It might seem like yesterday to some but it was already in 2009 that politicians in Europe began to talk about ‘austerity’, a concept that quickly became the new black in European political fashion. In brief, austerity in Europe is based on the idea that the accumulated sovereign debts are now dangerously large and need to be reduced by some combination of temporary (so they claim) tax increases and spending cuts. Once the debt is reduced to a more manageable level, so the thinking goes, taxes can be cut and spending restored to the previous level.
Sounds oh-so reasonable now, doesn’t it? The problem is, however, it isn’t working. As we approach the end of 2012, in every instance of austerity being applied, economic growth is weaker and government deficits higher than projected, the result being that the accumulated debt burdens continue to grow. Indeed, they are growing more rapidly than prior to the onset of austerity!
Now one key reason for this is that, concerned about the dire state of the economies in question, the financial markets have dramatically driven up their governments’ borrowing costs. Private sector investors seem unwilling to underwrite the risk that austerity might not work. To a small extent, the European Central Bank (ECB) has stepped in to fill the funding gap, purchasing selective clips of bonds from distressed euro-area governments, but this provides only temporary support.
The simple math of the matter is that unless borrowing costs fall substantially, austerity will fail. But how to bring down borrowing costs when private investors are not convinced austerity is going to work? Why, have the ECB take a much larger role. Hence the showdown between the German Bundesbank, opposed to open-ended bank and sovereign bail-outs, and, well, just about every euro-area politician, policy maker and Eurocrat involved. Let’s briefly explore this important tangent.
AUFTRITT DER UNBEUGSAME WEIDMANN
(ENTER THE UNYIELDING WEIDMANN)
To outside observers, this situation may seem rather odd. Following the introduction of the euro, the Bundesbank ceded power over German monetary policy and, by extension of the German mark’s previous role as anchor currency, over euro-area monetary policy as well. (The Bundesbank retains an important regulatory and supervisory role with respect to German financial institutions.) So how is it, exactly, that the Bundesbank is somehow in a position to resist what has now become a near universal euro-area march toward some form of debt monetisation?
Well, as it happens, the German public hold the Bundesbank in rather high regard. Most Germans recall how the Bundesbank long presided over Europe’s largest economy, maintaining price stability and fostering a sustained relative economic outperformance. Many Germans probably recall how, on multiple occasions, the Bundesbank successfully resisted inflationary government policy initiatives. Older Germans recall how the Bundesbank contributed to the Wirtschaftswunder (economic miracle) of the 1950s and 1960s. And Germans know that the ECB was supposedly modelled on the Bundesbank and the euro on the German mark.
So when the Bundesbank speaks, Germans listen. And when the Bundesbank voices concern over ECB or German government policy, Germans become concerned. And so it is today. It has been widely reported in the German press that Bundesbank President Jens Weidmann has threatened to resign at least once in protest over potential German government participation in inflationary bail outs of distressed euro-area banks and governments. Apparently Chancellor Merkel has pleaded for Weidmann to remain at the helm and so far she has succeeded. 
But what if she should fail? What if Weidmann does indeed resign in protest at some point? His former colleagues Axel Weber and Juergen Stark have already done so (In Stark’s case, from the ECB, not the Bundesbank). What if some of his Bundesbank board colleagues join him?
I can’t emphasise this point enough: The institution of the Bundesbank is held in such high regard among the German public that should Weidmann and any portion of his colleagues resign in formal protest of bailouts in whatever form, it may well bring down the German government, throw any bailout arrangement into complete chaos, spark a huge rout in distressed euro-area sovereign and bank debt and quite possibly result in a partial or even complete breakup of the euro-area. The Bundesbank thus represents the normally unseen foundation on which the entire euro project rests. Should it remove its support, it may all come crashing down.
But why would the Bundesbank ever do such a thing? Isn’t it just a bureaucracy like any other, expected to serve the government? Well, no. Consider the unique role of the Bundesbank under German Law. It is not answerable to the government. It is its own regulator. Its board members are appointed by the president—the head of state—not the chancellor, the head of the government. Its employees are sworn to secrecy during both their active service and in retirement. The Bundesbank alone determines whether its employees have infringed its code of conduct and determines what disciplinary actions, if any, should be taken.
Weidmann’s intransigence is thus entirely in line with German law and tradition. The Bundesbank, by design, will confront the government if it believes that such action is necessary to carry out its mandate. And what is that mandate? As per the original Bundesbank Act, “The preservation of the value of German currency.” Previously the mark, the euro is now the German currency and the Bundesbank’s mandate is to preserve its value. Needless to say, open-ended bailouts of euro-area banks and sovereign countries would, without question, threaten that value.
You can be certain that when President Weidmann said earlier this year that what was being proposed by the ECB “violated its mandate,” he chose his words very, very carefully. In a subsequent speech on the same topic, he quoted from Goethe’s Faust, arguably the most famous play in German literature and a classic warning against hubris and temptation. You don’t do that if you are not deadly serious. The implication, no doubt, is that Weidmann is sending a message that the Bundesbank is independent of the ECB with respect to determining whether or not ECB policies are consistent with “the preservation of the value of German currency,” which now happens to be the euro. The Bundesbank has thus re-assumed this dormant but ultimate power over German monetary policy. Under just what circumstances it will choose to exercise it, I don’t know, but if the German and other euro-area governments continue along the road to bailouts, it will almost certainly happen at some point, presenting the greatest challenge yet to the sustainability of EMU in its current form.
WHY ‘AUSTERITY’ DOESN’T WORK
As mentioned earlier, austerity isn’t working, in many countries largely because borrowing costs are not declining. But if austerity were credible, they would. What is it about austerity as implemented that is failing to win over bond investors?
I have some ideas. First, note that, so far at least, austerity in practice is more about tax increases than spending cuts. However, the countries in question are already among the most highly taxed in the world. As Arthur Laffer and others have suggested in theory and has often been observed in practice, beyond a certain point, tax increases not only fail to generate additional revenue but actually reduce it. (It so happens that the Scandinavian debt crisis of the early 1990s was addressed not with tax increases but with tax cuts, as well as spending cuts. Rapid growth followed, although for a variety of reasons including substantial currency devaluation.)
Second, consider that the countries in question have enormous accumulated debt burdens, in some cases previously disguised and underreported. Cooking the books does not instill investor confidence. Yet paying down such a large debt mountain is going to take a long, long time. Today’s investors need to trust not only today’s politicians, but their successors down the road, to make good on promises that will remain subject to political opportunism and expedience for many years.
Third, governments may talk a good game but can they walk the walk? A close look at European ‘austerity’ legislation reveals that actual spending cuts are few and far between. What is being proposed in most cases is that the rate of spending increases declines. But an increase is still an increase and absent healthy economic growth needs to be financed with, you guessed it, more debt. Investors may want to see real rather than ‘faux’ austerity before accepting lower debt yields.
Fourth, let’s consider the possibility that what investors are really interested in is not some accounting plan that looks nice on paper, assuming governments can rein in runaway spending, but rather a more comprehensive plan that fundamentally reforms economies, making them more flexible and competitive. If growth is not to be provided by deficit spending—the traditional welfare state model—it must be provided by an unsubsidised private sector. If an economy lacks capital or skilled workers, or taxes either labour or capital at too high a rate, it is not going to be able to grow and pay down debt. Such fundamental reform remains essentially off the table in the austerity plans discussed to date.
Finally, let’s turn to a technical but extremely important point, namely, how austerity as observed in practice adds further evidence to the already substantial pile demonstrating that the dominant neo-Keynesian paradigm held by the economic policy mainstream is itself deeply flawed.
INCONVENIENT MULTIPLIER MATHS
The difficulties with austerity go beyond merely placating the bond markets. The fact is, a large debt burden is a huge economic problem. Sure it is preferable to be able to finance the debt at low rates, but if you want to pay it down you must divert resources from elsewhere. That is going to be painful at any interest rate. But such are the political pressures on the modern welfare state that the accumulation of an excessive, unserviceable debt over time is a near certainty.
Why should this be so? Well, back in the days before the modern welfare, or ‘nanny’ state, politicians didn’t pretend to have solutions for everything. If you were overweight, it was your problem. If your kids didn’t learn basic reading, writing and numeracy, at home or at school, it was their problem. With the growth of the welfare state, however, more of your problems become politicians’ problems and, by extension, those of the taxpayers who must provide the funds for the ‘solutions’.
As the tax burden grows over time, however, taxpayers gradually begin to resist tax increases. In practice, this has resulted in the welfare states steadily accumulating debt, as taxpayers have repeatedly refused to pay the high rates of tax up front to finance the welfare policies in question.
In many welfare states, the average taxpayer is a major receiver of benefits, including publicly provided heathcare and education. Taxpayers in welfare states are suffering a collective ‘tragedy of the commons’, in which each tries to extract maximum benefit for minimum cost. The result is a steadily accumulating debt, representing that portion of welfare not covered by current tax revenues.
The dangers of an accumulating debt can be disguised, however, as long as economic growth appears healthy enough to service the debt. This is where the so-called ‘multiplier’ comes in. As the debt grows, it adds to GDP growth via the multiplier effect: for each unit of deficit spending, the economy will in fact grow by some multiple of that. (This is because deficit spending creates money through borrowing that would not otherwise have been created and this new money flows out into the economy where it stimulates growth generally). This process can go on for many years, as we have seen.
The neo-Keynesian economic mainstream doesn’t see anything wrong with this in principle, as long as debts don’t become excessive relative to GDP. But welfare politics being what they are, they do. (It is a rare welfare state indeed that can rein itself in as debts swell. Indeed, the exceptions that prove the rule here are few and far between and are explained primarily by natural economic advantages.) When a welfare state finally reaches the limits of debt accumulation, as the bond markets refuse to finance any further increase in debt at serviceable rates, some form of austerity would seem to be required.
No so fast. In its most recent World Economic Outlook, the International Monetary Fund (IMF) surveys the evidence of austerity in practice and does not like what it finds. In particularly, the IMF notes that the multiplier associated with fiscal tightening seems to be rather larger than they had previously assumed. That is, for each unit of fiscal tightening, there is a greater economic contraction than anticipated. This results in a larger shrinkage of the economy and has the unfortunate result of pushing up the government debt/GDP ratio, the exact opposite of what was expected and desired.
While the IMF might not prefer to use the term, what I have just described above is a ‘debt trap’. Beyond a certain point an economy has simply accumulated more debt than it can pay back without resort to currency devaluation. (In the event that a country has borrowed in a foreign currency, even devaluation won’t work and some form of restructuring or default will be required to liquidate the debt.)
The IMF is thus tacitly admitting that those economies in the euro-area struggling, and so far failing, to implement austerity are in debt traps. Austerity, as previously recommended by the IMF, is just not going to work. The question that naturally follows is, what will work?
Well, the IMF isn’t exactly sure. The paper does not draw such conclusions. But no matter. If austerity doesn’t work because the negative fiscal multiplier is larger than previously assumed, well then for now, just ease off austerity while policymakers consider other options. In other words, buy time. Kick the can. And hope that the bond markets don’t notice.
Speaking of not noticing, one could be forgiven for wondering whether this IMF paper was not in fact written with precisely this agenda, that is, to provide an expedient justification for easing off the austerity brakes for awhile. Why? Well as it happens, the IMF’s analysis is not particularly robust. First, they use a data set with a rather short history. Second, their claim to have generated robust statistical results seems questionable. How so? Well, have a look at the following chart:
Now the slope of the line through the data is meant to show the forecast error based on the old multiplier assumptions, in other words, the extent to which the IMF has got things wrong. Note Greece in the lower right corner, representing the unanticipated negative effects of a rather extreme fiscal tightening, and Germany in the upper left, representing the forecast error associated with a moderate fiscal expansion. But if you eliminate these two extreme observations from the sample—something any good statistician would do as a reality check—guess what? You are left with a statistically insignificant ‘blot’ of observations from which you can’t really conclude anything. In other words, the IMF is jumping to conclusions. Now why might that be?
I have an idea. Consider: some of the more outspoken Keynesians wasted no time touting these findings as ‘proof’ that austerity can’t work; that what is really needed is more stimulus, not less; that their arch-Keynesian views have now been vindicated!
Among this group are Paul Krugman, who never saw a stimulus he didn’t like; and former Fed economist Richard Koo of Nomura, who shows a bit more discretion in his views. But in this case they are on the same page: the IMF data are clear, unambiguous evidence, in their view, that the problems created by excessive debt are best addressed with more debt, rather than less. Logic, apparently, is mere inconvenience for those with a PhD in Keynesian economics, as are questionable, cursory statistical analyses, normally referred to pejoratively as ‘data-mining’.
MULTIPLIER REALITY CHECK
Now that we have seen how two prominent Keynesians have responded with applause to an unabashedly Keynesian-inspired IMF study, let’s step back and consider the broader implications for a moment. As is the case with many policy papers, this one is perhaps more notable for what it doesn’t say than for what it does.
Consider: even if the IMF paper is correct in its questionable statistical observations, why, exactly, might the multiplier be larger on the downside than on the upside? Could it be that the net economic benefits of borrowing and consuming through the years are more than outweighed by the eventual requirement that the accumulated debts are paid down? Could it be that borrowing and consuming your way to prosperity doesn’t actually work? Or, conversely, that good, old-fashioned saving and investing your way to prosperity does?
The IMF does not ask and thus does not even begin to answer these common-sense questions. If it did, it might come to some rather common-sense conclusions. That they just perform a data-mining exercise, apparently to serve an agenda, rather than ask and answer the real questions, is yet more evidence that the dominant neo-Keynesian paradigm is being exploited by self-serving policymakers seeking any excuse they need to keep borrowing, spending and consuming, so that the inevitable, unavoidable hard choices need not be made on their watch. Leave it rather to their successors or, better yet, the next generation, or the generation after. After all, isn’t it just human nature for parents and grandparents to expect their children and grandchildren to take care of them in their old, infirm age? In any case, it takes hard work and some sacrifice to actually provide for the next generation to have a higher standard of living. But hey, we’re rich enough as it is, aren’t we? Isn’t poverty a thing of the past? And don’t we aspire to higher things these days like economic equality, political correctness, or ‘nanny’ rules and regulations to keep us from smoking, or drinking, or gambling, or whatever other immoral, reprehensible, irresponsible behaviours? Worrying about debts and budgets is just so passé!
Well, ask the Greeks or the Spanish how they feel about political correctness these days. Or ‘nannystate’ rules on personal behaviour. Something tells me they might be rather more concerned with putting food on the table. And something tells me that the theoretical future of the welfare state, long predicted by von Hayek, von Mises, Friedman, Buchanan and other notable, non-Keynesian economists, is rapidly colliding with the actual present, in a list of countries that continues to grow.
Before we move to the next topic, some readers might be asking themselves, if neither ‘austerity’ nor stimulus is the answer, what on earth is? My answer to this question is that the ‘faux austerity’ I mentioned earlier isn’t really austerity at all. Tightening the screws on a failing welfare state without fundamental reform is not going to convince investors to hold additional debt. Corporations that are fundamentally uneconomic need to do more than cut a few costs here and there if they want to rollover their debts. They need to engage in some ‘creative destruction’ of their operations. Anything less, and bond investors will walk away and leave them to their fate.
Unfortunately, the political processes of the modern welfare state, entrenched as they are in administering entitlements of various kinds, do not lend themselves to fundamental economic reform. Thatcher’s near-bankrupt Britain is a rare exception, in which a highly charismatic politician, against all political odds, took a principled stance against the relentless growth of the welfare state and managed to slow its growth for a time. She didn’t stop it, however, something that the present British government, soon to face near-bankruptcy yet again, no doubt regrets.
While Keynesians prefer to ignore relevant examples, the fact is, real austerity is possible. Look at the Baltic States of Estonia, Latvia and Lithuania. Look at Bulgaria, or Slovakia, or Iceland. Look at South Korea, Thailand, Malaysia and other Asian countries hit hard by their collective debt crisis in the late 1990s. It can be done. But it implies real economic hardship for a period of time and it goes right to the heart of the government, which must shrink relative to the private sector. Many career politicians and bureaucrats will simply find that they are out of work and that they must seek private sector jobs, without guaranteed state pensions and other benefits, like most ordinary folks.
THE IMF RESURRECTS THE ‘CHICAGO PLAN’
The reality of contemporary welfare state politics being what it is, I would argue that there is essentially zero chance that the Keynesians in charge are going to do an about-face. Sure, they might have realised that their policies are not working, but this just means that they are going to raise the stakes. As some are now beginning to argue, there is in fact no reason to worry. Austerity might not work once you are stuck in a debt trap, but so what? What if you could just wave a magic wand and make the debt disappear? Now that would solve all our problems, wouldn’t it?
We know intuitively that this is nonsense. But just because something is nonsense doesn’t stop policymakers from spouting it when expedient. As I wrote in an Amphora Report back in 2010, as the euro-area debt crisis was escalating:
Just as there is no free lunch in economics generally, there is no magic wand in economic policy. Policymakers who claim otherwise are like magicians distracting their audience. As is the case in the physical world, in which there is conservation of energy–the first law of thermodynamics–there is also conservation of economic risk. It cannot be eliminated by waving a magic wand. It can, however, be transformed from one type of risk to another.
As it happens, such sleight-of-hand risk transfer forms the core of the sophistic argument put forth in a superficially scholarly paper published recently by the IMF. The authors, Jaromir Benes and Michael Kumhof, resurrect the long-forgotten ‘Chicago Plan’ of the 1930s, first proposed by Irving Fisher, an early exponent of the Monetarist economic school associated with the University of Chicago. In brief, the Chicago Plan proposes changing the nature of money and money creation in the economy from a nominally private-sector affair, in which commercial banks serve as the engines of money growth, to an exclusively public sector one. Somehow, replacing private sector assets and liabilities with public sector ones is supposed to reduce or eliminate the various problems associated with the current system, in which money creation is supposedly a ‘private’ affair.
While I could have a go at pointing out in detail just how hideously flawed this paper is, fortunately I don’t need to. My friend and fellow financial writer Detlev Schlichter recently penned a devastating critique and I highly recommend reading it in its entirety. For our purposes here, a few particularly relevant quotes follow:
[T]he paper sets up an entirely new and I believe bogus problem based on the premise that in our monetary system money is supposedly provided ‘privately’, that is, by ‘private’ banks, and ‘state-issued’ money only plays a minor role. From this rather confused observation, the paper derives its key allegation that ‘state-issued money’ ensures stability, while ‘privately-issued money’ leads to instability. This claim is not supported by economic theory… Monetary theory does not distinguish between ‘state-controlled money’ and ‘privately produced’ money, it is a nonsensical distinction for any monetary theorist. An attempt to give credence to this distinction and its alleged importance is made in a later chapter in the Benes/Kumhof paper but, tellingly, this attempt is not based on monetary theory but on an ambitious, if not to say bizarre, re-writing of the historical record.
Detlev then goes on to point out precisely why this ‘public’ vs ‘private’ money distinction is all but meaningless not only in theory but in practice:
In recent decades, the global banking system found itself on numerous occasions in a position in which it felt that it had taken on too much financial risk and that a deleveraging and a shrinking of its balance sheet was advisable. I would suggest that this was the case in 1987, 1992/3, 1998, 2001/2, and certainly 2007/8. Yet, on each of these occasions, the broader economic fallout from such a de-risking strategy was deemed unwanted or even unacceptable for political reasons, and the central banks offered ample new bank reserves at very low cost in order to discourage money contraction and encourage further money expansion, i.e. additional fractional-reserve banking. It is any wonder that banks continued to produce vast amounts of deposit money – profitably, of course? Can the result really be blamed on ‘private’ initiative?
To answer Detlev’s rhetorical question: of course not! Just because commercial banks are legally private entities does not in any way imply that they are not de facto agencies of the government. Fannie Mae and Freddie Mac were private sector entities too, prior to being placed into official government ‘conservatorship’, albeit ones engaged in even narrower, more heavily regulated activities than ordinary commercial banks.
Perhaps the best way to think about how banking institutions have operated in recent decades is as private utility companies, with their activities heavily regulated and subsidised by the central bank and a handful of government agencies. Or, to use another industry as an example, consider defence contractors. Sure, they might be private firms in the legal sense, but the business in which they are engaged—defence—is so intertwined with the activities of government that it is essentially impossible to distinguish just where the public role ends and the private role begins.
No doubt the legal grey area that exists between public and private activities in any industry is fertile ground for corruption and abuse. In finance, however, this grey area reaches right into the heart of the money and credit creation process and, thereby, has an insidious if largely unseen impact on the entire economy. To blame ‘private sector’ money and credit growth for the mess we are in, as Messrs Benes and Kumhof do in their paper, demonstrates either colossal ignorance or disingenuousness. I leave it to the reader to decide which.
MONETISATION BY ANY OTHER NAME
If while reading the above you thought that what in effect is being proposed is a massive monetisation of debt, you are right. That is exactly what it is. All but the most radical of Keynesian economists, however, refrain from using the ‘m’ word. They prefer wonkish terms like ‘quantitative easing’ for example. Or, when there is natural downward pressure on prices, they say extreme measures are called for due to ‘inflation targeting’. When they get really desperate, they do occasionally refer to things like the ‘printing press’ or even ‘helicopters’, but somehow the ‘m’ word is something only ever contemplated by two-bit dictators, be they fascist, communist or some combination of the two. After all, monetisation is blatant, in-your-face wealth confiscation from private sector savers to public and financial sector borrowers. Modern, enlightened welfare state democracies would never contemplate such a thing now, would they?
Perhaps this is one reason why the German Weimar hyperinflation is regarded with such horror in the modern economics profession, even though it is but one of many fiat money hyperinflations of the past century. How could a reasonably free and open democracy—indeed, the one in which the idea for the modern welfare state originated—possibly resort to monetisation to solve its excessive debt problem, a legacy of WWI? How irresponsible! Had they just done as Krugman, Koo or other modern Keynesians recommend, and stuck to QE and double-digit fiscal deficits, why, they would have been just fine!
Yes, I’m being faceitious yet again. But come on folks, the idea that somehow, by calling ‘monetisation’ something else makes it so, is just another example of the intellectual sophistry being practiced at the IMF and elsewhere in Keynesian policy circles. They are playing a semantics game while trying desperately to get governments the world over to get on with outright debt monetisation, assuming that this would never morph into a hyperinflation or other such economic calamity.
Ah, but it might. Sorry to sound alarmist, but at some point it might. Reality is a harsh mistress. The future has a way of arriving now and again, sometimes when you least expect it. Responsible folks need to take a sober look at the road we are on. Ignore the can being kicked along the road and focus instead on where the road leads. In this case, it leads to some combination of currency debasement, devaluation and debt default (with the latter substantially less likely, in my opinion, although I would not rule it out in certain cases). It might, just might, lead to a hyperinflation.
So what is a defensive investor, interested primarily in wealth preservation, to do? My advice in this matter has changed little since the first Amphora Report went out in early 2010. Diversify out of financial and into real assets that cannot be debased, devalued or defaulted on. Within financial assets, overweight income-generating stocks in industries with pricing power, that is, those more easily able to pass cost increases through to consumers. Within real assets, acquire some physical, allocated gold and silver but note that these are already trading somewhat expensive relative to most other commodities.
One important lesson of the Great Depression and other periods of severe economic deleveraging is that the prices of less fashionable commodities such as agricultural products can become extremely depressed from time to time and that they tend to outperform precious metals once they cheapen (in relative terms) to a certain point. I would argue that we are at or near that point already.
The Amphora mantra has always been and remains to diversify. Diversification is the only ‘free-lunch’ in economics, frequent Keynesian claims to the contrary notwithstanding, and it is the best form of financial insurance there is. Better than gold. Better than silver, or any single commodity. Better than any one stock, or stock market for that matter. Better than any one bond market, or any one currency. In a world of not just known unknowns, but even unknown unknowns, it would be imprudent to place any number of eggs in just one basket. Even golden ones.
 ECB President Mario Draghi affirmed this policy at today’s monthly ECB press conference and also suggested strongly that the ECB is likely to purchase substantially more debt in future.
 Among other German publications, Der Spiegel reported on this. The link to the article is here.
 Weidmann’s specific words, in German, for those interested, were the following: “Die Bundesbank steht hinter dem Euro. Und gerade deshalb setzen wir uns mit Verve dafür ein, dass der Euro eine stabile Währung bleibt und die Währungsunion eine Stabilitätsunion. Es gibt verschiedene Wege, dieses Ziel zu erreichen. Sicherlich nicht erreichen werden wir dieses Ziel aber, wenn die europäische Geldpolitik in zunehmendem Maße für Zwecke eingespannt wird, die ihrem Mandat nicht entsprechen. The link to this speech is here. His reference in a subsequent speech to Goethe’s Faust can be found at the link here.
 Those welfare states with manageable debt burdens tend to be endowed with plentiful natural resources, such as Norway, Sweden Finland, or Canada, for example. This makes them natural exporters and enables them to finance a certain degree of domestic welfare without resorting to chronic debt accumulation.
 The IMF World Economic Outlook can be found here.
 For more on the concept of a ‘debt trap’, please see “Caught in a Debt Trap”, Amphora Report vol 3 (July 2012). The link is here.
 I have written at length about the critical yet commonly overlooked role that Schumpeterian ‘creative destruction’ plays in a healthy economy. For a recent example, please see “Why Banktuptcy is the New Black,” Amphora Report vol. 3 (April 2012). The link is here.
 “There May Be No Free Lunch, but Is There a Magic Wand?” Amphora Report vol. 1 (September 2010). The link is here.
 The entire paper, The Chicago Plan Revisited, can be found on the IMF’s website here.
 Detlev’s paper is posted to his blog, linked here. I also highly recommend Detlev’s book, Paper Money Collapse, details of which you can also find on his blog.
 For those curious, German chancellor Bismarck introduced the first European pay-as-you-go state pension in the 19th century. It has served as the original model for state pensions subsequently introduced in most of Europe and North America. Germany was also an early adopter of compulsory public education.
 You can find the inaugural Amphora Report here.
Currently serving as the Chief Investment Officer of a commodities
fund, John was previously Managing Director and Head of the Index Strategies Group at Deutsche Bank in London, where he was responsible for the development and marketing of proprietary, systematic quantitative strategies for global interest rate markets.
A cum laude graduate of Occidental College in California, John holds a Masters Degree in International Finance and Economics from the Fletcher School of Law and Diplomacy, associated with Harvard and Tufts Universities.
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13 November 12 | Tags: Bundesbank, Chicago Plan, ECB, Euro, Hyperinflation, Inflation, Irving Fisher, Keynesianism, Laffer Curve, Richard Koo, Sovereign Debt | Category: Economics | One comment
The minor uptick in China’s ‘flash’ PMI estimate for October – from 47.9 to 49.1 – has sparked the usual explosion of uncritical hopefulness (on the part of those who, by and large, thought there never could be a slowdown under the aegis of the all-powerful CCP to begin with,) that this finally marks a bottom in that country’s economic cycle.
In giving vent to such optimism, the Sinomaniacs conveniently overlooked the fact that much of the improvement was down to the fact that it was the price indices, rather than those relating to output or employment, which struggled back above the expansion/contraction threshold of 50 – a circumstance which might just temper their extend-and-pretend expectations of an ever-imminent monetary relaxation, were they to reflect on it for a moment between jubilations.
Worse still, the Pollyannas appear to have forgotten that the PMI simply gauges whether things are generally better or worse than they were last month – and that in a non-quantitative manner, to boot. The unequivocal answer is worse (if marginally so, this time) for the twelfth consecutive month and for the fifteenth out of the last sixteen occasions. Thus, it may be true that the rate of decline seems to have slowed – how enduringly, only time will tell – but the fact of that ongoing decline itself remains, even after so many uninterrupted months of economic deterioration.
China bulls and the other assorted, ‘next quarter’ blue-skyers may have either venal or psychological reasons to puff this one reading up as a sign of a coming (and oft-postponed) dawn, but the test of an analyst who knows his stuff – and who is not afraid to be honest with you – is whether he makes this simple, but crucial, distinction in his commentary.
Of course, such an outpouring of positive sentiment will be very much to the taste of those in Beijing who have managed the seemingly miraculous feat of going into the Party Congress to the glowing accompaniment of an official GDP series which has been accelerating all year, quickening from a 6.1% annualized pace in the first quarter to 8.2% in the second and a resounding 9.1% in the third.
The fact that those same quarters have seen rail freight traffic slow from 3.7% YOY to 0.8% and on to a contraction of 5.8%; or have witnessed Shanghai port container throughput reverse from an expansion of 3.5% YOY to a shrinkage of 1.2% is, apparently, not to be invested with any significance.
Nor is the fact that while industrial production is officially up 10% YTD, those same industries have managed to consume smaller and smaller marginal increments of electrical power along the way; sliding, month by month, from a 4.1% YOY gain in March to a 3.2% one in June and on to a paltry 0.9% increase in September (which slender, overall uptick was comprised of an actual fall in heavy industrial usage).
In much the same manner, apparent consumption of refined oil products was up only 3.4% YTD, with diesel barely ahead at +1.1%. Again, not much evidence of a robust economy, there.
As the slowdown progresses, everywhere but in the reports of the authorities and the minds of their cheerleaders, profits have collapsed in their turn. So far this year, the chemical industry has seen earnings decline 18.1%; cement makers returned 53% less than in 2011; flat glass makers swung to a loss equivalent to around one-third of last year’s reported profits. Miners – whether ferrous or non-ferrous – saw income slip by around 5%, while that accruing to smelters/processors in the first group slumped by no less than 81%, flattering the performance of companies in the second category, even though they themselves booked 30% less.
The other side to this has been a surge in the debts companies owe to one another. As Caixin reported, the China Iron & Steel Association said that, at the end of July, the amount of net receivables and net payables of the 81 steel companies it monitored were up 17.8% and 10.6% respectively from the same month the previous year.
In even worse straits, the 90 enterprises monitored by the China National Coal Association reported an increase of 48.7% in net receivables from 2011, while the China Machinery Industry Federation said those for its members were up 16.9% YOY to a monster CNY 2.5 trillion. No wonder Caterpillar announced it was ‘ramping down’ production in the country.
To see these trends in a little more detail, let us examine those cosseted children of the latest economic cycle, the SOEs. These reported 9-month revenues of CNY 31 trillion which represented a relatively anaemic 9.5% gain from the like period in 2011 when sales had stormed ahead by almost a quarter from 2010. Costs were up 11.1% and hence profits fell a sharp 11.4% to CNY1.6 tln.
That represented a nominal ROE of 5.1% overall, split as to 5.5% for the centrally-controlled firms and a bare 2.9% for their local peers – which latter therefore made a big fat zero in real terms after accounting for the concurrent rise in consumer prices.
Even that does not tell the full horror of the troubles afflicting them, for the simultaneous rise in the tally of accounts receivable amounted to 1/3 of those ostensible ‘profits’ (the overall stock of receivables now stretches to 1.7 times annualised earnings), while inventories swelled by an amount equivalent to the whole of reported income. Days’ sales of inventory rose from 83 to 94.4, while days of receivables climbed to 31.8 from 28.8, putting their combined drain on working capital up to a whopping 126 days-equivalent!
So, here we have a bleak vista of mounting credit, declining margins, unpaid bills, underemployed capacity – even the rare earth market has swung so far from dearth to glut that plant is now being mothballed! – and there also remains precious little hope for making non-operating gains by diverting preferentially-granted credit into a bubbling property market. A clear indicator of this stress is that credit (deferred payment) is rising much faster than money (immediate payment).
This is an ugly constellation indeed, especially since it is giving rise to official concerns about the state of local government finances. Faced with slowing – even falling – tax revenues, these latter are squeezing already pincered companies by demanding advance payment of taxes, as well as by organizing sweeps whose aim is the mass-levying of ‘fines’ for alleged regulatory violations (presumably something of a shock after all these years of turning a blind eye in the pursuit of growth at all costs). These are also, of course, the very same local authorities who are nursing the sickliest of the SOEs and they are the same institutions who will supposedly be riding to the rescue by showering trillions of yuan on even more infrastructure and real estate developments of dubious commercial worth.
According to a report issued by the Development Research Centre of the State Council, the final months of this year will be critical to the pretence of providing ‘stimulus’ via this medium as something of the order of two-fifths of all local government debts fall due by the end of this year, with another 10% or so scheduled to mature by the close of 2013.
Having all but tripled in the last six years, something in excess of CNY11 trillion is now owed by such entities – largely through the conduits offered by the infamous ‘financing vehicles’ – leaving Wei Jianing, deputy director of the Macroeconomy Department at the DRCSC, to fret that: “There are worries over whether local governments could pay off the principal and interests when the repayment hike comes.”
Presumably Mr Wei will be taking little comfort from the happenstance of a nugatory uptick in the Purchasing Managers’ Index!
Far across the Senkaku Islands, Japanese money supply has been decelerating from its recent impressive lick, while small business confidence has plummeted below even the post-Fukushima trough. Meanwhile, the nation’s exports languish at levels first seen in 2004, thanks to the toxic mix of the fallout from the territorial spat with the Chinese and the general Asian weakness – also evident this week in Singapore (IP -2.5% YOY), Thailand (manufacturing output off 13.7% YOY to rest where it was in 2007), and the Philippines (exports off 9% YOY to stand no higher than in 2005).
All this sufficed to bring about a record trade deficit of close to Y1 trillion in Japan itself last month, at which point it was threatening to swallow the large monthly investment income component whole and, hence, to restrict the growth of the capital pool on which the country so heavily relies.
Nothing daunted, after two decades of bluebottle-against-a-windowpane policy-making, the country is again to be dosed with the same old, ineffective, patent medicine as the BoJ prepares to increase its version of QE by a cool Y10 trillion ($125 billion), some of which will help fund the already over-indebted government’s imminent Y700 billion fiscal injection.
You would think they would long since have have learned the futility of what they are about; the fact that this has eluded them for all these years should worry us greatly about our own masters’ willingness to draw the correct lessons on that grim tomorrow when their own programmes are undeniably seen to have failed. Can we not admit it is folly always to resort to the crude economics of a Krugman – the macroeconomic equivalent of the château generalship of the Somme – and to whine that we have only failed because we have not thrown enough money or lives into the fray.
In Europe meanwhile, the gaudy circus of summitry has again rolled through town to little effect. Greece seems to be back to playing brinkmanship with the Troika. ‘Two more Years of Foot-dragging’ was the headline in one German newspaper as it was rumoured that our inveterate Hellenic hand-out seekers were about to pouch another €20 billion, together with extended payment terms and a reduced coupon on their Pelion upon Ossa of existing loans. Talk about creating financial zombies!!!
Draghi bearded the lions in their den when he dissembled before the Bundestag, giving them his earnest that he would never exceed his mandate; that it was simply inconceivable that his unlimited bond purchases could be construed as monetizing state debt, or that it could in any way turn out to be inflationary.
No-one asked the obvious question that if all this was true, and if the OMTs were to exert such a subtle influence on the economy, why he felt compelled to ride roughshod over the (adopted) traditions of the institution he heads in order to implement them.
Among the few dissenting voices was that of the president of the German Savings Bank Association, Georg Fahrenschon, who declared that: “Private savings should not be further penalised. The ECB should not direct itself to minimizing the outlays of the debtor countries, but to ensuring monetary stability, today, tomorrow, and the day after that”
At the same press conference, however, he revealed the schizophrenia which Draghi’s actions have induced. German savers prefer to hold their wealth in the form of savings accounts – out of distrust and uncertainty – yet half of them see a house as the best guarantee for their old age and a third of them intend to buy one now.
If the former impulse gives way only a little in favour of the latter, that double-digit rate of increase in the local money supply will soon deliver the thrifty German burgers, almost the last of their breed, into that vortex of balance sheet ruination which is widely seen (if less openly articulated) as the real key to solving Europe’s otherwise intractable debt crisis.
Before then, however, it would seem that the country might be in for more testing times than has been the case to date. Certainly the decline in the IfO index this past six months – registered despite a rising stock market and a diminution of the sense of crisis in the Zone – is of a magnitude which has typically accompanied significant downturns in activity. With monetary creation running so hot in Germany, it would be unusual, to say the least, for revenues and profits to fall sufficiently far to trigger a serious setback – which is essentially what the IfO index is telling us is expected to occur – but nevertheless this does bear close attention.
Finally, there are one or two hints that the US is starting to sputter. Certainly, the rapid decline in core (ex-defence and aircraft) capital goods numbers tells us so. At -10% YOY, orders are now falling at the sorts of rates experienced in both the Tech bust and the GFC itself. In the past three months, nominal levels have come to rest where they were in the late 1990s while, in real terms, the series has not been this depressed since it was first compiled in the current form, two decades ago.
Those, like us, who have tended to regard the States as the best of a bad bunch, will have to hope this is nothing more than a little pre-election caution and that it will be accordingly reversed in a month or two’s time.
The euro debt crisis in Europe has presented Germany with a unique opportunity to lead the world away from monetary destruction and its consequences of economic chaos, social unrest, and unfathomable human suffering. The cause of the euro debt crisis is the misconstruction of the euro that allows all members of the European Monetary Union (EMU), currently 17 sovereign nations, to print euros and force them on all other members. Dr. Philipp Bagus of King Juan Carlos University in Madrid has diagnosed this situation as a tragedy of the commons in his aptly named book The Tragedy of the Euro. Germany is on the verge of seeing its capital base plundered from the inevitable dynamics of this tragedy of the commons. It should leave the EMU, reinstate the deutsche mark (DM), and anchor it to gold.
The Structure of the European Monetary Union
The European System of Central Banks (ESCB) consists of one central bank, the European Central Bank (ECB), and the national central banks of the EMU, all of which are still extant within their own sovereign nations. Although the ECB is prohibited by treaty from monetizing the debt of its sovereign members via outright purchases of their debt, it has interpreted this limitation on its power not to include lending euros to the national central banks taking the very same sovereign debt as collateral. Of course this is simply a backdoor method to circumvent the very limitation that was insisted on when the more responsible members such as Germany joined the European Monetary Union.
Corruption of the European Central Bank into an Engine of Inflation
When the ECB was first formed around the turn of the new millennium, the bond markets assumed that it would be operated along the lines of the German central bank, the Bundesbank, which ran probably the least inflationary monetary system in the developed world. However, they also assumed that the EMU would not allow one of its members to default on its sovereign debt. Therefore, the interest rate for many members of the EMU fell to German levels. Unfortunately, many nations in the EMU did not use this lower interest rate as an opportunity to reduce their budgets; rather, many simply borrowed more. Thus was born the euro debt crisis, when it became clear to the bond market that debt repayment by many members of the EMU was questionable. Interest rates for these nations soared.
Over the past few years the European Union itself has established several bailout funds, but the situation has not been resolved. In fact, things are even worse, for it now appears that even larger members of the EMU succumbed to the debt orgy and may need a bailout to avoid default. Thus we have arrived at the point predicted by Dr. Bagus in which the euro has been plundered by multiple parties and the pot is empty. The ECB and many sovereign members of the EMU want unlimited bond buying of sovereign debt by the ECB. Only Germany opposes this plan, but it is the lone voice against this new bout of monetary inflation.
The Historical Context of German Antipathy to Monetary Inflation
In 1923 Germany experienced one of the world’s worst cases of hyperinflation and the worst ever for an industrialized nation. The reichsmark was destroyed by its own central bank, plunging the German people into misery and desperation. Now, after only a dozen years of relative monetary discipline, the euro faces the same fate as country after country demands to be bailed out of its mounting debts by unlimited printing of money by the ECB. Because Germany is part of the EMU, it must accept these newly printed euros. This threatened monetary inflation of unlimited amounts has shaken German bankers to the core. It is the nightmare scenario that they feared when, against their better judgment, the German politicians agreed to give up their beloved deutsche mark and place the economic fate of the nation in the hands of a committee of foreigners not as concerned about monetary inflation. But Germany can put a stop to this destruction and save the world while it saves itself. It can leave the EMU, reinstate the deutsche mark, and tie it to gold.
A Golden Deutsche Mark Is Possible and Desirable
Despite the haughty pronouncements of EU officials, there is nothing that can stop a sovereign country from leaving the EMU and adopting a different monetary system. The most likely scenario would be a one-for-one redenomination of German banks’ euro-denominated accounts for deutsche marks. Thereafter, the DM would float freely in currency markets in the same way as British pounds and American dollars. The Bundesbank would be responsible for monetary policy just as it was before Germany joined the EMU. By leaving the EMU Germany would insulate itself from the consequences of the euro as a tragedy of the commons; i.e., monetary inflation by third parties would end, Germany would not experience higher prices due to the actions of third parties, and the capital-destroying transfers of wealth would end.
Yet Germany should go one step further. It should anchor the DM to gold. Germany is the world’s fourth-largest economy, behind only the United States, China, and Japan. Furthermore, Germany owns more of the world’s gold than any other entity except the United States, more than either China or Japan and more than any other European country. A prerequisite to market acceptance of any gold money would be confidence in the integrity of the sponsoring institution. Not only is the Bundesbank known for its integrity and reverence for stable money; Germany itself has a worldwide reputation for the rule of law, advanced financial architecture, and a stable political system. For these reasons, Germany would prove to the world that a gold-backed money is not only possible but desirable. Expect a cascade of similar pronouncements once Germany’s trading partners realize the importance of settling international financial transactions in the best money available — which initially at least would be a golden DM.
Germany Should Seize the Moment!
Of course the beneficial consequences of tying money to gold go beyond ending price inflation and capital-destroying wealth transfers. We can expect all the beneficial consequences of a return to limited government, for government could no longer fund itself through the unholy alliance with an inflationary central bank that creates fiat money in order to monetize government’s profligate spending. The people would no longer be so subservient to government, pleading and begging for special interests at the expense of the rest of society, for government would be forced to go to the people for approval to increase its budget. The list of benefits goes on and on. Suffice it to say that it all begins with truly sound money, money anchored in gold. Germany can lead the way and earn the just respect of a grateful world. It is in the right place at the right moment in history. It should seize the moment!
This article was previously published at Mises.org.
“The issuer’s promise” is a phrase I have used recently to describe the backing for fiat currencies. The purpose of this article is to define it further, given that it is increasingly likely to be challenged in the foreign exchange markets with respect to the euro.
To begin we need to define the principal difference between gold and a fiat currency. Gold has no price when it is used as money, other than what it is exchanged for in goods. Uniquely as money, it was in demand everywhere by all societies to settle their own domestic and foreign trade. Fiat money is only used to settle transactions in the jurisdiction to which it relates, and foreigners who end up with it exchange it for their own fiat money, because out of jurisdiction it is not money.
There are three basic exceptions to this rule. The dollar, through its original gold convertibility became a substitute for gold, and still enjoys an international role as a result of that legacy. A second exception is when governments intervene and build up holdings of foreign fiat money. And the third is when ownership of foreign currencies accumulates for speculative purposes. Otherwise, outside its jurisdiction a fiat currency has no useful value.
Its validity is based on a promise by the issuing central bank and the relevant government that it actually has value. The value of that promise is subjectively assessed in foreign exchange markets, where dealers compare fiat currencies. The result is that the purchasing power of a fiat currency can diminish substantially in foreign exchanges before disrupting its domestic monetary role. The dollar, for example, has lost most of its purchasing power since it became completely disconnected from gold in 1971, but Americans still think automatically “I have 10 bucks to spend: what shall I buy?” rather than “I must get rid of these 10 bucks before they lose yet more value”.
We all think like that with our respective fiat currencies, and the moment we don’t marks the start of a collapse in confidence in the issuer’s promise. This could be the euro’s Achilles Heel, because there is no identifiable government actually prepared to stand behind the European Central Bank, and as the crisis intensifies, there is a growing risk the promise will be found wanting by the eurozone’s own citizens.
Fiat money is managed by neoclassical economists at central banks who think they understand price theory. The euro is in danger of a sudden collapse, and it is not clear that the powers-that-be in the ECB understand this. It is not even clear if they understand that hyperinflation is not, as the term in modern usage suggests, an accelerating rise in the price of goods. Instead it is a collapse in the value of fiat money that arises from a reassessment of the issuer’s promise by domestic users.
The euro’s future is essentially tied to a collection of disparate governments. If any of them leaves, it risks bringing on a collapse in its value that is completely beyond the control of the ECB.
On Thursday the European Central Bank’s Mario Draghi was moved to defend the euro, after Spain’s government bond yields rose dramatically through the 7% level. And when Valencia asked the central government for a bailout, followed by indications that other cities and regions have similar problems, it became clear that Spain is in deep trouble. We have got used to the concept of too-big-to-fail; now we have too-big-to-rescue.
We normally talk about Spain and also Italy in terms of government debt and budget deficits, forgetting they are only part of the problem. To these must be added regional and local governments, nationalised and subsidised industries, and off-balance sheet guarantees for other entities. Forget, for the moment, future health and welfare costs, which statistically dwarf everything: they are not the immediate problem. This still leaves us with rescues, without even considering commercial banks, amounting to perhaps between two and four times the headline government debt. People think Spain can be rescued, but when you take everything into account, including the prospect of a policy-induced slump from macro-economic mistakes, it is simply too big.
The failure to face up to financial reality is essentially political. Spain’s President of the Government, Mariano Rajoy, was elected with a clear majority last November, and has failed to cut spending. Instead of reducing the burden of the public sector on the economy, he has chosen to penalise the productive private sector through extra taxation. If anyone had an opportunity to face up to reality with an electoral mandate it was Rajoy, but he failed to do so either because he deemed it politically impossible or because he is simply too weak.
Perhaps it is political reality: this is certainly echoed in all the other crisis-hit states. France’s electorate has cut out any argument by electing a socialist president intent on increasing both public spending and taxes at the same time. The result is that Europe faces economic collapse sooner than it might otherwise, escalating the burden principally on Germany of bailing out impecunious states.
Germany is becoming isolated, and no longer is Chancellor Merkel able to pretend that, deo volente, it will come right in the end. Instead Germany faces a crippling bill, now recognised by the rating agencies. In a GoldMoney podcast released last Wednesday, Philipp Bagus estimated the total cost to Germany to be four times her total tax revenues. That implies personal taxes of over 100% of private sector income. How do you carry your electorate along with you, simply to keep the euro project alive, with that sort of cost?
You cannot. Bagus sees no alternative to money-printing, and that is effectively what Draghi now says he is prepared to do; but unlike other fiat currencies, the euro has no single government backing it. Therefore the effect on the euro of Draghi’s money printing could be catastrophic.
It would be quite an event. We have not seen a major fiat currency collapse in recent decades, though there are those in Germany who remember the misery it brings. The speed at which the euro weakens could be very surprising indeed.
When currencies and monetary arrangements have broken down it has always been because the currency issuer can no longer fight the lure of the seigniorage to be gained by over issue of the currency. In the twentieth century this age-old impulse was allied to new theories that held that economic downturns were caused or exacerbated by a shortage of money. It followed that they could be combated by the production of money.
Based on the obvious fallacy of mistaking nominal rises in wealth for real rises in wealth, this doctrine found ready support from spendthrift politicians who were, in turn, supported by the doctrine.
Time and again over recent history we see the desire for seigniorage allied with the cry for more money to fight a downturn pushing up against the walls of the monetary architecture designed to protect the value of the currency. Time and again we see the monetary architecture crumble.
The classical gold standard
At the start of the twentieth century much of the planet and its major economic powers were on the gold standard which had evolved from the 1870s following Britain’s lead. This was based on the twin pillars of (1) convertibility between paper and gold and (2) the free export and import of gold.
With a currency convertible into gold at a fixed parity price any monetary expansion would see the value of the currency relative to gold decline which would be reflected in the market price. Thus, if there was a parity price of 1oz gold = £5 and a monetary expansion raised the market price to 1oz = £7, it would make sense to take a £5 note to the bank, swap it for an ounce of gold and sell it on the market for £7.
The same process worked in reverse against monetary contractions. A fall in the market price to 1oz = £3 would make it profitable to buy an ounce of gold, take it to the bank and swap it for £5.
In both cases the convertibility of currency into gold and vice versa would act against the monetary expansion or contraction. In the case of an expansion gold would flow out of banks forcing a contraction in the currency if banks wished to maintain their reserve ratios. Likewise a contraction would see gold flow into banks which, again, in an effort to maintain their reserve ratios, would expand their issue of currency.
The gold standard era was one of incredible monetary stability; the young John Maynard Keynes could have discussed the cost of living with Samuel Pepys without adjusting for inflation. The minimisation of inflation risk and ease of convertibility saw a massive growth in trade and long term cross border capital flows. The gold standard was a key component of the period known as the ‘First era of globalisation’.
The judgement of economic historians Kenwood and Lougheed on the gold standard was
One cannot help being impressed by the relatively smooth functioning of the nineteenth-century gold standard, more especially when we contemplate the difficulties experienced in the international monetary sphere during the present century. Despite the relatively rudimentary state of economic knowledge concerning internal and external balance and the relative ineffectiveness of government fiscal policy as a weapon for maintaining such a balance, the external adjustment mechanism of the gold standard worked with a higher degree of efficiency than that of any subsequent international monetary system
The gold exchange standard and devaluation
The First World War shattered this system. Countries printed money to fund their war efforts and convertibility and exportability were suspended. The result was a massive rise in prices.
After the war all countries wished to return to the gold standard but were faced with a problem; with an increased amount of money circulating relative to a country’s gold stock (a problem compounded in Europe by flows of gold to the United States during the war) the parity prices of gold were far below the market prices. As seen earlier, this would lead to massive outflows of gold once convertibility was re-established.
There were three paths out of this situation. The first was to shrink the amount of currency relative to gold. This option, revaluation, was that taken by Britain in 1925 when it went back onto the gold standard at the pre-war parity.
The second was that largely taken by France between 1926 and 1928. This was to accept the wartime inflation and set the new parity price at the market price.
There was also a third option. The gold stock could not be expanded beyond the rate of new discoveries. Indeed, the monetary stability which was a central part of the gold standard’s appeal rested on the fixed or slow growth of the gold stock which acted to halt or slow growth in the currency it backed. So many countries sought to do the next best thing and expand gold substitutes to alleviate a perceived shortage of gold. This gave rise to the gold exchange standard which was put forward at the League of Nations conference in Genoa in 1922.
Under this system countries would be allowed to add to their gold reserves the assets of countries whose currency was convertible into gold and issue domestic currency based on this expanded stock. In practice the convertible currencies which ‘gold short’ countries sought as reserves were sterling and dollars.
The drawbacks were obvious. The same unit of gold could now have competing claims against it. The French took repeated advantage of this to withdraw gold from Britain.
Also it depended on the Bank of England and Federal Reserve maintaining the value of sterling and the dollar. There was much doubt that Britain could maintain the high value of sterling given the dire state of its economy and the dollar was weakened when, in 1927, the Federal Reserve lowered interest rates in order to help ease pressure on a beleaguered sterling.
This gold exchange standard was also known as a ‘managed’ gold standard which, as Richard Timberlake pointed out, is an oxymoron. “The operational gold standard ended forever at the time the United States became a belligerent in World War I”, Timberlake writes.
After 1917, the movements of gold into and out of the United States no longer even approximately determined the economy’s stock of common money.
The contention that Federal Reserve policymakers were “managing” the gold standard is an oxymoron — a contradiction in terms. A “gold standard” that is being “managed” is not a gold standard. It is a standard of whoever is doing the managing. Whether gold was managed or not, the Federal Reserve Act gave the Fed Board complete statutory power to abrogate all the reserve requirement restrictions on gold that the Act specified for Federal Reserve Banks (Board of Governors 1961). If the Board had used these clearly stated powers anytime after 1929, the Fed Banks could have stopped the Contraction in its tracks, even if doing so exhausted their gold reserves entirely.
This was exacerbated in the United States by the Federal Reserve adopting the ‘real bills doctrine’ which held that credit could be created which would not be inflationary as long as it was lent against productive ‘real’ bills.
Many economists, notably Ludwig von Mises and Friedrich von Hayek, have seen the genesis of the Depression of the 1930s in the monetary architecture of the 1920s. While this remains the most debated topic in economic history there is no doubt that the Wall Street crash and its aftermath spelled the end of the gold exchange standard. When Britain was finally forced to give up its attempt to hold up sterling and devalue in 1931 other countries became worried that its devaluation, by making British exports cheaper, would give it a competitive advantage. A round of ‘beggar thy neighbour’ devaluations began. Thirty two countries had gone off gold by the end of 1932 and the practice continued through the 1930s.
Bretton Woods and its breakdown
Towards the end of World War Two economists and policymakers gathered at Bretton Woods in New Hampshire to design a framework for the post war economy. Looking back it was recognised that the competitive devaluations of the 1930s had been a driver of the shrinkage of international trade and, via its contribution to economic instability, to deadly political extremism.
Thus, the construction of a stable monetary framework was of the most utmost importance. The solution arrived at was to fix the dollar at a parity of 1oz = $35 and to fix the value of other currencies to the dollar. Under this Bretton Woods system currencies would be pegged to gold via the dollar.
For countries such as Britain this presented a problem. Any attempt to use expansionary fiscal or monetary policy to stimulate the economy as the then dominant Keynesian paradigm prescribed would eventually cause a balance of payments crisis and put downward pressure on the currency, jeopardising the dollar value of sterling. This led to so called ‘stop go’ policies in Britain where successive governments would seek to expand the economy, run into balance of payments troubles, and be forced to deflate. In extreme circumstances sterling would have to be devalued as it was in 1949 from £1 = $4.03 to £1 = $2.80 and 1967 from £1 = $2.80 to £1 = $2.40.
A similar problem eventually faced the United States. With the dollar having replaced sterling as the global reserve currency, the United States was able to issue large amounts of debt. Initially the Federal Reserve and Treasury behaved reasonably responsibly but in the mid-1960s President Lyndon Johnson decided to spend heavily on both the war in Vietnam and his Great Society welfare program. His successor, Richard Nixon, continued these policies.
As dollars poured out of the United States, investors began to lose confidence in the ability of the Federal Reserve to meet gold dollar claims. The dollar parity came under increasing pressure during the late 1960s as holders of dollar assets, notably France, sought to swap them for gold at the parity price of 1oz = $35 before what looked like an increasingly inevitable devaluation. Unwilling to consider the deflationary measures required to stabilise the dollar with an election due the following year, President Nixon closed the gold window on August 15th 1971. The Bretton Woods system was dead and so was the link between paper and gold.
Fiat money and floating exchange rates
There were attempts to restore some semblance of monetary order. In December 1971 the G10 struck the Smithsonian Agreement which sought to fix the dollar at 1oz = $38 but this broke down within a few months under the inflationary tendencies of the Federal Reserve. European countries tried to establish the ‘snake’, a band within which currencies could fluctuate. Sterling soon crashed out of even this under its own inflationary tendencies.
The cutting of any link to gold ushered in the era of fiat currency and floating exchange rates which lasts to the present day. Fiat currency gets its name because its value is given by governmental fiat, or command. The currency is not backed by anything of value but by a politicians promise.
The effect of this was quickly seen. In 1931 Keynes had written that “A preference for a gold currency is no longer more than a relic of a time when governments were less trustworthy in these matters than they are now” But, as D R Myddelton writes, “The pound’s purchasing power halved between 1945 and 1965; it halved again between 1965 and 1975; and it halved again between 1975 and 1980. Thus the historical ‘half-life’ of the pound was twenty years in 1965, ten years in 1975 and a mere five years in 1980”
In 1976 the pound fell below $2 for the first time ever. Pepys and Keynes would now have been talking at cross purposes.
Floating exchange rates marked the first public policy triumph for Milton Friedman who as long ago as 1950 had written ‘The Case for Flexible Exchange Rates’. Friedman had argued that “A flexible exchange rate need not be an unstable exchange rate” but in an era before Public Choice economics he had reckoned without the tendency of governments and central banks, absent the restraining hand of gold, to print money to finance their spending. World inflation which was 5.9% in 1971 rose to 9.6% in 1973 and over 15% in 1974.
The experience of the era of floating exchange rates has been of one currency crisis after another punctuated by various attempts at stabilisation. The attempts can involve ad hoc international cooperation such as the Plaza Accord of 1985 which sought to depreciate the dollar. This was followed by the Louvre Accord of 1987 which sought to stop the dollar depreciating any further.
They may take more organised forms. The Exchange Rate Mechanism was an attempt to peg European currencies to the relatively reliable Deutsche Mark. Britain joined in 1990 at what many thought was too high a value (shades of 1925) and when the Bundesbank raised interest rates to tackle inflation in Germany sterling crashed out of the ERM in 1992 but not before spending £3.3 billion and deepening a recession with interest rates raised to 12% in its vain effort to remain in.
This brief look back over the monetary arrangements of the last hundred years shows that currency issuers, almost always governments, have repeatedly pushed the search for seigniorage to the maximum possible within the given monetary framework and have then demolished this framework to allow for a more ‘elastic’ currency.
Since the demise of the ERM the new vogue in monetary policy has been the independent central bank following some monetary rule, such as the Bank of England and its inflation target. Inspired by the old Bundesbank this is an attempt to take the power of money creation away from the politicians who, despite Keynes’ high hopes, have proved themselves dismally untrustworthy with it. Instead that power now lies with central bankers.
But it is not clear that handing the power of money creation from one part of government to another has been much of an improvement. For one thing we cannot say that our central bankers are truly independent. The Chairman of the Federal Reserve is nominated by the President. And when the Bank of England wavered over slashing interest rates in the wake of the credit crunch, the British government noisily questioned its continued independence and the interest rate cuts came.
Furthermore, money creation can reach dangerous levels if the central bank’s chosen monetary rule is faulty. The Federal Reserve has the awkward dual mandate of promoting employment and keeping prices stable. The Bank of England and the European Central Bank both have a mandate for price stability, but this is problematic. As Murray Rothbard and George Selgin have noted, in an economy with rising productivity, prices should be falling. Also, what ‘price level’ is there to stabilise? The economy contains countless different prices which are changing all the time; the ‘price level’ is just some arbitrarily selected bundle of these.
An extreme example, as noted by Jesús Huerta de Soto, is the euro. Here a number of governments agreed to pool their powers of money creation and invest it in the European Central Bank. The euro is now widely seen to be collapsing. So it may be, but is this, as is generally assumed, a failure of the architecture of the euro itself?
Let us remember that the purpose of erecting a monetary structure where the power to create money is removed from government is to stop the government running the printing presses to cover its spending and, in so doing, destroy the currency.
The problem facing eurozone states like Greece and Spain is presented as being that they are running up debts in a currency they cannot print at will to repay these debts. But is the problem here that these countries cannot print the money they need to pay their debts or that they are running up these debts in the first place? The solution is often offered that either these countries need to leave the euro and adopt a currency which they can expand sufficiently to pay their debts or that the ECB needs to expand the euro sufficiently for these countries to be able to pay their debts. But there is another solution, commonly called ‘austerity’, which says that these countries should just not run up these debts. As de Soto argues, the euro’s woes are really failures of fiscal policy rather than monetary policy.
It is thus possible to argue that the euro is working. By halting the expansion of currency to pay off debts and protecting its value and, by extension, preventing members from running up evermore debt, the euro is doing exactly what it was designed to do.
There is a growing clamour inside Europe and outside that ‘austerity’ alone is not the answer to the euro’s problems and that monetary policy has a role to play. The ECB itself seems to be keen to take on this role. But it is simply the age-old idea, based on the confusion between the real and the nominal, that we will get richer if we just produce more money. Germany is holding the line on the euro but history shows that far sounder currency arrangements have collapsed under the insatiable desire for a more elastic currency.
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HUERTA DE SOTO, J. 2012. “In defence of the euro: an Austrian perspective”. The Cobden Centre, May 29th
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TIMBERLAKE, R. 2008. “The Federal Reserve’s Role in the Great Contraction and the Subprime Crisis”. Cato Journal, Vol. 28, No. 2 (Spring/Summer 2008), James A. Dorn, ed. Washington DC: Cato Institute, pp. 303-312.
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John Phelan is a Masters student at the London School of Economics who has worked in the public and private sectors for ten years. He has written for the Wall Street Journal Europe, Standpoint, City AM, and Economic Affairs. He blogs at http://phelanomics.wordpress.com/ | Contact us
6 June 12 | Tags: Euro, Fiat money, gold standard, Sovereign Debt | Category: Economics | 6 comments
The eurozone continues to keep us in suspense in the wake of the French elections, and pending the second Greek election in as many months, the underlying financial deterioration is accelerating. Funds are being withdrawn from banks in troubled countries, rapidly depleting their capital. At the same time collateral held against loans is often over-valued, so write-offs that should have been taken have not. The predictable result is a developing run on both individual banks and whole national banking systems.
It should be noted that there are two reasons depositors are fleeing banks: fear that the bank itself is insolvent, and fear that the relevant government might impose restrictions on the movement of money. Fear of bank insolvency is driving funds out of Spanish banks, while fear of government restrictions is driving funds out of Greek banks. To deal with these problems they must be recognised as distinct and different.
A potential banking crisis, as that faced by Spain, requires two further considerations. The first, of providing liquidity, has been addressed by the European Central Bank through its long-term refinancing operation (LTRO); but this is a stop-gap measure and requires the second consideration to be addressed: the reorganisation and recapitalisation of the banks. And here, the cost for Spain is impossible to meet at a time when she faces a combination of deteriorating government finances and escalating borrowing costs.
Greece’s difficulties are even greater, given that depositors are trying to discount the possibility she may leave the euro entirely and introduce exchange controls to manage a new drachma. The virtually unanimous consensus among Keynesians and monetarists is that such a move is both inevitable and desirable, but public opinion in Greece is increasingly in favour of sticking with the euro. Call it the difference between macro-economic theorising and on-the-ground micro-economic reality. For the fact of the matter is that neoclassical solutions that rely on devaluation as an economic remedy provide only temporary relief at best at greater eventual cost, and exiting the euro is neither a legal nor a practical option.
That is the monetary reality behind the eurozone’s crisis. The solution is not to ease the pressures on governments to address their excessive spending: if anything this pressure needs to be intensified, a point well made in a recent Cobden Centre article by Jesús Huerta de Soto. And the idea that more money should be made available for profligate governments through multi-government sponsored bond issues should be firmly rebutted. The banks, which should be allowed to fold, should be removed from the system in a controlled manner, that is to say that the ECB and the national central banks must devise a solution, perhaps a good bank/bad bank division, to give depositors sufficient confidence to keep their funds in the system.
Unfortunately, the political tide is running strongly against this two-pronged approach, with the developing rebellion against “austerity” from all European politicians, and the Keynesian and monetarist pressures from everyone else to reflate increasing. The chances of the ECB properly ring-fencing funds to deal with the banks and stopping them being used to prop up eurozone governments are becoming more remote by the day.
On Tuesday, March 26, 2012, I was invited by Ron Paul and his staff to assist a meeting of the Domestic Monetary Policy and Technology Subcommittee of the House Committee on Financial Services. The title of the hearing was “Federal Reserve Aid to the Eurozone: Its Impact on the U.S. and the Dollar.”
Unfortunately, Ben Bernanke had not come to the hearing, being busy with propaganda lectures in favor of the Fed. Instead, two of his colleagues, Mr. William C. Dudley (president and chief executive officer, Federal Reserve Bank of New York) and Dr. Steven B. Kamin (director, Division of International Finance, Board of Governors of the Federal Reserve System), showed up to answer the committee’s questions on currency swaps with other central banks.
But why did European banks need help from the Fed in the first place? European banks had borrowed dollars short term in international wholesale markets and lent these dollars for the long term to US companies or households. The maturity mismatch is highly risky, because once a bank cannot renew its short-term debts it becomes illiquid.
We approached such a situation last year. European banks had been pressured by their governments to buy their governments’ debts. Italian banks are loaded with Italian government bonds, Spanish banks with Spanish bonds and so on. As the sovereign-debt crisis increased once again in the summer of 2011 with governments short of collapsing, European banks had increasing difficulties renewing their short-term dollar loans. As the ECB can only print euros, not dollars, European banks got nervous. While US banks did not want to lend to European banks anymore, in September 2011, the Fed stepped in and bailed out European banks through currency swaps. Through the swaps, the Fed assumed its role as the international lender of last resort.
During the financial crisis between 2007 and 2009, the Fed had bailed out European banks mainly through direct loans to subsidiaries in the United States. In order to conceal the bailouts, the Fed now uses mainly currency swaps. In the swap, the Fed sells dollars to the ECB and buys them back later at the same price, receiving interests. This construction resembles a dollar loan to the ECB at about 0.6 percent (0.5 percent above the federal-funds rate). The ECB can then use these dollars to lend them to troubled European banks.
At the hearing the Fed officials did not deny the obvious: the bailout of European banks by the Fed. Rather, they claimed that the bailout was basically a free lunch for US taxpayers, as they would get an almost-risk-free benefit in the form of the interest on the swap.
Further, the Fed officials maintained that the bailout was necessary because a default of European banks would cause stress in financial markets. Through the interconnectivity of financial markets, US banks would get into problems; lending to US households and companies would be affected negatively.
Lastly, they made assurances that the Fed will end the swap-bailout policy once it becomes imprudent and the costs and risks of such a policy exceed the benefits for the US public.
Let’s have a look at these startling arguments.
First, there ain’t no such a thing as a free lunch; not even for the Fed, the ultimate money producer. Just remember that US banks did not want to lend to European banks, because they regarded it as too risky. Even the central-bank swap is not risk free. It is true that the Fed has locked in the exchange rate and expects to get back the same amount of dollars plus interest. Yet there remains counterparty risk: what if the ECB, goes bust? Then the creditors, including the Fed, will take over the ECB’s assets. Creditors would receive assets such as Greek government bonds, or loans to Portuguese banks. These banks depend on ECB liquidity lines and are collateralized by bonds issued by the Portuguese government, which also depends on the ECB to support it.
In the end, the ECB balance sheet is backed to a large extent by bonds from insolvent governments that are only kept afloat thanks to the ECB’s promises to keep printing money and the pledged support of German taxpayers.
While an ECB bankruptcy does not seem imminent, the ECB has increased its capital to make good for potential losses already back in 2010, and the Bundesbank increased its provisions for losses in 2011. In the mean time, the ECB has bought even more Greek government debt. The ECB is probably one of the most highly leveraged banks in history.
Of course, the Fed hopes that eurozone governments will always recapitalize the ECB if it is necessary, so that ultimately taxpayers return the dollars to the Fed. But what if Germany leaves the eurozone? While this is unlikely in the short term, the possibility exists for the long run. Then southern European governments will default on their debts — and take their banks and the ECB down with them. Then who will pay back dollar swaps to the Fed?
The swap is also no free lunch as opportunity costs are involved. By abstaining from producing dollars and lending them to the ECB, the US-dollar money supply would be smaller and backed by better-quality assets (not indirectly by Greek government bonds). The dollar production also implies a redistribution toward the first receivers of the new dollars, the ECB, European banks, and their borrowers (mainly irresponsible and insolvent governments) to the detriments of the last receivers, mainly US citizens, who are confronted with a debased dollar.
There are other opportunity costs. The Fed could have produced the same amount of dollars and not invested in the central-bank swaps. These swaps earn very low interest. Instead of the swaps, the Fed could have purchased other assets, like stocks of Apple or gold, which may rise more in value.
One cost of the swap operation acknowledged by the officials in the hearing is the moral hazard created. Banks and governments worldwide may expect that the Fed will come to save them, too, especially if they are well connected with the US financial system. So why be prudent?
The highest cost of the swaps, though, may be something else. Through the swaps, the Fed is helping the ECB to bail out European banks that finance insolvent and irresponsible governments. The Fed is indirectly bailing out countries like Greece, Portugal, and Spain, debasing the dollar. Thanks to the bailouts, the political project of the euro continues. Without the swaps, some European banks might have failed, and with them their sovereigns. Thanks to the swaps, the eurozone stays intact.
The project of the euro leads to an ever-increasing rescue fund, and gradually toward a fiscal union and more centralization. A European financial government and the European super state, which would most likely abolish tax competition in Europe, are on the horizon. The highest cost of the Fed policy, therefore, may be liberty in Europe.
The Fed officials also made clear that they think the swap arrangement benefits the US public by keeping stress away from US banks and financial markets. The Fed does not want stock markets to fall or interest rates to increase. For them, low interest rates are the panacea for all economic ills. However, having artificially low interest rates climb back to more normal levels is no disaster. Sustainable investments are always restricted by real savings. Lowering interest rates does not increase the amount of real savings at all. Moreover, an important feature of a market economy is that people take responsibility for their actions. If US banks have granted loans to European banks and governments, they should assume the losses from their risky behaviour.
Finally, the Fed claims to be prudent. But how can the Fed know the point at which it is no longer prudent to bail out foreign banks? How can it know when the costs of the bailouts start to exceed the benefits to the US public? How can they know what is best for the United States? Interpersonal-utility comparisons are arbitrary. Thanks to the bailouts, some banks may win, some stock owners may win, but at the cost of liberty in Europe and to the detriment of dollar users. Moreover, bailouts produce moral hazards, crises, and losses for individuals in the future. Yet the Fed claims to know what to do: social engineering at its best — or, as Hayek would put it, a fatal conceit on the part of central (banking) planners.
In sum, the Fed has assumed the task of bailing out the financial industry and governments worldwide by debasing the dollar. Fed officials claim to know that the bailout-swaps are basically a free lunch for US taxpayers and a prudent thing to do. Thank God the world is in such good hands.
This article was previously published at mises.org.
Greece has now defaulted, and other eurozone governments as well as agencies such as the International Monetary Fund, European Central Bank and European Investment Bank have retrospectively inserted themselves as senior creditors, a precedent that should be of great concern and which has profound implications for private sector banks.
Furthermore, when a state defaults it is only a small part of the whole story, because governments today are major participants in their economies. The consequences of a central government default extend to state guarantees for other entities and related businesses: in the case of Greece its default has altered the assumptions behind all non-central government public-sector loans, such as railway bonds. And the private sector not directly dependent on government subsidies or contracts is also affected by the prospect of excessive taxes.
For this reason, the consequence of Greece’s default goes considerably beyond the loans directly involved, and all other eurozone nations are in a similar position. The headline numbers are a fraction of the total involved.
This brings us to a fundamental truth. Government debt is the basis for fiat money systems. This basis is now being questioned. It is the key component of the capital held by banks, as well as cash and deposits at central banks – both of which are also government creations ultimately backed by government debt. Ever since gold was legislated out of the monetary system, confidence has become totally dependent on the validity of government debt.
The insolvent position of a number of eurozone nations invalidates the general assumption that government paper provides a solid foundation for eurozone banks. That the stronger euro-countries can underwrite the weak is now also doubtful. The precedent that has been set by the retrospective interposition by governments and their agencies as senior creditors undermines the value of government debt even further for private-sector banks, who become junior creditors. It is not surprising that they have re-deposited the bulk of the money lent to them by the ECB with the ECB itself. Euros held at the ECB only give refuge from exposure to specific government paper and is the best of a bad choice. Banks outside the region are exercising the option of opting out altogether.
It may seem unnecessary to question the very basis of the European financial system in this way. But this is bound to be debated in boardrooms across the entire banking network, inside and outside the euro area, and banks will react. It is also the underlying reason why the situation remains so precarious regarding Europe’s debt crisis. The way Greece’s default has been handled brings an increased risk of capital flight from the region at the worst possible time. Funding for all eurozone nations has become a lot more difficult. The ECB will come under growing pressure to not only rescue banks, whose balance sheets are imploding, but also to directly bail out governments as well.
Because of the systemic role of government debt, the crisis can be expected to spread rapidly from the insolvent weaker euro-nations to all the others. In short, the mishandling of Greece’s debt problems has made things worse.
In this video Philipp Bagus, Assistant professor of Economics at Madrid’s Universidad Rey Juan Carlos and author of The Tragedy of the Euro and Alasdair Macleod of the GoldMoney Foundation talk about the eurozone facing the problem that is characterised in the “tragedy of the commons” analogy. Bagus explains this phenomenon by way of an example of overfished and over-exploited oceans due to a lack of property rights on oceans. In Europe, governments run larger deficits than their “competitors” in order to externalise the costs to all users of the currency. Knowing these incentives, the Stability and Growth Pact was put in place as per the early 1990s Maastricht Treaty, capping budget deficits at 3% of GDP and the debt to GDP level at 60%. However there was no enforcement of these rules which is why there have already been more than 80 infringements to this stability pact without any repercussions.
They talk about possible solutions to the euro crisis. Bagus points out that there are basically three different ways to go about it. Firstly, governments could make drastic cuts in public spending and privatise public assets in order to balance their budgets. However, there will be – and is – strong political resistance to such proposals. Secondly, the eurozone could disintegrate, driven by a reluctance of German citizens to pay for other countries’ expenditures. And lastly, central banks and governments could decide to print their way out of the crisis, leading to high inflation.
Bagus says that as long as the incentive for running deficits exists there won’t be an increase in countries’ savings rates. Macleod points out that there is great institutional resistance to breaking up the euro. Bagus explains that the official opinion towards the euro is positive in Germany; however the sentiment on the streets looks quiet different. But as long as there is no political party devoted to this issue this mood is not likely to gain traction at least as long as inflation remains moderate.
Amid the ongoing expansion of the money supply and persistent deficits, Bagus can’t see the dollar gaining in value over the medium to long term. He also says that ECB policies are a lot more pragmatic than the ones undertaken by the US Federal Reserve. Talking about sound money, Bagus explains different ways to go about its introduction. One way would be to back all the money in existence by gold, adjusting the price of gold accordingly. Another would be to take away legal tender laws and have competing currencies. However this would require the governments to impose dramatic reforms, which is partly why they will oppose such measures.
This interview was recorded on November 15 2011 in Madrid.