See no evil … (Restructuring is coming)

My house had a problem with pigeons nesting in the chimney. Sometimes we’d come home to find one sitting on the couch. On one such occasion I could hear the bird in the chimney. To keep it from coming into the living room (and having to deal with its mess), I decided the easiest thing was to barricade the fireplace with flattened cardboard. I assumed it would eventually go back where it came from.

My decision to ‘see no evil’ is not uncommon. It’s what a lot of people do with problems whose solutions are inconvenient. Thinking about this helped me to understand how perfectly sensible policymakers and opinion-shapers can coalesce around nonsensical policy. I still have Greece in mind. It was far easier for the EU policy establishment to wish the problem away than address its core. Perhaps they thought that the problem would solve itself if they applied a tough enough lid. What else to compare the 110 billion euro package of financing but a lid to cover an intractable problem? All of the adjustment was placed upon the debtor; none on the creditor.

What I did not know about the pigeon, and did not inquire to check, was that it was unable to fly back up the chimney. I had sentenced it to bloody its wings to the point of exhaustion. As days passed without the bird’s escape, I had to consider that the box was no solution at all. The problem would not fix itself. By that time it was too late. I took the box away and helped the creature outside through the front door. Its wings were so badly damaged that it couldn’t fly. It crawled beneath a bush and I think there it demised.

Will the EU realistically face its inconvenient problem before the worst damage is done? Some signs are hopeful. The EU’s Economy Commissioner Olli Rehn yesterday said that the a majority of the 440 billion euro support scheme for Greece, Spain, Portugal sovereign finance can be converted into a European TARP (this is the “European Financial Stability Facility”, which is worth potentially 750 billion euros when IMF contributions and additional support using the EU budget as collateral are added). Not pro-actively, but in the event that domestic banks are found wanting as a result of stress tests that will now include a sovereign debt “shock”. How big of a shock should those tests apply? One answer comes from John Dizard, who on July 4 highlighted the extent to which quasi-sovereign Greek debt is already being restructured (h/t Naked Capitalism). According to this June 9 press release (pdf), the Greek Ministry of Finance is offering to assume several tranches of outstanding hospital debts in exchange for zero-coupon securities, for an overall haircut estimated at 19%. (Dizard quotes a London emerging-market bond dealer who scoffs at that discount; he thinks the market would buy such debt at 70% discount.)

Greece is a microcosm. We live in a world where the creditor-debtor relationship will not be resolved as expected at the time when the debt was contracted. Putting a lid on the problem — even a very expensive lid with pledges of ‘shock and awe’ support — is not going to solve it. Does Greece need to reform? Absolutely. Can reforms alone bring its economy back to a sustainable growth path? Absolutely not. Creditor adjustment is around the corner. If Rehn’s latest statements mean that the European banking system will be treated to capital support from the ‘Financial Stability Facility’ as a consequence of some relief for the debtor (whether friendly or otherwise), that is fantastic. After a financial crisis, the economy’s external position must flip over. Where once it ran big current account deficits it now must run big surpluses. One step toward doing so is relief in the form of lower servicing on outstanding debt. Just look at Argentina’s current account items post-2001 and you’ll see how dramatically this contributed to the economy’s financial surplus.

It is true too that we live in a world with vast underemployed resources. The way forward is debt restructuring: some mixture of relief for the borrower and recapitalisation for the creditor, which recapitalisation is financed by the manufacture of new money. Yes! Austrian-school adherents might not like it, but that doesn’t matter. If the monetary authority does not create this money, the assured consequence is deflation. 1/ How can it create new money? It needs to mark distressed assets on its balance sheets as ‘fudge’: neither money-good nor written off. If the central bank has to write down bad assets, the loss comes out of its capital. Since central banks operate on a thin capital cushion, the finance ministry has to provide the additional capital. The extreme paranoia over fiscal accounts makes this politically difficult. Hence: don’t write down the debt, but don’t expect its repayment either. The end result is that illiquid assets in the economy are replaced with perfectly liquid assets — central bank money, which is ‘outside money’ so long as the illiquid assets acquired by the central bank are no longer treated de facto as anyone’s liability.

This is already happening at the world’s largest central banks. But it needs to be ramped up dramatically. Over the howling protestation of Austrian-school acolytes. An accurate grip on the nature of money is crucial to devising the proper policy path. Money is a means of exchange. That’s it. Finis. Forget about being a store of value, a unit of account, etc. Yes, it is those things, but they pale in significance compared to the means-of-exchange role of money. 2/ There is no sense in which a puritanical view is appropriate for money. Money must be supplied to the point of calling into employment the productive capacity of the economy. This essential insight has been re-discovered time and again, always at the point of greatest financial distress. If you are the slightest interested in this, have a look at Jacob Viner’s 1939 Studies in the Theory of International Trade, which reviews the rich debate over the nature of money during the decades of inconvertibility of British sterling into gold during the Napoleonic Wars (but keep in mind that despite Viner’s otherwise fulsome support for what we would call a ‘fiat money’ position he somehow comes down on the side of Ricardo and the need for a gold foundation of money, an anomaly which I put down to the overwhelming dogma of the interwar years in which Viner wrote — namely, the view that gold was the proper basis for money, which did not abate when convertibility was suspended generally around 1931, on which topic is my entire phd thesis).

Obviously, Argentina’s path post-2001 cannot be travelled by everyone simultaneously; there cannot be a net global current account surplus. From where will come the deficits? This is where my view turns the most gloomy. Those in the best position on a net international investment position basis are those which must take up the burden. (If consuming in excess of production can be considered a burden.) And yet we see Germany embracing “tough” austerity measures, in the notion that it must set an example for peers.  It needs to do exactly the opposite. And what about China? I cannot say at present; I need the time to look into the situation much more deeply, and I don’t have it. But in the end, countries like China and Germany must be cautious about what they wish for. The US economy cannot be the consumer of last resort in this era. And yet it cannot take control of its exchange rate because it is the global numeraire. Hence I see few options except a unilateral universal import surcharge akin to Nixon’s 10% surcharge accompanying the dollar devaluation in August 1971. 3/ After all: who has benefited the most from globalization over the last decade or two? US households have clearly enjoyed some nice goodies (financed by debt), but Chinese households have emerged from poverty on a scale never before witnessed (over three decades). And I would urge caution on those who are tempted to think the US “can’t make anything”. Times will be austere, it can make a lot of what it needs, you just wait.

1/ I’m constantly having to restate this, but it’s worthwhile. Deflation is not ‘OK’. If you’re of a financially puritanical mindset, as are the Austrian school adherents, then you probably see deflation as no worse than inflation, or a perfectly reasonable payback for the excesses tolerated during the prior boom. What this view ignores is the real-world problem of nominally contracted debt. When prices are falling, your income probably does too (and for sure if you are a vendor!). But what about your obligations — do they fall with the price level? Usually not. And that’s the problem.

2/ Some of my views have matured since writing this 2008 essay on gold’s enduring allure. Regarding the exchange function of money: this is the reason for inevitable emissions of quasi-monies in severe financial contractions; people need a medium of exchange. If they cannot come into receipt of the “ideal unit” (as Nussbaum called it) then they will try something else. Community vouchers are already much in evidence in the United States and I would bet on seeing a lot more of them.

3/ Ever wondered how the OECD world came round to floating their currency regimes? One factor was this import surcharge. The world’s key creditor economies at that point, eg Japan and Germany, were also steadfast peggers to the dollar, even after Nixon’s August devaluation. But that, combined with the import surcharge, proved too much, and they had to let go. Also helpful, of course, was an intellectual climate for the first time strongly in support of floating exchange rates.

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