“Giarre, a town in eastern Sicily, sits above the sea on the slopes of Mount Etna. It was once a collection point for the wine produced on the hills above, which was rolled down its main street in barrels to the port below. Today, Giarre bears a far more dubious distinction. The city of 27,000 hosts the largest number of uncompleted public projects in the country: 25 of them, nearly one for every 1,000 inhabitants. So spectacular is the waste that some locals have proposed promoting Giarre’s excess as a tourist attraction.
On an afternoon in September, I toured some of Giarre’s most notorious eyesores with Turi Caggegi, a journalist who has been writing about government waste since the 1990s. Caggegi showed off a partly built, graffiti-covered theater where work has started and stopped 12 times. It has yet to host a show. Not far away stood a hospital that took 30 years to build and was outdated before it was ready to open. Later, Caggegi drove past an Olympic-size swimming pool that was sunk but never completed. “So much money wasted,” he said. “And it wasn’t that they were spending it on productive investments. They were buying votes.
In 2011 the Sicilian regional government ran a €5.3 billion ($6.8 billion) deficit on a €27 billion ($34.8 billion) budget. This year, with the island’s credit rating hovering just above junk status and Italian Prime Minister Mario Monti cutting subsidies to the regions in an effort to shore up the national budget, Sicily has reached the breaking point.
“Bread and circuses,” said Caggegi. “That’s what the Romans used to say.” Italians are discovering what happens when the bread runs out.””
“Riot police were out in force in Tehran’s main squares yesterday as merchants kept their shops shut in protest at the falling rial, despite threats of prosecution.. The rial has fallen 30 percent in the past week, raising questions about Iran’s economic health in the face of tightening international sanctions. Wednesday’s strike by bazaar merchants in the capital, accompanied by unexpected protests by currency traders, led to clashes between riot police and demonstrators..”
- From the Financial Times, ‘Iran riot police on alert as merchants step up protest’, 5.10.2012.
That roaring sound you hear is the noise of chickens coming home to roost across the western world. We have had four decades since President Nixon took the US dollar off gold in 1971, during which time our politicians have happily promised us the earth and made up for the inevitable shortfall by borrowing from the bond markets, and therefore from the future. But even governments cannot live beyond their (taxpayers’) means indefinitely. As the likes of Greece and Sicily are now discovering, the future has caught up with us.
There is a thesis, with which we agree, that suggests that the world now requires constant economic growth solely to service its mountain of outstanding debts. So what happens when that constant economic growth starts to turn into a synchronised slowdown – or worse? So far, with private sector borrowers furiously deleveraging (even at near zero interest rates: NOBODY WANTS TO BORROW – see Japan, last 20 years), the major central banks have aggressively taken the other side of the trade, and pumped money into the banks through the magical money-creation Ponzi scheme known as quantitative easing. The banks aren’t particularly keen on lending it out. That may be because they’re predominantly insolvent, but let’s not go there. So we have a stand-off, of sorts. On the one hand, individuals and corporates, having binged on easy credit for far too long, are now mostly sickened by the stuff. On the other hand, central bank governors don’t want to take the credit for Great Depression II. They’ll get it anyway, because the markets cannot be fooled indefinitely either. Meanwhile, the price signals that would ordinarily be a guide to entrepreneurs and other risk-takers are being hopelessly distorted by money-printing.
One side-effect of QE is that increasingly dangerous sovereign debt (as a shorthand: G7 government debt) optically resembles high quality debt in that the miserly yields available seem to reflect some form of ‘flight to quality’. What those miserly yields actually reflect is financial repression – namely that the government and its regulators are effectively forcing captive investors (not least pension funds) to invest almost exclusively in this garbage. In the process, by happy coincidence, heavily indebted governments are able to fund themselves. The private sector has a word for this policy: extortion.
Another side-effect of QE is that the perception of value in the variously affected currencies swings even more wildly than usual. Somebody intelligent once wrote that paper currencies don’t float, they just sink against each other at different rates. Since 1971 this has undoubtedly been the case. But since the Fed and the ECB went all-in in their pursuit of QE ad absurdum, the risk of disorderly currency collapse has risen markedly.
Don’t just take our word for it. CLSA’s Christopher Wood in his recent ‘Greed and Fear’ commentary writes as follows:
While the central banks have undoubtedly bought some time by creating the newsflow to allow most world stock markets to rally last quarter after the Eurozone-driven risk-aversion seen in the previous quarter, the decision by the Fed to adopt “open-ended” QE, and the overwhelming reaction of the investor consensus to support that decision, has re-enforced the base case long argued by Greed & Fear. That is that the “capitalist” world is on the path to the collapse of the fiat paper system. For once the “open-ended” principle is established, as it now has been, it can be expanded ad infinitum.
..the game will be up when investors cease viewing the relevant sovereign bond as a safe haven and that government bond yields spike as a result of supply concerns. At the point when such turmoil hits the reserve currency of the world, namely the US dollar and its government bond market, quantitative easing will be discredited, and most likely the modern fiat paper monetary system along with it, as well as of course monetarist and Keynesian orthodoxies.
Nor is Christopher Wood alone in a financial wilderness in this bleak prognosis. SocGen’s Dylan Grice in last week’s ‘Popular Delusions’ commentary cited Bernd Widdig and his analysis of Germany’s inflation crisis (‘Culture and Inflation in Weimar Germany’):
Next to language, money is the most important medium through which modern societies communicate.
As Dylan Grice indicates,
His may be an abstract observation, but it has the commendable merit of being true.. all economic activity requires the cooperation of strangers and therefore, a degree of trust between cooperating strangers. Since money is the agent of such mutual trust, debasing money implies debasing the trust upon which social cohesion rests.
And he adds,
I feel queasy about the enthusiasm with which our wise economists play games with something about which we have such a poor understanding.
For students of markets and economics this recalls a quotation by Keynes himself:
But to-day we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time — perhaps for a long time.
Keynes also once wrote that he worked for a government he despised for ends he considered criminal. We would adopt that phrase and direct it to the leading neo-Keynesian economists – overzealous believers in a false science – who are even now leading the delicate mechanism of the western economies into a fatal experiment with unsound money, egged on by bankers whose ethical compass has already been shown to be hopelessly compromised.
Today the currency of Iran. Tomorrow ..?
This argument happens to transcend the mundane and partially subjective business of shepherding pounds, shillings and pence to the safest havens; it touches on issues of fundamental morality. If we are debating with the ignorant, ignorance can ultimately be addressed, given an open mind. If we are debating with the profoundly stupid, that stupidity may admittedly be a barrier to full resolution of the debate. But if we are debating with people who are going to do harm, whether deliberately or inadvertently, the debate should be conducted at the fullest volume and with the widest number of engaged participants.
“I believe in an America where millions of Americans believe in an America that’s the America millions of Americans believe in. That’s the America I love.”
- US Presidential Candidate Mitt Romney.
Never try to teach a pig to sing, advised Robert Heinlein. It wastes your time and it annoys the pig. We try to shy away from overmuch coverage of politics in this commentary for similar reasons – it’s probably a waste of time, and many readers hate it. But trying to avoid politics in the financial world is easier said than done. Five years of enduring crisis have gifted more and more power both to the politicians whose easy spending helped cause the crisis, and to their appointees in central banks who have run out of conventional policy options and are now busily stacking up unintended but nevertheless vast and intractable problems for the future. Market prices are no longer determined by the considered assessment of independent investors acting rationally (if indeed they ever were), but simply by expectations of further monetary stimulus. So far, those expectations have not been disappointed. The Fed, the ECB and lately even the BoJ have gone “all-in” in their fight to ensure that after a grotesque explosion in credit, insolvent governments and private sector banks will be defended to the very last taxpayer.
Mitt Romney was widely derided as having “gaffed” when he spoke of the now infamous 47%
who are with [the President], who are dependent upon government, who believe that they are victims, who believe the government has a responsibility to care for them, who believe that they are entitled to healthcare, to food, to housing, to you-name-it. That that’s an entitlement. And the government should give it to them.
Romney may have been “inelegant” in his choice of words. But at least he had the guts to voice what many silent millions must surely be thinking across the ailing western economies. It takes many things to bring errant government finances under control. Simply pledging to squeeze the rich (and casually conflating tax avoidance – which is legal – with tax evasion – which isn’t) is an aggravating diversion for wealthier voters. As any hole-digger knows, the very first policy response on recognition of the hole should be to stop digging. For a heavily indebted government, the equivalent of stopping digging is cutting spending. And yet we have a coalition government allegedly focused on austerity and deficit reduction which is content, for example, to keep giving hundreds of millions of pounds of development aid to wealthy countries.
Just as government-led austerity is something of a myth in the UK, deleveraging would seem to be a myth of comparable standing in the US. The consistently excellent Doug Noland points out the absurdity of the US deleveraging myth:
US non-financial credit market debt grew by 5% in the second quarter, its strongest expansion since Q4 2008;
Corporate credit market borrowing grew by 6.9%;
Consumer credit grew by 6.2%;
Federal borrowing grew by 10.9%;
While household debt has declined by $800 billion since the end of 2007, to $13.5 trillion, federal debt has expanded by more than seven times that decline: total non-financial debt ended Q2 at a record $38.9 trillion, having expanded by $6.5 trillion over 16 quarters;
As a percentage of GDP, total non-financial debt has grown from 124% of GDP in June 2008 to 249% of GDP as at the end of the second quarter.
As Noland suggests, a genuine deleveraging would see price levels and market-based incentives adjust across the economy in a manner that would support business investment. Genuine deleveraging would see a change in economic emphasis from credit-fuelled consumption towards savings and productive investment. Central bankers, on the other hand, having driven interest rates to the zero bound, seem determined to destroy savers. Genuine deleveraging would see a meaningful reduction in non-productive debt. Genuine deleveraging would see market prices determined by fundamental forces and not by government intervention, manipulation and inflationism. Instead, we get a profound form of ‘mission creep’ by central banks like the Fed, which in the words of veteran analyst Jim Grant has evolved well beyond its origins as a lender of last resort and not much else, and now is fully engaged in
the business of steering, guiding, directing, manipulating the economy, financial markets, the yield curve; it manipulates and pegs interest rates – it is all over the joint, doing what so signally failed in the old eastern bloc.
And so it is that the government agencies that have given themselves the mission of economic oversight are now working to destroy the very same economies they are nominally tasked with protecting. It is a wholly specious argument to suggest that the creation of trillions of dollars / pounds / euros / yen out of thin air will not ultimately be inflationary; like saying that storing an infinite amount of tinder next to an open flame does not constitute a fire hazard. Admittedly, the explicit inflationary impact of historically unmatched monetary stimulus will not be fully visible until those trillions are circulating in the economy in private exchanges between buyers and sellers – rather than squatting ineffectively in insolvent banks’ reserves. But financial markets are nothing if not capable of anticipating future trends. Investors, traders, speculators – call them what you will – are already weighing up the probability of a reduction in future purchasing power driven by open- ended commitments to money printing today, and the prices of alternative money such as gold and silver, as denominated in unbacked fiat currency, are already responding.
Financial repression, of course, is all about wealth transfer. Inflationism is the textbook response to a crisis of too much debt (even if you were the over-borrowed entity that triggered the crisis in the first place). Many constituents (pensioners in traditional schemes and on fixed incomes, annuity holders, depositors) will be more or less powerless to avoid the looming inflationary wave. But it is not too late for savers and investors less constrained by circumstance. Brent Johnson of Santiago Capital has a nice line in telling it how it is. With one eye on ‘The Usual Suspects’ he indicates that
the greatest trick central bankers ever pulled was convincing the world that they work for the public and not for the banks.
His advice, which we fully endorse, is to move away from the realm of paper assets and towards the world of real ones. Anticipating that inflationary tsunami is not a precise science because market confidence in intangible paper currency does not persist in a linear fashion. It lasts until it doesn’t last any more, and then it runs the risk of shattering instantaneously, along with faith in most G7 government debt. Like Hemingway’s bankrupt we go broke slowly, and then all at once. But one of the most grotesque ironies of our time is that the asset class that is objectively the least attractive as well as the proximate cause of the world’s financial problems – western market government debt – is also the most expensive. Just because sheep-like bond fund managers are providing a real time lesson in the perils of agency risk does not mean we have to follow them down the primrose path. Cash, most forms of bonds, and fixed annuities all look like poor prospects for the years ahead. Productive real estate, defensive equities of businesses with pricing power, gold and silver all look like better alternatives.
The last Fed chairman with the guts to do the right thing for the economy rather than just its banks, Paul Volcker, has rightly observed that “monetary policy is about as easy as it can get”. Another round of QE “will fail to fix the problem”. That is in part because the Fed, along with its international peer group, now is the problem. The sooner voters come to appreciate the dangers inherent in modern central banking and its unlimited powers to manipulate the financial system, the better. Are there any politicians out there who can rise to the challenge?
Two Bloomberg correspondents reported on August 8 that the US Government’s unfunded liabilities rose by $11 trillion last year, “ten times larger than the official deficit”, and are now at an estimated $222 trillion. The authors base their estimates on figures supplied by the Congressional Budget Office. This makes talk about the “fiscal cliff”, as the Bush tax cuts come to an end, a secondary issue. Meanwhile in Germany the Constitutional Court will be told on 12 September that the bailout costs faced by Germany are €2 trillion with a further €1.7 trillion in the pipeline, compared with only €170 billion a year ago.
In contrast with these accelerating deficits, the gold price has fallen from over $1,900 to recent lows under $1,600. Admittedly this move has been accompanied by growing apathy in the market, matched perhaps by complacency in bond markets over the state of the government finances quoted above. Furthermore similar budgetary problems, particularly those welfare-related, afflict all advanced economies. And these liabilities are not just rising; they are accelerating and are unlikely to remain hidden for much longer.
While the general public is aware that the eurozone, for example, has difficulties and that world economic conditions are far from blissful, it is unaware of the enormous scale of the global sovereign debt crisis. Even economists who should know better ignore it; however, they are gradually beginning to realise, contrary to what their text-books tell them, that stuffing new money into an economy is not leading to recovery and underwriting future tax revenues. This being the case, unfunded liabilities will emerge at the same time tax revenues diminish.
Waking up to this reality will create its own financial shock, made worse perhaps because it has been the intention of governments to hide the truth. They have pursued this deception with zero interest rates, which have artificially cut the cost of government borrowing and kept stock markets from falling. At the same time they have fostered the myth that government spending can make a positive difference to the economic outcome. Contrast this with Spain and Italy, who are unable to conceal their financial difficulties any longer. Their problems are a foretaste for what the rest of us will eventually face.
Do recent stirrings in precious metal prices indicate an end to this complacency, or is it just a speculative bounce? Time will tell, but given the rapid deterioration of government finances, gold and silver have been left a long way behind. But summer’s lease hath all too short a date. In the next few months we will think less about outdoor activities and more about what’s ahead of us. Some of our future pre-occupations are easy to anticipate, such as the growing risk of the eurozone disintegrating. Others are less visible, but could this winter see us waking up to the consequences of governments’ off-balance sheet liabilities turning into actual deficits?
If this is the case gold and silver – having dallied for a year – have a lot of catching up to do, and the recent rise should be the start of a major move upwards.
“Toby Baxendale is an entrepreneur who built up, amongst other things, the UK's largest fresh fish supplier to the Food Service sector, see www.directseafoods.co.uk, and recently sold it. Toby is dedicated to furthering the teaching of the Austrian school of economics. He established and funded the 1st Distinguished Hayek Visiting Teaching Fellowship Program at the LSE in Honour of the Nobel Laureate F A Hayek. Toby is Chairman of The Cobden Centre. Richard Cobden's timeless principles of the abolition of legal privilege of the few at the expense of the many are worthy in this day and age to promote. | Contact us
12 August 12 | Tags: Keynesianism, Sovereign Debt | Category: Economics | Leave a comment
Economists and journalists often point to the danger of external public debts — in contrast to internal debts, which are regarded as less troublesome. Japan is a case in point. Japan has an enormous public-debt-to-GDP ratio of more than 200 percent. It is argued that the high ratio is not a problem, because the Japanese save a lot and government bonds are held mostly by Japanese citizens; it is internal debt.
In contrast, Spain with a much lower public-debt-to-GDP ratio (expected to be at 80 percent at the end of this year) is regarded as more unstable by many investors. One reason given for the Spanish fragility is that about half of Spanish government bonds are held by foreigners.
At first sight, one may doubt this line of reasoning. In fact, as an individual living in Spain, I do not care if I get a loan from a Spanish or a German friend. Why would the Spanish government be different? Why care if loans come from Spaniards or from Germans?
Governments are ultimately based on physical violence or the threat of physical violence. The state is the monopolist of violence in a given territory. And in violence lies the difference. Internally held debts generate income for citizens, which can be taxed by the threat of violence. This implies that part of the interest paid on internal debt flows back to the government through taxes. Interest paid on external debt, in contrast, is taxed by foreign countries.
There is another, even more compelling, reason why the monopoly of violence is important: I can force neither my Spanish nor my German friend to roll over his loan to me when it comes due. While the government cannot force individuals outside its territory to roll over loans, it can force citizens and institutions within its jurisdiction to do so. In a more subtle form, governments can pressure their traditional financiers, the banks, to roll over public debts.
Banks and governments live in a relationship akin to a symbiosis. Governments have granted banks the privilege to hold fractional reserve and have given them implicit and explicit bailout guarantees. Further support is provided through a government’s controlled central bank, which may help out in times of liquidity problems. In addition, governments control the banking system through a myriad of regulations. In return for the privilege to create money out of thin air, banks use this power to finance governments buying their bonds.
Due to this intensive relationship and the government’s monopoly of violence, the Japanese government can pressure its banks to roll over outstanding debt. It can also pressure them to abstain from abrupt selling and encourage them to take even more debt onto their books. Yet the Japanese government cannot force foreigners to abstain from selling its debt or to accumulate more of it. Here lies the danger for governments with external public debts such as the Spanish one.
While Spanish banks and investment funds will not flush the market with Spanish government bonds, foreign institutions may well do so. The Spanish government cannot “persuade” or force them not to do so as they are located in other jurisdictions. The only thing that the Spanish government can do — and the peripheral governments are actually doing — is to pressure politicians in fellow countries to pressure their own banks to keep bonds on their books and roll them over.
External public debts also pose a danger for the US government. Foreign central banks such as the Bank of China or the Bank of Japan hold important sums of US government bonds. The threat, credible or not, to throw these bonds on the market may give their governments, especially the Chinese one, some political leverage.
What about a Trade Deficit?
In regard to the stability of a currency or the sustainability of government debts, the balance of trade (the difference between exports and imports of goods and services) is also important.
An export surplus (abstracting from factor income and transfer payments) implies that a country accumulates foreign assets. As foreign assets are accumulated, the currency tends to be stronger. Foreign assets can be used in times of crisis to pay for damages. Japan again is a case in point. After the earthquake in March 2011, foreign assets were repatriated into Japan, paying for necessary imports. Japanese citizens sold their dollars and euros to repair damage at home. There was no need to ask for loans denominated in foreign currencies, thereby putting pressure on the yen.
Japan’s export surpluses manifest themselves also on the balance sheet of the Bank of Japan. The Bank of Japan has bought foreign currencies from Japanese exporters. These reserves could be used in a crisis situation to reduce public debts or defend the value of the currency on foreign exchange markets. In fact, the net level of Japan’s public debts falls 20 percent taking into account the foreign exchange reserve holdings of the Bank of Japan (over $1 trillion). Thus, export surpluses tend to strengthen a currency and the sustainability of public debts.
On the contrary, import surpluses (abstracting from factor income or transfers) result in net foreign debts. More goods are imported than exported. The difference is paid for by new debts. These debts are often held in the form of government bonds. A country with years of import deficits is likely to be exposed to large holdings of external public debts that may pose problems for the government in the future as we have discussed above.
The balance of trade may also be an indicator for the competitiveness of an economy, and, indirectly, for the quality of a currency. The more competitive an economy, the more likely the government can support its fiat currency by expropriating the real wealth created by this competitive economy and will not get into public-debt problems. Further, the more competitive the economy, the less likely that public-debt problems are solved by the production of money.
While an export surplus is a sign of competitiveness, an import surplus may be a sign of a lack thereof. Indeed, long-lasting import deficits may be the sign of a lack of competitiveness, and often go hand in hand with high public debts, exacerbating the lack of competitiveness.
Economies with high and inflexible wages — as in southern Europe — may be uncompetitive, running a trade deficit. The uncompetitiveness is maintained and made possible by high government spending. Southern eurozone governments hired people into huge public sectors, arranged generous and early retirement schemes, and offered unemployment subsidies, thereby alleviating the consequence of the unemployment caused by inflexible labor markets. The result of the government spending was therefore not only a lack of competitiveness and a trade deficit but also a government deficit. Therefore, large trade and government deficits often go hand in hand.
In the European periphery, imports were paid with loans. The import surplus cannot go on forever, as public debts would rise forever. A situation of persisting import surpluses such as in Greece can be interpreted as a lack of political will to reform labor markets and to regain competitiveness. Therefore, persisting import surpluses may cause a currency or public-debt sell-off. In this sense, the German export surplus supports the value of the euro, while the periphery’s import surplus dilutes its value.
In sum, high public (external) debts and persisting import surpluses are signs of a weak currency. The government may well have to default or to print its way out of its problems. Low public (external) debts and persisting export surpluses, in contrast, strengthen a currency.
 Another important reason is that the Spanish government cannot use the printing press at its will, because it is shared by other Eurozone governments that might protest. Japan, however, controlls its central bank and thereby the printing press.
 It should be noted that ever more new Spanish debt is held exclusively by Spanish banks, because other investors are progressively less interested in financing a government that simply refuses to enact real and effective austerity measures.
This article was previously published at Mises.org.
Throughout the European debt crises, Germany and its allies in the austerity camp have been urged by financial commentators, particularly in the United Kingdom and the United States, to show more “flexibility” to help the high-debt countries in the periphery of the single currency union.
Such flexibility first took the form of a bailout for Greece when it teetered on the brink of sovereign default in 2010. When that failed to stem the crisis, European leaders were urged to create a bailout fund for in case other nations would find it difficult to borrow on financial markets as well. They did. Ireland and Portugal subsequently tapped into that bailout fund, the European Financial Stability Facility.
When that failed to stem the crisis, the prevailing wisdom became that the bailout fund was too small and only temporary, raising concern about Germany’s willingness to bankroll peripheral eurozone nations in the long term. So Europe’s leaders devised a bigger, permanent bailout fund, the European Stability Mechanism.
Yet the crisis goes on and the new solution floated by commentators is the pooling of sovereign debt in the eurozone in the form of eurobonds. As with the Greek bailout and the erection of the bailout funds, Germany is hesitant. It fears that financial support for troubled eurozone economies removes the incentive on their part to improve their competitiveness relative to stronger European economies which Germany sees as the way to ensure long term stability in the euro area.
Moreover, there has been growing weariness in core eurozone countries like Germany and the Netherlands to bailing out weaker euro states. The political leaders of these countries can ill afford electorally to advance schemes for further European integration, which is increasingly unpopular.
This has been seized upon by those favouring, for instance, eurobonds as proof that their solutions to Europe’s debt woes are perfectly valid. The only reason they aren’t implemented—even if, so far, they usually have been, only maybe not very fast—is that Europe’s leaders are afraid of their voters who stop them from doing what’s right.
It turns out, the proponents of further European integration are quite afraid of the European electorate as well. Writes Martin Wolf, the Financial Times‘ chief economics commentator, in a recent blog post:
I fear that austerity without end will bring about a return to the unstable populist politics the European Union was designed to prevent. That could shatter the eurozone and, with it, the EU, thereby ending the most successful attempt to build peace and prosperity in Europe since the fall of the Roman Empire.
Wolf even invokes the rise of Adolf Hitler which he claims had nothing to do with hyperinflation during the Weimar Republic but was entirely due to the economic hardships of the 1930s Depression. “Deep economic collapses are dangerous.”
Indeed they are, as they often lead policy makers to experiment with unconventional economic policies because they haven’t the patience to let the market correct itself, which is exactly what should have happened after the credit crunch of 2008. Instead, by repeated government interventions in the private economy, the recession has been prolonged and the sort of creative destruction that has to take place before there can be a true and sustainable recovery has not been allowed to occur.
Notice the panic that arises whenever a single bank is about to go under. Tens of billions of euros doled out to Spain so the country can save its troubled banks. There can be no failures because the financial industry is so interconnected — it is feared that the collapse of one bank will drag others down with it, resulting in widespread financial panic.
So we have malaise instead until Germany pulls out the “bazooka” and makes clear that it will pay everyone’s bills. That is what Wolf means when he writes that “the creditworthy country has to lend freely if a fixed exchange rate system (or in this case a currency union) is to survive.”
If Chancellor Angela Merkel announces next week that she wants to quadruple the bailout fund, that she’s willing to underwrite every bad loan both German and peripheral banks ever made, will it end the crisis?
Maybe. Or maybe markets will come to their senses soon thereafter and wonder whether the German voters wouldn’t tear up such a commitment in the next election?
Maybe they’ll even realize that it doesn’t matter as long as Greece, Italy and Spain don’t change their ways and implement the sort of regulatory, labour market and entitlement reforms that are needed to move their economies away from clientalism and protectionism toward entrepreneurship and free trade.
Wolf doesn’t seem to particularly care about the longer term imperatives. He ominously writes of “populist politics” unless a short term solution is found. Without one, he believes, “the eurozone may never reach the long term”. It’s not so much an argument as it is a threat — integrate now or the “populists” win!
In fact, the push for European integration in spite of the clear wishes of voters in core eurozone countries is exactly what fuels the anti-European sentiment that Wolf despises.
But what’s more concerning is that Wolf apparently seeks deeper European integration for political reasons, not economic ones. Which raises the question: does he want want an even bigger bailout fund, does he want eurobonds and does he want to keep the euro together because it makes economic sense for Germany and the other countries in the euro, or because he wants this political project to succeed?
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.
ANDERSON, B.M. 1949. Economics and the Public Welfare – A Financial and Economic History of the United States 1914-1946. North Shadeland, Indiana: Liberty Press
BAGUS, P. 2010. The Tragedy of the Euro. Auburn, Alabama: Ludwig von Mises Institute.
CAPIE, F., WOOD, G. 1994. “Money in the Economy 1870-1939.” The Economic History of Britain since 1700 vol. 2: 1860-1939. Roderick Floud and D.N. McCloskey, ed. Cambridge: Cambridge University Press, pp. 217-246.
DRUMMOND, I. 1987. The Gold Standard and the International Monetary System 1900-1939. London: Macmillan
FRIEDMAN, M. 1950. “The Case for Flexible Exchange Rates” Essays in Positive Economics. 1953. Friedman, M. Chicago: University of Chicago Press, pp. 157-203.
HOWSON, S. 1994. “Money and Monetary Policy in Britain 1945-1990.” The Economic History of Britain since 1700 vol. 3: 1939-1992. Roderick Floud and D.N. McCloskey, ed. Cambridge: Cambridge University Press, pp. 221-254.
HUERTA DE SOTO, J. 2012. “In defence of the euro: an Austrian perspective”. The Cobden Centre, May 29th
KENWOOD, A.G., LOUGHEED, A.L. 1992. The Growth of the International Economy 1820-1990. London and New York: Routledge
KINDLEBERGER, C.P. The World in Depression 1929-1939. London: Pelican
MYDDELTON, D.R. 2007. They Meant Well – Government Project Disasters. London: Institute of Economic Affairs
ROTHBARD, M. 1963. America’s Great Depression. BN Publishing
SAMUELSON, R.J. 2010. The Great Inflation and its Aftermath – The Past and Future of American Affluence. New York: Random House
SELGIN, G. 1997. Less Than Zero – The Case for a Falling Price Level in a Growing Economy. London: Institute of Economic Affairs
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.
VAN DER WEE, H. 1986. Prosperity and Upheaval – The World Economy 1945-1980. London: Pelican
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.
There is a big shift in political sentiment among G8 leaders towards less austerity and more emphasis on economic growth, which was evident at their meeting last weekend. The triggers are the election of Francois Hollande, the threatened collapse of the eurozone, and the impending US presidential election. The obstacle in the eurozone is Germany, whose citizens are being asked to pay up, throwing their limited savings at a seemingly unlimited problem. The IMF also opined on the United Kingdom last Tuesday, saying further UK quantitative easing may be necessary.
Putting G8 politics to one side, the eurozone’s problems have reached a critical point: it is clear that either a lot more money is needed to buy some time, or it faces systemic collapse. Greece’s problems are bad enough, but Spain, Italy, Belgium, Ireland and Portugal are also ensnared in debt traps from which there is no obvious escape. Even France has a developing banking problem, with a large state-backed mortgage lender downgraded by Moody’s having difficulties funding its balance sheet. France’s commercial banks are also horribly exposed to Italy, Spain and Belgium.
We often focus on state finances and forget the impact on the private sector of the systemic crisis. Higher government borrowing costs push up mortgage lending rates, which are bound to undermine over-leveraged property markets, particularly in Portugal, Spain and Ireland. The French lender mentioned above, Caisse Centrale du Credit Immobilier, is in danger of needing a state rescue, and this in a country not thought to have residential property problems. Mortgage rates in the UK are also rising, as lenders tighten their lending criteria, and houses aren’t shifting. And the effect of rising interest rates on other property markets is obvious. It is early days, but it appears that these property markets are stalling again, which will worry central banks.
Their overriding fear has always been a debt-deflation collapse, where falling asset prices trigger self-perpetuating collateral liquidation. Central banks must think that the risk of this happening is increasing again. It all adds up to pressure on the European Central Bank to join with the Fed and the Bank of England in a renewed expansion in monetary policy.
Historians may look back at the G8 meeting last week and see it as the point in the continuing crisis when central banks were given the green light for a final, catastrophic monetary easing. It is game-on again for the Keynesians, and is an opportunity for them to push hard for a Roosevelt-type expansion of money and spending. Both Obama and Hollande favour this approach, and more conservative politicians who might argue against it do not have sufficient understanding of sound economic theory to put forward a valid counterargument. But the Roosevelt stimulus failed to stop a renewed downturn in 1938 nine years after the Wall Street Crash of 1929, and is not a happy precedent for today’s situation.
A new wave of stimulus seems certain to undermine confidence in the dollar, and now also the euro. And as Germans wake up to the possibility of their third currency wipe-out in a century, there is only one escape route for them: the accumulation of gold.
In recent weeks, while the eurozone has suffered escalating levels of systemic stress in government bond markets and its banking system, the gold price has fallen under $1,600. One would have thought that – but for the occasional fat-finger trade – gold would rise in all this instability, not fall. Putting aside short-term considerations, the simple reason has to be that the investment establishment, which has bought into the bond market bubble, does not believe that gold is any longer an alternative to paper money.
We can understand why they think this. Though the Keynesian vs Austrian economic debate is attracting increasing attention, financial services companies recruit economists who have been trained in the traditions of Keynes and Friedman. They are thus immersed in economic disciplines that assume gold is old-fashioned and has no meaningful place in a modern economy. While they might accept that gold has an historical attraction for some investors, they see it as a “risk-on” investment. This is jargon for something you buy when you want to take risks, the opposite of gold’s traditional role.
For further proof, you need look no further than the average level of portfolio exposure, which across the global investment management industry is said to average less than one per cent. This is certainly not compatible with the level of risk in today’s markets, with many nations on the edge of bankruptcy. The result is that flaky gold bulls are experiencing the discomfort of rising panic.
Let us go back to fundamentals. The Keynesians and Friedmanites are oblivious to the debt trap faced by all major currencies. Central banks are printing money to fund government deficits at the lowest possible interest cost. The inevitable consequence of printing money is price inflation, and price inflation always leads to higher interest rates. Higher interest rates exacerbate budget deficits.
You cannot put it more simply than that. The alternative is to stop printing the money and jack up interest rates, but in that event at the head of the insolvency queue is government itself, so this can be ruled out as a deliberate policy. That is what a debt trap is all about: whichever way you turn, there is only one outcome: bankruptcy.
When a government goes bust, its paper is valueless: not just its bonds, but its fiat currency as well. On the surface it is different in Euroland, because the nation states do not issue their own currency. On this basis the demise of the euro is an event one step removed from the bankruptcy of individual nation states. The relationship with the other major fiat currencies is direct.
The destruction of fiat currencies themselves is becoming more likely by the day. Meanwhile, the weakness of “risk-on” gold has led to a serious mispricing in the market. This has happened because the financial community, sucked into the bond market bubble, has not even begun to discount the debt threat to government paper from sovereign bankruptcies.
When this mispricing is inevitably resolved, it is unlikely to be gradual. It will be so swift that those old-fashioned enough to own gold for insurance purposes will have the protection they sought. Those that fall for modern neo-classical economics will learn a very sudden lesson about what gold is actually for.