Global macro with a memory
Slovenia’s Milivoje Novakovic evades a tackle by Algeria’s Hassan Yebda. Photo: Reuters/Christian Charisius.
In September 1931 Great Britain ceased paying gold for UK currency and there ended the interwar international gold standard, as most of the world followed Britain off gold. The doctoral thesis I’m writing takes up the story from there. What kind of beast was the international monetary system for the remainder of the 1930s? The figure above illustrates one of the central points. It is a 3D representation of an equation which solves for the optimum choice of domestic assets of the central bank, based on an optimisation of a simple central bank “loss function” at work in the 1930s.
In English: the central bank tries to get the money supply as close to its target quantity of money as possible, but is constrained by the existence of something called a “cover limit”. These limits were ubiquitous in the 1930s, outliving even gold-to-currency convertibility, and dictated a minimum proportion of gold (or foreign assets) that the central bank must hold as a proportion of the money supply. The X axis is the range of such a proportion, from zero (which was the case in Germany) to 0.5. For higher cover limits, the central bank is not able to achieve its target money supply. The money supply target can be reached when the combination of foreign and domestic assets is 2 (because central bank assets back the money supply).
In the figure, when foreign assets are 2, there is no problem — the central bank does not need to acquire domestic assets, and they trace out the level of zero on the Z axis. Now, as we wind foreign reserves backward to smaller levels, higher levels of domestic assets are needed in order to achieve that magic 2 of the money supply target. Yet this is progressively less achievable at higher cover limits and lower reserves.
The loss function, optimisation and 3D graph illustrate the fetters on central banks even after the suspension of gold convertibility. In a sense, the “gold standard” existed in a limping form throughout the 1930s, which helps explain the high levels of observed central bank conservatism during that decade, whether it be the proclivity to peg the exchange rate or the willingness to leave foreign reserve losses unsterilized.
and again.
Published in CNN-Expansión (Mexico)
English translation:
Greece and the Great Depression
Scott Urban
Guest contributor to Centro de Estudios Espinosa Yglesias
In the Great Depression, the prevailing wisdom argued that currency was only trustworthy if pegged to another currency — preferably, one which is pegged to gold. The idea was to limit the potential for fiscal malfeasance. The key link was the foreign-exchange market. If the government spent too much, the extra spending tries to leave the economy, via the fx market. Unless all the other governments are behaving this way, there won’t be enough foreign currency in the market, so the central bank has to supply it from its reserves. These are obviously limited, so the government has to reverse its fiscal misbehaviour and relieve the strain on the fx market.
But a government can be fiscally virtuous and still face a gaping hole in the fx market. A big trading partner might suffer a contraction and stop demanding your goods. Its price level might far so fall that your entire traded sector is uncompetitive. Either of these will create a gap in the fx market which the central bank cannot fill. To maintain the currency peg, policymakers must embrace austerity. Yet this austerity will have a knock-on effect on your other trading partners, prompting them to pursue austerity. This chain-reaction explains part of the severity of the Great Depression.
Fast forward 80 years. Greek debt is unsustainable without dramatic official support. As a result, the EU has arranged 110 billion euros in offical loans to ensure that Greece does not need to face the international capital market for the next two years. The plan calls for a resumption of Greek debt sustainability in 2014 on the basis of a growing economy and primary fiscal surplus. The recipe for both is austerity. Nowhere in the programme documents are wage cuts specified beyond the public sector. But independent analysts estimate they will need to be 20% or more, barring a surge in wage growth outside Greece.
Unsurprisingly, the market is sceptical. The plan is highly unlikely to succeed. In the meantime, it will kill GDP growth in Greece and its euro-neighbours, and necessitate a depreciation in its non-euro trading partners. The British pound is falling because of Greece, not British politics. The Turkish lira dropped 7% on May 6. At the end of all this, Greek debt will be no more sustainable than when it started, which means the sovereign debt crisis has only been postponed. And the patience of the population might well be exhausted.
To understand the pressure to follow this path, go back to the Great Depression. The prevailing wisdom which urged policymakers to pursue more and more austerity, more and more poverty was the gold standard. Its defence was likened to defending civilization itself. Monetary arrangements have a tendency to do this; Mexico’s pre-1994 experience is no exception. Yet warnings of calamity often prove unfounded, which makes their assertion an example of dogma. In the Great Depression, the gold standard dogma had the power to compel masochistic policy and a plunge in the world economy. As it turned out, to escape the downward cycle, a nation had to forget the dogma and leave the gold standard (or choose autarky).
The EU leadership portray Greek travails as an “existential” crisis for Europe. Such talk is not only unfounded but dangerous. If the Great Depression is any lesson, condemning workers to the sacred cow of a monetary order is risky business. Far more is at stake than the future of Europe’s monetary union.
Times of crisis give rise to reconsideration of the monetary order. It has always been that way. With no small help from the likes of Peter Schiff, Rand Paul and other advocates of the Austrian school, the gold standard is enjoying a renaissance. At least around the water cooler. It’s time to pour some of that cold, pure-filtered water on the concept, before sensible people get too enamoured of this monetary scoundrel.
The gold standard had better be pretty helpful if it’s going to be worth that deflationary tendency (which is often termed “capricious” albeit never by the Austrians).
Here’s the clincher: The very attributes that we seek from the gold standard — stability of the monetary unit — are easily swept aside. In other words, governments throughout history have abrogated or suspended the gold standard when expediency requires (usually in time of war but by no means always; the universal abrogation circa 1931 was not in time of war). Maybe you think we can do better this time (“This time is different”, right?) but that certainly is not how it worked out the last two times the world was on gold (1870-1914 and 1925-1931).
So long as the world is not disturbed by wars or other disastrous events, the [gold] cover of bank-notes is of very little concern to the public, whereas, in the event of such a disturbance, even a cover of 100% would not be possessed of the power to preserve confidence.
–League of Nations, Gold Delegation: Selected Documents (Geneva, 1930), page 66.
Even a purely metallic currency in normal times gains little if anything by have a legal ‘backing’ of gold or foreign assets; while in abnormal times the cover regulations have usually had to be suspended, repealed or relaxed in any case.
— Ragnar Nurkse, International Currency Experience (Princeton, 1944), page 96.
About two years ago I had lunch with one of the most eminent economic historians alive today. We were reflecting on how aggressive were the actions of governments to combat the global downturn. “Does the expansion of government spending put central banks at risk of being forced to pick up the tab?” we wondered. In the end, you have to conclude that government fiat trumps central bank independence, no matter how well the latter is “enshrined” in law. As my dining companion put it, “The state is sovereign.”
I am reminded of that now, in monitoring the progress of ‘de-leveraging’ unaffordable public-sector wages and benefits (a pet preoccupation of this blog). In the USA as elsewhere, municipalities — and states — are starting to get their way when it comes to re-negotiating public sector contracts. It might not be the case that a city is “sovereign”, but a similar principal applies: Governments that can’t pay won’t pay.
From For Calif. public workers, it’s more give than take (Reuters):
Savings from union concessions [in San Francisco], including for many city employees the equivalent of nearly 5 percent wage cuts for the next two fiscal years, will be considerable….
I can think of a Mediterranean country which recently pushed through a 5% wage cut…. But back to the article:
“Big city, small city, rich city, poor city, negotiations are occurring in ways they haven’t in 20, 30 years,” [Santa Monica city manager Rod] Gould said. “Cities are coming to the table with nothing to give or with little to give and asking for something back.”
And if the unions don’t budge, declare a fiscal emergency. And if that doesn’t work — declare bankruptcy:
In addition to forcing massive layoffs, obstinate unions could force local governments over the financial brink and into bankruptcy like Vallejo, California, which made headlines two years ago by taking that dramatic step, a stigma with municipal bond investors and credit rating agencies.
Bankruptcy, however, has helped Vallejo rein in compensation and benefits for its unionized employees, especially those in its public safety units, where paychecks were well above the state average.
Since Vallejo’s bankruptcy proceedings began, three of four city public employee unions have agreed to reduced compensation and benefits.
Anyone still interested in arguing that inflation is the major threat facing us today? On top of the austerity being meted out at the local and state level, now we have a super-charged US dollar. Just wait for the impact on prices — and heaven help you if you’ve got nominally contracted debt.
I’ve said it before, but this is too much like the Great Depression. Again quoting Barry Eichengreen, the pre-eminent scholar on the monetary dimensions of that story:
There is no little irony in the fact that inflation was the dominant fear in the depths of the Great Depression, when deflation was the real and present danger.
–Eichengreen, B., Golden Fetters (Oxford, 1992), page 24.
In the first year of any macro course a key emphasis is the fact that real variables matter. Nominal variables are what you see quoted — and usually reported. So, for example, when you read that the euro has fallen to 1.20 dollars, that’s the nominal exchange rate. The real exchange rate is this nominal rate with the important adjustment of inflation at home and abroad. If two currencies trade at a stable rate for a couple of years but country A has twice the inflation of country B, then country A becomes a lot more expensive relative to B (even though the quoted exchange rate hasn’t budged). It has undergone a real appreciation. (You can download real exchange rate time-series from the Bank for International Settlements.)
Differences in inflation are often minimal, so most of the action in real exchange rates is simply the movement in nominal exchange rates. Where the nominal exchange rate doesn’t matter — can’t matter — is when the exchange rate is pegged. Which brings us to China. The United States has been desperate for China to command by government diktat a rise in the real exchange rate of the renminbi. This was always unlikely, because the real exchange rate would adjust to underlying factors regardless of changes to the nominal exchange rate. Had China acquiesced in a revaluation, then Chinese domestic prices would have responded with a decline.
What changes this is the rise in Chinese wages, which will generate broader inflation in China and therefore a rise in the renminbi’s real exchange rate. The source of Chinese wage rises is the traded-goods sector. Chinese workers are aware that their wage should equal the marginal product of their labour, and now they’re able to demand it due to the changing demographic profile in the country. High productivity growth in the traded sector brings up the wages. Since other sectors of the economy must compete with the traded sector for the same pool of labour, those higher wages are spread across the traded and non-traded sectors (the high-productivity and low-productivity sectors). Non-traded sectors are not priced internationally (their output is not tradable), so these prices will rise in order to pay for the more expensive labour. That’s the Balassa-Samuelson effect, which explains the real currency appreciation we see as countries develop.
This development is bullish for China and for the world economy. It could not have come at a better time. The problem facing the global economy today is a massive shortfall in demand. As China’s currency appreciates in real terms, its non-traded sector absorbs more resources, and the Chinese economy will see much higher rates of import growth. The world economy is not a zero-sum game (1/); China’s improvement in living standards is not made at someone else’s expense. Rather, it is a boost to the world economy. It not only means more demand for our output, but it will also migrate more jobs to poorer neighbours as the Chinese economy moves up the value chain.
Counter-intuitive though it might seem, this is also good for the environment, if you believe in an environmental Kuznets curve.
What’s happening in China in some respects reflects the predictions of the Lewis Model of industrial growth, where wage growth lags productivity growth because the industrial sector can draw labour from the agricultural sector. Once that source begins to dry, wage growth can take off. The result is rising inequality in the initial stages of industrialization (since more of the profits accrue to capital, i.e. the owners of production) and then falling inequality as labour demands a greater share of profits through rising wages.
We’ve been here before and it’s name is Germany. Fortunately, the economist Oliver Grant has written a masterful survey of this process in Germany during the last decades of the first modern age of globalisation, roughly 1870-1913 (2/):
The analysis contained in the preceding chapters has provided ample evidence of the existence of labour surplus conditions in Germany in the late nineteenth century…. High levels of rural-urban migration provided the motor for rapid economic growth….
No other European country had such a rapid transition to an urban industrial society. The rate of growth of the major cities was unusually high; the numbers migrating internally was also above the levels in other countries….
As a late-industrializing country, with a massive need to import food and raw materials, Germany had to expand exports rapidly, gaining share at the expense of other countries. This meant that wages had to be kept down….
The implications of the labour surplus period are set out in the propositions of the Lewis Model: growth will be high as under-employed labour is transferred to productive occupations; wages will tend to lag behind productivity in the advanced or industrial secgtor; the profits share will rise; the benefits of industrialization will go disproportionately to the owners of capital. Inequality in the urban sector will be high and remain so until the labour surplus phase is over, when the ‘turning point’ is reached.
I would not be surprised if the Chinese leadership decide to get ahead of events by endorsing higher wages or limited collective-bargaining rights or something of the kind. They will also face the choice of higher inflation or a revaluation in the peg. I would guess they’ll opt for the latter. When people tell you that higher productivity growth will offset the wage growth (by keeping unit labour costs in check), remember Balassa-Samuelson. Yes, Chinese industry will still be competitive, and it will enjoy rising productivity growth. But a higher marginal product of labour means higher wages, and these will be shared in lower-productivity sectors in the non-traded economy, which means rising output prices i.e. inflation.
Endnotes
1/ The temptation to see growth as zero-sum is greatest in regard to natural resources. This oversight claimed even J.M. Keynes, whose otherwise thoughtful insights are so important today notwithstanding the global outbreak of economic puritanism. Writing on the eve of World War One, Keynes opined that the fantastic growth of the first modern globalisation could not be sustained, and that resource constraints would soon bind, bringing a decline in the standard of living. In fact, agricultural resources (to which Keynes referred) were on the verge of finding vast new acreages for development. I might reproduce his exact words later.
2/ Grant, O., Migration and Inequality in Germany, 1870-1913 (Oxford, 2005), pp 293-294.
If EMU-integrity is seen as a ‘Maginot line’ for the European project, then we have to be honest about the consequences. Will the citizens of a democracy put up with interminable austerity and rising unemployment? If not, and if EMU-integrity is sacrosanct, then the trilemma suggests that capital controls are the only option, because they can be combined with a fixed currency and internal demand-management policy (reflation). (‘Fixed-currency’ is relevant here despite having a unified currency, because a reflationary policy will require the emission of a parallel legal tender.)
Capital controls would by necessity have draconian ends, for the reasons already stated. But if EMU is seen as inviolable, it might be the unforeseen consequence. Sadly, Europe has been here before — in some respects, precisely here. But that’s another story.
Fantastic column this morning by Kevin O’Rourke — a guy who knows a thing or two about globalization. (He wrote the book.) Turns out that markets — not unreasonably — want both fiscal realism and economic growth. In other words, an austerity programme which delivers only that (austerity) is useless to investors, and won’t be rewarded by them.
So how do we get growth? You know where I stand: default, devalue, reflate, reform. Kevin advocates an EU-brokered fiscal expansion. I’m all for it.
Michael Mussa, former head of research at the IMF and presently a senior fellow at the Peterson Institute, argues that Greece ought not restructure (pdf) and definitely ought not leave the euro-area, whilst also sketching out how unwieldy are the debt dynamics with or without the IMF/EU program. It’s an example of the cognitive dissonance we’re seeing a lot lately, in discussing best strategy for Greece and Europe. The unsustainable debt dynamics are carefully acknowledged, but the usual solution (default and devaluation) is asserted to be unavailable, on circular grounds. Thus,
A number of critics of the present approach have suggested, not without reason, that a debt restructuring for Greece is probably inevitable.
Moreover, the economy will need to grow. And this raises real problems for the fiscal-probity approach:
With the exchange rate pegged within the euro area, Greece requires outright wage deflation to restore competitiveness within the area. Achieving this will not be good for nominal GDP growth and for debt dynamics.
In other words, Plan A is mission impossible. But it must be followed, because … well, just because. The alternative (default, devalue, restructure, reflate), we’re told, is Just Plain Scary. I’ll pick this point back up in a moment. But first, the Scare:
In the extreme, if Greece were to exit from the eurozone in an effort to gain international competitiveness and spur economic growth, this would undoubtedly escalate concerns about the viability of the European Monetary Union for all of its members. This means that exit of Greece from the euro area must be viewed as an extreme step that should be avoided at virtually all cost.
The functioning of the Greek financial system will be seriously impaired for some time. The whole Greek economy will suffer. Thus, looking only at Greece, there is good reason to try to avoid sovereign default and restructuring as long as there is some reasonable chance of being successful. Sovereign default is not a cheap way out. Exit from the eurozone would be even more disruptive and expensive.
We need substantiation for such categorical assertions. Perhaps Mussa and others could cite Hong Kong. Now there’s an economy that can weather a crisis — and severe currency overvaluation — without devaluing and without default. The question for the rest of us is, Is Greece more like Hong Kong or Argentina? Well, let’s start with why Hong Kong is so good at keeping a fixed currency over a business cycle and indeed in the midst of a severe regional financial crisis (1997-98). Hong Kong’s economy is the most flexible in the world, in terms of factor and product market prices. It gets top marks from the Heritage Foundation, no cream puff when it comes to matters laissez faire. Hong Kong is also more a city-state than a full economy. It’s not even a sovereign country.
What about Argentina? It’s sure sovereign. As is Greece. (Come to think of it, maybe that’s why comparing Greece to California is slightly misleading.) It’s also an example of an economy that bounced back after a sharp devaluation, having suffered years of GDP contraction under an overvalued peg. But it’s not alone. Almost everything we know about devaluation is that it begets growth. You might cite a basket-case economy to warn of the futility of devaluation, but Greece is no basket case. Forget what you’ve heard about the recklessness of the Greek government, the corruption of the elites, the avoidance of taxes. Is Greece worse than Argentina in these departments? Moreover, one should hold up a mirror when hurling accusations of malfeasance. (Note: I am very much in favor of structural and fiscal reform in Greece. I just recognise that these alone are inadequate to the larger task of revitalizing the economy and stabilising the debt load.)
If we’re willing to plunge into the memory hole (I use the term advisedly: it seems that even the leading scholarship on the period I’m about to discuss have completely lost sight of its lessons), there is a very good example for a time when Europe was confronted with a system of irrevocably fixed exchange rates and a global debt crisis. I’m referring to the Great Depression. At that time, a country’s commitment to pegging its currency to gold was irrevocable. And utter damnation would befall anyone unwise enough to reject this monetary order. (Examples of some relevant scaremongering are here, and fuller treatments of the connection between EMU today and the gold standard in 1931 are … all over the archives of this blog. Have a look.) Of course, from the safety of hindsight, we now agree that the best thing a country could do in the Great Depression was leave the gold standard: devalue the currency, even if it meant default. Not only was this best for the country, it would theoretically have been best for the global economy. The fact that it took until the 1980s before the academic scholarship settled on this view gives you some indication of the weight of orthodoxy when it comes to the monetary order. Perhaps few things inspire as much dogmatic thinking (and hence cognitive dissonance and doublespeak) as do matters of monetary order. (If you have any doubt, try suggesting to a member of the Austrian school that the gold standard exacerbated the Great Depression.)
and blocked in China, according to a Beijing correspondent.