the criteria for a currency union are with whether it should exist in its present form or not.
If the criteria for the currency union were correctly met, such targeted fiscal policy would be unnecessary. Resources would be automatically reallocated as prices adjust to make this possible. Fiscal consolidation within Europe does nothing to promote such reallocations. Indeed, it could well inhibit it. German transfer payments to Greece in the current crisis remove the incentive Greeks have to reduce their prices downward to regain competitiveness. It also removes the incentives for Greeks to migrate to other Eurozone areas to find employment.
As this current recession progresses, instead of focusing attention on how to save the existing currency union, perhaps time would be better spent reviewing the initial arguments for its formation. The Eurozone was oversold at inception, the painful economic results of which are now all too obvious.
In the next article of this two-part series, we will look at the political arguments for currency integration, and see if they have fared any better than these economic arguments.
There have been many books attempting to find and explain the causes of the ongoing financial crisis. Authors have approached the issue from all sorts of ideological perspectives and with different sets of evidence. Most of these works are lacking, incomplete, or even flat-out wrong. Many of them do not even care for the facts, instead using vague generalizations to justify the application of broad economic theories. There has not, until recently, really been a meticulous analysis of the mechanics of the causes of the Great Recession, despite the enormous interest displayed by the economics profession in the subject.
This lacuna has been filled by Jeffrey Friedman, editor of Critical Review, and Wladimir Kraus, in their recently published book: Engineering the Financial Crisis. The authors make the purpose of their study evident from the very beginning. They shed themselves of any ideological priors which may have otherwise impaired their analysis, even going as far as to disprove a number of general theories from either side of the spectrum (insufficient regulation versus insufficient economic freedom), and task themselves simply with accumulating, analyzing, and interpreting the evidence. The data they look at has to do with the regulations which governed the financial institutions that presided over the network of financial instruments which suddenly lost the bulk of their value. The question they ask is a simple one: based on the facts, was the recession caused by under-regulation or was it something in the regulation itself which may have influenced the ways banks invested?
Friedman and Kraus give reason to believe that it was the latter — perverse regulations — which gave way to the great contraction which took place between 2007 and 2009. Looking through the relevant legislature which dictates the laws governing the banking industry, the authors find that it was this regulatory web which led banks to invest in the specific financial assets that would soon after be deemed nearly worthless.
Friedman and Kraus emphasize the importance of the fact that the banking industry had no idea — what they call “radical ignorance” — about just what kind of quagmire they were investing themselves into. They use evidence to illustrate the fact that, predominately speaking, the bankers, regulators, politicians, and other major actors in this crisis had absolutely no idea of the relevant potential for a recession to occur, let alone that the highly rated assets they invested into would soon become relatively valueless.
We can see now the broad thesis of Engineering the Financial Crisis. Bankers did not buy large amounts of soon-to-be “toxics assets” because the risk had been externalized to the taxpayer. [1] Neither is their any evidence suggesting that bankers purposefully ignored high risk in favor of pursuing high profits. The majority of assets purchased were actually AAA rated, and because of this the risk-load they carried, as perceived at the time of purchase, was relatively low. What manipulated the relevant price signals which funneled investment into the housing market were regulations which rewarded these type of investments. To a lesser extent, the authors also point at government programmes which pushed for house ownership and the relatively low rates of interest on new loans which made borrowing seemingly more affordable.
Leading up to the crisis, bankers were generally very risk sensitive, preferring assets with lower revenue returns. Roughly 93 percent of mortgage bonds held by U.S. Commercial banks were AAA-rated mortgage backed securities (both private label [PLMBS] and agency rated [MBS]), and almost another 7 percent were AAA-rated collectivized debt obligations (CDO). [2] Missing from this collection of assets were any mortgage bonds rated less than AAA, which were usually the bonds which the highest rate of return.
Most commercial banks in the United States were also above their legal capital reserve minimum on the eve of the financial crisis — the twenty largest banks held capital levels averaging 11.7 percent, where the legal minimum was 10 percent of a bank’s total assets (as dictated by the Federal law, whereas the Basel I accords had set it at 8 percent). More specifically, if one only accounts for “Tier 1” capital [3] banks retained a capital cushion of 50 percent, even while federal law required a minimum of 5%. In other words, most banks opted to retain a substantial capital cushion, where one would expect a bank interested in maximizing profit (while ignoring risk) to push the boundaries of its legal requirements. [4]
The issue, then, was not about bankers with low risk aversion, seeking high profits by investing mostly in high-risk assets. The evidence suggests quite the contrary. U.S. commercial banks invested in what were perceived as low-risk, low-return assets, and on top of this held higher than required capital cushions. Also going out the window is the “too big to fail” theory, or any other case that argues that it was risk externalization which created an incentive for an over-concentration of investment into the mortgage market. Simply put, there was a high aversion to risk during the years leading up to the crisis.
Friedman’s and Kraus’ explanation of what caused the crisis can be divided into two parts: what caused the over-concentration of investment into mortgage-backed securities and why these securities, which by 2008 had lost the majority of their value, had been rated so highly by the major rating agencies. The strength of their book is found in its accounting of the first — what led to the pattern of investment that characterized U.S. commercial bank assets prior to the recession.
Because different types of investments generally have different degrees of risk, a capital requirement minimum that encompasses all assets is illogical. Rather, it makes more sense to create different capital reserve requirements for different sorts of investments, based on the general perceived riskiness of the different types. The Basel I accord was an attempt to correct the issues of a homogenous treatment of assets by creating different categories and attaching a capital reserve minimum to each category. Higher risk assets, therefore, were categorized into higher “risk buckets” and required a greater capital cushion. In other words, the greater the risk the asset carried, the more it cost the banks to protect against, by reducing the amount of capital available to invest.
The issue, as explained by Friedman and Kraus, is that these regulations led to “regulatory arbitrage”. For example, a bank could invest into mortgage bonds with a risk-weight of 50 percent, then re-sell these bonds to a government sponsored enterprise (such as Freddie Mac and Fannie Mae), and buy them back as an agency bond. These agency bonds were risk-weighted at 20 percent, effectively reducing the capital cushion necessary to back the asset, even though the composition of the asset remained exactly the same. The Basel regulations made it more expensive to issue business loans than home loans, creating a financial incentive to issue more home loans. Basel I created incentives for banks to make certain types of loans and then securitize them.
A further boon to securitization came with the adoption of the Recourse Rule, which borrowed the Basel II accord’s method of rating privately issued securitized assets by risk. This system caused banks to increase investment in AAA-rated securitized mortgage bonds, especially since the risk-weight of unsecuritized mortgages remained at 50 percent (as dictated by Basel I). It remained cheaper to invest in mortgages, rather than other types of loans to consumers and businessmen, and then banks could further increase profitability by securitizing these mortgages and releasing part of their capital reserves for further investments. This explains the concentration of investment in mortgage backed securities.
We see a pattern between 2001 and 2007 of an increase in housing loans and investment into mortgage backed securities. We know that at the time these types of investments being made were being pooled into buckets which were considered generally less risky than other forms of investment. It was not an issue, therefore, of carrying on more risk. In fact, this pattern of investment was created out of the fact that the regulations incentivized purchase of less risky assets. The problem which led to the financial collapse, therefore, deals exclusively with the fact that these assets carried more risk than was originally perceived by the regulators (and banks). In fact, the collapse of the subprime mortgage market came as a total surprise, both for the bankers and the regulators.
It was not just the architecture of the impending financial collapse that the regulatory web was responsible for, but also the magnification of the disaster. Thanks to the capital reserve minima, many banks faced insolvency even though the circumstances did not really call for it. In order to remain legally solvent, U.S. banks are forced to maintain a certain capital reserve minimum. As the crisis unfolded, bonds which had been previously rated at AAA were suddenly downgraded, raising the necessary capital reserve minima for each risk-bucket. In other words, as ratings fell for different types of bonds, banks were suddenly forced to raise new capital to cover their loss.
Furthermore, regulations forced banks to mark-to-market their assets to reveal their “true value”. This process was not done on an individual basis; rather, different bonds were lumped together and them marked-to-market as a group. So, even individual bonds which may have not actually lost value were readjusted on a bank’s balance sheet as assets that were suddenly worth less than had been perceived prior to the crisis. It was on the basis of these new market values that a bank’s solvency was judged. The issue is that by late 2009 many of these same bonds had recuperated much of their value, and so a bank that had been legally insolvent in early 2008 may not have been two years later. In other words, many banks were forced into insolvency that could have survived the crisis, and other banks had to radically contract outstanding liabilities in order to remain solvent.
The consequence of these regulatory restrictions was a giant credit contraction — much larger than was actually necessary. And, of course, the monetary contraction only worsened the situation, as it reduced the financial viability of the various investments that depended on this credit.
Friedman and Kraus blame the inadequate rating of mortgage bonds on the cartelization of the major rating agencies — Moody’s, Standard & Poor’s (S&P), and Fitch. Basel II and the Recourse Rule had effectively tied their capital reserve requirements to the ratings provided by these three agencies. It was these three rating agencies that had been classified as Nationally Recognized Statistical Rating Organizations by the Securities and Exchange Commission (SEC) in 1975, and the various regulations that relied on risk ratings depended exclusively on this cartel. None of the three “nationally recognized” rating agencies, furthermore, had accounted for the possibility of a nationwide hosing crisis leading up to 2008.
There were private rating agencies, though, that had recognized the potential for crisis. According to Friedman and Kraus one such company was First Pacific Advisors, which sold its $1.85 billion investment in mortgage-backed bonds in late 2005.
Friedman’s and Kraus’ analysis hinges on the notion that what was ultimately at fault were these rating agencies. Had they been more accurate in their risk assessments then banks would not have malinvested in so many mortgage-backed bonds. But, why had the banks relied exclusively on the risk-assessment provided by the three “nationally recognized” agencies? Were these banks not aware of the risk assessments being made by private investment companies?
Perhaps the authors put too much weight on the notion that it was this cartelization of the rating agencies which made possible the crisis, and that had there been more competition in this industry the recession may have been less destructive than it turned out to be. But, Friedman and Kraus do not make clear exactly how many private agencies had foreseen the crisis. Few investors sold off their mortgage-backed bonds in anticipation of a market crash. Indeed, the majority of investors were still fairly confident in the strength of the housing market.
Here is where the explanation of the crisis becomes more detached from the data. Friedman and Kraus leave room for further interpretation, since their explanation for why the different bonds were assessed as they were comes off as inadequate (or, at least, incomplete). Understandably, they are looking to separate themselves from ideology — even though the book’s conclusions are extremely pro-market — and thus avoid applying far-reaching theories to the evidence they were able to collect
However, that there is still room for further interpretation is not necessarily a bad thing. As far as their analysis on the impact of regulations on the housing boom and the consequent financial crisis goes, it is difficult to refute. That there is still room for the application of theory means that their empirical findings can easily be assimilated into grander explanations of the financial crisis.
For the task it sets out to accomplish, Engineering the Financial Crisis is undoubtedly one of the best books written yet on the causes of the Great Recession. Jeffrey Friedman and Wladimir Kraus painstakingly dig through the data to provide a solid picture of why there was such an overconcentration of investment in the mortgage market. The evidence clearly shows that it was the web of regulation on the banking industry that shaped the structure of banking investment by favoring certain investments over others. The entire system collapsed when it turned out that these regulations had depended on agency assessments that had totally miscalculated the risk these favoured assets carried. Thus, banks had loaded themselves up with mortgage backed bonds, completely unaware of the fact that these bonds would soon be relatively valueless. It was not the market which caused the crisis, rather the distortions to the market that were created by government intervention.
[1] That banks did not buy mortgage-backed securities and other similar assets because the bankers knew that there was no risk for them is a very specific claim, and it does not include many banking practices which are undertaken because of risk externalization (such as the extent of fiduciary expansion, which in our present banking system is a product of its cartelization under the Federal Reserve System).
[3] Basel I divides bank capital by the type of asset, Type I being the safest pool. Type I is composed of “funds received from sales of common equity shares and from retained earnings.” Ibid., p. 40.
[4] A capital reserve basically allows banks to take losses, since it gives it a cushion of assets it can capitalize on to make up for net losses (before liabilities exceed assets).
