Open Thinking

I will be on an Oxford Analytica conference call on the Greek crisis today from 4-5 pm BST.

If a transcript can be made available, I will post one here.

UPDATE 26/5/2010

No transcript available. The call went well, with expert analysis on the political situation in Greece and Spain, the economic outlook there, and the politics of the EU more broadly. Best audience attendance seen in a while.

At the time of the Great Depression, the prevailing wisdom held that no currency was trustworthy unless it was “pegged” to other currencies. I’ll explain this in a minute. The point here is that this arrangement means that the government is forced to keep its budget in order. If it spends more than it taxes, the extra money it spends finds its way to the foreign exchange market (simply, the market where supply and demand for foreign currency meet). Normally, just about as much foreign money is arriving at the fx market seeking local money, as local money is seeking foreign money; supply and demand are balanced and the exchange rate is steady. (The central bank can fine-tune the market to ensure that supply and demand exactly balance — thus “pegging” the exchange rate. It does this by buying foreign currency when too much is offered and selling it when  too little is offered.) When the government overspends, there’s too much money arriving at the fx market. Unless all the other governments are spending this wildly, there’s no reason to expect their monies to show up at the fx market in these greater amounts. Hence, the ‘home’ government has created an excess demand for foreign currency (synonym: foreign exchange) in the fx market.

Here’s the rub: even when the government is completely virtuous (no fiscal deficits), a gap in the fx market can still materialize. The government next door might run a fiscal surplus (collecting more tax than it spends — maybe it’s worried about inflation). A smaller amount of its money will show up at the fx market, while the same amount of your money shows up, meaning there is an excess demand for foreign currency in the fx market. Although your central bank can fine-tune these discrepancies in the market, it cannot indefinitely supply the excess foreign currency demanded, because its reserves of foreign money are not unlimited. So, in order to keep supply and demand balanced (in the fx market), your government is going to have to cut its spending and/or raise taxes to generate a surplus. It will have to do this even if the economy already has a high unemployment rate and spending cuts will throw even more people out of work. The prevailing wisdom demands it! That is the essence of the story, and for the connection to the euro-area today, just skip to the bottom.

Before lowering this conceptual framework onto the Great Depression, some admin. The government budget is a policy tool in the previous example. Another, more immediate tool, though ultimately beholden to the budget (pdf), is the central bank’s interest rate. It has the power to affect demand and supply in the fx market immediately (except in acute circumstances — on which more later). By raising the interest rate offered on deposits in the domestic money, the central bank increases the demand for domestic money (both among local residents and foreigners). Voilà, the fx market gap is filled. So we have two policy tools. Now, when the fx market yawns, you’ve got to deploy these tools if you intend to keep the currency stable, or “pegged”. And you do intend to do so, because it’s the prevailing wisdom. You can see how these tools can be painful (and politically difficult). Imagine your own government jacking up taxes and your central bank sharply raising interest rates in the midst of today’s recession.

The final ‘admin’ is to discuss the various causes of such drains in the fx market. We’ve seen they can result from your own fiscal deficit (in the absence of fiscal deficits among the neighbours), and from your neighbour’s fiscal surplus (in the absence of your own fiscal surplus). Think of any source of demand or supply for foreign exchange, and you’ve identified a source of fx gap. (Another is implied in the previous paragraph: a hike in your neighbour’s central bank interest rate.) In the Great Depression, several sources of fx drain hit the world economy in quick succession. Each necessitated a counter-response: a tightening in fiscal or monetary policy or both. The essence of the Great Depression is that each tightening required another tightening, and so forth. It’s worth detailing these causes, as they happened, because they are no mere relics but alive and present. We’ve either seen them already in today’s cycle or may soon. For the chronology I draw heavily on Eichengreen, Golden Fetters (Oxford, 1992).

Commodity collapse. The first round of the Great Depression was underway before the US stock market crashed in October 1929. This round touched the economies which were exporters of primary commodities. A late-1920s decline in the prices of their exports resulted in lower export earnings. Yet their imports, which contained a large proportion of manufactured goods, were not getting cheaper. This generated gaps in their fx markets which drove them to a variety of policy responses: not only fiscal and monetary austerity, but re-doubling their quantity of commodities exported in order to raise more earnings. This itself only exacerbated the decline in commodity prices. In mid-1929, the bottom fell out:

… the precipitous drop in commodity prices after the summer of 1929 rendered even the most heroic adjustments inadequate. Resistance to policies of austerity, which were blamed for worsening the economic crisis or shifting the burden onto the working class, was mounting throughout Central Europe and Latin America. (p. 231). 

Capital retreat. As the US stock market bubble inflated in 1928 and 1929, it lured US capital back from abroad, as well as attracting foreign capital to the United States. Moreover, the Fed was raising the interest rate to fight the bubble, making US deposits more attractive. This was particularly damaging to Europe, because US citizens had been important providers of short-term capital there in the form of bank deposits.

Foreign bust. If a major trade partner suffers recession, it will affect your fx market in two ways. First, the depressed state of the economy reduces the demand for your exports — hence fewer export earnings. Second, if that economy starts deflating, then its prices are falling below yours, so that your economy is uncompetitive against it — again reducing your exports. The US economy had a big enough trade presence globally in 1929 to inflict such stress widely. Its downturn in 1929, starting in August, compounded the strains already besetting commodity exporters and central European debtors. By the end of 1929 “recession was almost universally evident. Only France, Sweden and a few of their economic satellites were spared.” (p. 246)

Debt. Commodity exporters were also international debtors. Though their export earnings were falling (due to falling world commodity prices), their international debt obligations were fixed. They had to service and re-pay the same amount of debt out of a declining income stream. This exact dynamic also strangulated indebted households and businesses, no matter where located. The US price level was already deflating before 1929; when prices began falling sharply from 1929, debt burdens ballooned. As firms and households subsequently became insolvent, their insolvency undermined the financial position of the lender (typically, a regional bank). Aware of the declining health of the lender, depositors withdrew money, triggering bank runs. Irving Fisher in 1933 called this the “Debt-Deflation Theory of Great Depressions.” Note his use of the plural here.

1931. Till this point there had been no major sovereign debt default. Souring loans among the commodity exporters killed the appetite for foreign lending, and this “transformed the Central European financial situation” (p.261). The banking system there had grown heavily dependent upon foreign funds. As those vanished, there was little left to liquidate domestic depositors who wanted out. In May 1931, a lot of them did: the financial status of Austria’s biggest bank was revealed: “deteriorating loan performance had completely wiped out” its capital, in a bank whose balance sheet was as large as the government’s total budget (p. 265). The ensuing bank crisis was enough to bring down the Austrian currency and turn the spotlight on troubles in Hungary and Germany, bringing down their currencies too. Recall the household debt-deflation sequence above: the consequence of insolvencies is to question the financial health of the creditor. On an international scale, the equivalent of the local bank run is a run on the currency. Britain was a major creditor to central Europe, and the loss of those assets seriously undermined the already faltering confidence in sterling. By September 21, Britain’s own currency had been brought down. There was little the Bank of England could do: in an acute phase of flight from the domestic currency, no level of central bank interest rate will prove attractive.

“Brought down” in this context means violating the prevailing wisdom: either losing the peg to the foreign currency, or departing the open world financial and trade system (in order to keep the currency ostensibly pegged; after all, if you can control trade and financial flows, you can control the supply and demand for foreign exchange). Both routes enabled recovery. The country could conduct expansionary policy (i.e. budget deficit and monetary expansion), possibly generating demand for the rest of the world as well. Indeed it is now an accepted conclusion that the first countries to leave the gold standard in the great depression were the first to recover. Those who could afford to, like France, stayed on the gold standard. France and its friends kept to it until 1935-36, calling themselves the ‘gold bloc’. The USA kept to it until 1933. In retrospect, the USA decision to devalue in 1933 was crucial: it turned the tide of the Great Depression in the United States. It also provided a liquidity boom for the world economy. By contrast, the gold bloc endured years of depression and deflation because they were hampered by uncompetitive exchange rates: all around them, trading partners had devalued.

Why did the gold bloc adhere to the pegged exchange rates? Because of the prevailing wisdom. The prevailing wisdom was so strong that it compelled everyone to go to great lengths to stay on gold. Those who stuck it out were simply those who could afford to (with the exception being the USA). Defence of currency pegs was a cardinal principle of the gold standard, and the defence of the gold standard was likened to defending civilisation itself. “It would be difficult to devise a measure that would give a greater shock to the world’s trade and credit than departure of Britain from the Gold Standard,” pronounced a British Cabinet memo on September 3, 1931. “And the world is in no condition to stand shocks to-day.” Such fears proved unfounded, which makes their unqualified assertion an example of dogma.

Which brings us to 2010. The crisis in the euro-area features sovereign debt of the weaker members of Economic and Monetary Union (EMU, the formal name for the euro-area). Sovereign debt is the debt borrowed by a government. US Treasury bonds are US sovereign debt. British “gilts” are British sovereign debt. Focusing on Greece for simplicity, Greek sovereign debt is not repayable. Yet it is owed to the banking system at the core of the EU. Hence, the EU has arranged a 750 billion euro package of loans to “help” Greece repay its debt (and to help Greece’s neighbours repay their debts). This does not address the underlying problem. Greek prices and wages are uncompetitive within the euro-zone and within the global economy. It needs both a debt restructuring and an independent currency. The reason for the latter is that this is the only realistic way of bringing Greek prices into line with the rest of the world. I could quote the IMF’s own projections to support the contention that programme fulfilment under the current plan is exceedingly optimistic, but this stuff is all over the internet.

The EU’s leadership is hamstrung by a prevailing wisdom which is taking on the quality of dogma. The EU itself is said to face an “existential” crisis if Greece defaults and/or withdraws from the euro (Angela Merkel’s words). What support does this statement have? The danger is that it traps policymakers into the absurd and the capricious, in the same way that gold standard dogma motivated such folly between the wars. Essentially, the EU is telling Greece (and its neighbours) to “take the pain” for an indefinite period, with severe austerity and certainly deflation and unemployment. All in the name of EMU. If the worry is the EU’s private banks, convert the 750 bn euro rescue package into a re-capitalisation fund for the banks, and let Greece default on its debt and re-issue its own currency (the drachma). I have sketched the key elements in a 5-part plan elsewhere. There should be no illusion that the consequences will be limited to Greece or the European banks. Whatever they profess now, Greece’s trading partners will be better off with a sharply expanding post-default, post-devaluation Greek economy than an interminably depressed one. Yet it is clear, too, that these trading partners will also need to depreciate, and that the loss of the euro as a reserve asset suggests an unpalatable strengthening in the US dollar. The next link in this story is undoubtedly the US-China nexus, which has interesting antecedents in the UK-US nexus in the various parts of the early 20th century.

But that is another story.

From Payback time: Padded pensions add to New York fiscal woes

An online, searchable database compiled by The Times contains the names and pensions of about 3,700 public retirees in New York who receive more than $100,000 a year. 

In fact, the cost of public pensions has been systemically underestimated nationwide for more than two decades, say some analysts. By these estimates, state and local officials have promised $5 trillion worth of benefits while thinking they were committing taxpayers to roughly half that amount.

There is hope for the press corps. This strikes me as true muckraking.

What’s this got to do with global macro? Plenty. Public-sector pensions are one of the liabilities of the state, in addition to other entitlements and financial debt. And the story is similar whether it’s Greece, the UK or New York City. Note that these liabilities only get more onerous for us, the taxpayers, with deflation, unless the pensions are indexed to both directions of inflation. They mostly can’t be clawed back. (However, a US city can declare bankruptcy; does this relieve its pension obligations?) Which makes me believe that the tax man cometh for pensions. Those beyond some threshold are going to get taxed big-time.

A few more points on this topic…. eventually I’ll need to write about something else.
From comments here and elsewhere I highlight the following:

Greek/Club Med default will make European banks (German, French especially) insolvent.
In other words, “the cure is worse than the disease”. There is an historical parallel. When Credit Anstalt imploded in Austria (May 1931), the searchlights turned on Germany, visiting it too with banking crises. One of the main reasons Britain came next was exactly because Britain was a big creditor to these countries, and when they imploded, these assets vanished — providing even more reason to question the sustainability of Britain’s peg to gold. Sales of sterling turned acute.
That’s why the EU must aim the eur 750 bn firehose at the balance sheet of the banking system. Make it a European TARP.

Won’t some combination of euro weakness and an inflation differential Germany-Club Med be enough to rescue these economies?
In other words: if one of the root requirements is increased competitiveness, then this can be achieved vis-a-vis extra-EMU via euro weakness, and intra-Euro via an inflation differential, i.e. this should provide the real devaluation needed in Club Med. In this scenario, the euro weakness overheats the German economy, the ECB stays on the sidelines, and voilà, a positive inflation gap between Germany and Club Med. Any part of this argument is ripe for contention. But the main problem is that it won’t provide the scale of devaluation needed, even if the EU relieved Club Med of its debt burden. European economies deflated madly in the Great Depression to achieve an inflation differential with the United States; it wasn’t enough. The whole point of seeing the gold standard as a dogma is that it drove policymakers to tighten the screws even when unemployment was 25% and deflation was rampant. Who in their right mind would pursue more austerity under these conditions? Yet the pressure to do so was extreme. Likewise I see EMU as a dogma. (I am not a euro-hater and I am not politically opposed to EMU; it is purely the economics I’m worried about.)

You cite Argentina as an example of the capital market’s short memory. But Argentina is still at loggerheads with creditors nearly ten years on.
True. I should have cited Russia and other post-communist countries, which did default and did come straight back to the markets, quite quickly. (That post is fixed.) The Economist got this right on the first try, in Default, and Other Dogmas. 


So who cares about Argentina 
Argentina illustrates the burden of being shackled to an expensive currency. It tied the peso to the dollar at the beginning of the nineties in a particularly severe arrangement called a currency board. When emerging markets started tumbling (Asia Crisis, 1997) there was no thought of leaving the currency board. Argentina clung to this woefully overvalued peg (with the blessing of the official international sector and much of the commentariat) until end-2001, suffering four years of negative GDP growth. After devaluation and default, growth went to 7%+ and stayed there till the recent global downturn. You have to be Hong Kong to sustain a currency peg, because it requires hyper laissez-faire.

Unlike Argentina, Greece doesn’t produce enough for export to benefit much from competitive exchange advantage
Everything we know about capitalism says this will not be a problem. That’s a pretty curt response, but it is true. The economy will find its feet, I assure you. (The same holds true of the US economy under a devalued dollar; the problem is that it needs a bloody weaker dollar and can’t get one.)

EMU as a currency regime / Why doesn’t California leave the dollar?
“Monetary union” is an exchange-rate regime. It appears with all the others (“free floating”, “crawling peg”, “currency board”…) in the taxonomy of exchange-rate arrangements. Monetary union is an exchange-rate regime because the states which adhere to it are sovereign. They choose monetary union; they un-choose monetary union. California does not have an exchange-rate regime because California is not sovereign.

Gold standard
The precedent for death-by-overvalued currency writ universal is the gold standard. The other posts in this blog go into details; particularly The Great Amnesia. Here I suggest further reasons why it fits.

• Like EMU, the adherents to the international gold standard were sovereign. (There is also a parallel between GS and EMU in the sense that the core countries came onto gold by choice, while some peripheries chose it under duress, strong guidance, or even had it written into their central banking law by foreigners. Similarly, longtime members of the EU were able to opt-out of EMU, but EU accession states have had to aspire to EMU as a condition of accession.) 
• Like EMU, the gold standard was a dogmatic arrangement. I use the term advisedly. (I am not sure whether the Austrian school favours EMU. But it definitely likes the gold standard, and I will post on this later.) Dogmatism is capable of shielding people from seeing what is before their very eyes. It was not until the 1980s that academic scholarship generally fixed on the idea of the gold standard as a regime of death-by-overvalued currency. (The pillar of this literature, for whom I have unlimited respect and admiration, does not advocate EMU dissolution; see page 5. He’s ten times smarter than me, so let this be a health warning for anyone reading this blog.) 
• Incidentally: the gold standard had this same capricious quality even in the glory years (1870-1914). The international monetary system was on the cusp of complete break-up in the 1890s due to the inherent deflationary quality of the gold standard; it drove commodity exporters to penury and then to default. The system was rescued by an avalanche of gold mined in South Africa (as well as the application of a new technology to mining: arsenic, I think). 

1. Convert the eur 750 bn rescue fund to a re-capitalisation fund for the banking system.
2. Force a restructuring of Greek sovereign debt; 70% write-down.
3. With an EU imprimatur, forcibly redenominate Greek contracts in drachma, including cross-border contracts.
4. Greek central bank exchanges euro for drachma at the rate of 1 for 1. There is no need to make it 1 to 5 or whatever. The point is that the drachma will depreciate against the euro and other currencies in the fx market, whilst still being used like a euro at home.
5. Gain the agreement of Greek unions not to index wage demands to expectations of inflation for a period of four years.

• stay the course (keep on the gold standard, but with tariffs)
• retreat to autarky (government authorisation for any trade transaction)
• devalue (introduce tariffs but still remain part of the open world trade system)

• The Devaluation Group (Group 3) performed the best during the rest of the decade. Group 1 (Gold Bloc) performed the worst — their currency was increasingly overvalued with time and their economies uncompetitive. Germany (in Group 2) grew strongly. What Group 2 and 3 had in common was leaving the gold standard; Group 3 stayed plugged into the world economy, Group 2 unplugged.
• If this story is anything to go by, Club Med are not going to follow the gold bloc route. They can’t afford it. Only Germany and Northern Europe can do that. And they well might, which is bad news for them and for us. Club Med and the Eastern accession members of the EU have to choose between the Autarky and Tariff routes.
• The devaluations during the Great Depression were an aid to growth. However, what really got the global economy going again was the USA devaluation 1933 and resolute German expansion (also 1933). The Gold Bloc finally joined the party with devaluations in 1935-36, but too tentatively and anyway too late: The US again staged a horrific downturn, when Congress tightened the fiscal position by 2.5 percentage points of GDP, the Fed twice increased the reserve ratio, and the Treasury sterilised gold inflows.
• Interestingly: the countries which had devalued around 1931 (some earlier, some later) had by 1937 built up such large reserves that they could ride out the US recession by spending down those reserves — no resort to austerity (and almost no devaluations).

This might suggest that in 2010 Club Med won’t go the Gold Bloc route. But this means only that they won’t choose austerity ad infinitum. That doesn’t necessarily mean they go the Group 3 route (devalue and keep trading). The 1931 story suggests that another route would be to stay in EMU and resort (somehow) to pretty massive external barriers. In fact, this is already happening. European banks have consented to restrictions on the disposal of Greek assets on their books. These are capital controls. But Greece (Club Med, really) will also need trade controls. That looks a lot trickier. But who is ready to rule anything out? If the emphasis on “saving the euro” is sufficiently attractive within the EU, then perhaps there can be some countenance of trade controls. Surely the Great Depression teaches us that nothing is off the table when push comes to shove. (It also teaches us that paranoia over upsetting the established monetary order — perhaps especially in Europe? — is one hell of a strong motivator. And, in that episode, was proven to be not only wildly exaggerated but absolutely unhelpful.)

• The retreat of USA short-term private capital from continental Europe from 1928+ undermined their currency pegs to gold. The consensus view is that USA private short-term capital was drawn back by a rising Fed discount rate as the Fed leaned into the stock market boom.
• The 1931 disturbance travelled from continental Europe to Britain in part because of British losses on credits to those debtors. A similar transmission between Greece and France/Germany is possible today. Which is why, I think, EU needs to set up a TARP/recapitalisation fund for those banks…

Defecting from EMU is being described as a horrible outcome — whether for Europe or for the benighted Greece et al is not always made clear. But the general tenor is that defection from EMU would constitute a shock which the world is in no condition to bear. We have been here before. In the waning days of the gold standard during the Great Depression, countries were urged not to abandon the standard lest they unleash a calamity on the global economic and financial system. This note by an undisclosed but “well known outside source” was circulated by the British Prime Minister to his cabinet on 3 September 1931:

More than anything, trust in sterling and in London will be fatally undermined:

Cabinet Papers 219(31): Memoranda distributed by the Prime Minister to the cabinet: Sterling and the Gold Standard

Today, it is *widely* accepted that leaving the gold standard was exactly the right thing to do in the teeth of Great Depression. Britain did so less than three weeks after the circulation of this memo. That decision was by no means lauded in the financial press. The Economist warned of a replay of the hyper-inflationary chaos of the immediate post-WW1 years (in fact, deflation was a permanent feature of the remainder of the interwar period).

The facts must be faced that the disappearance of the pound from the ranks of the world’s stable currencies threatens to undermine the exchange stability of nearly every nation on earth; that even though London’s prestige as an international centre may gradually recover from the severe blow which the sterling bill has received, banking liquidity throughout the world has been seriously impaired, much more so in other countries than this; that international trade must be temporarily paralysed so long as the future value of many currencies is open to grave uncertainty; and that, though the memory of the disastrous effects of post-war inflations should be a useful deterrent, there is an obvious risk lest we may have started an international competition in devaluation of currencies motivated by the hope of stimulating exports and leading to a tragic reversion to the chaotic conditions which existed five or six years ago.

“The End of an Epoch”, Economist, September 26, 1931, page 547. 

It’s amazing to me how reluctant people are to prescribe euro-exit. Eichengreen stops well short; quite the contrary, he portrays such a move as disastrous. (The technical issues (ATMs, etc) and legal issues (cross-border debt contracts) are daunting, and the political cost is even worse: second-tier status in the EU if not outright expulsion.) If I read him right, Krugman describes euro-exit as disastrous though increasingly likely (its announcement would trigger “disastrous bank runs”). Last but not least, Domingo Cavallo — formerly Argentine finance minister — says the first lesson of Argentina’s 2001 crisis is that euro-exit is not the answer. Wow. Never mind that once Argentina devalued, real GDP growth shot to 7.5% and stayed there (barring the recent global downturn), whereas GDP was contracting in each of the four years leading up to the devaluation.

What’s striking about this widespread rejection of euro-exit is the re-writing of the lessons of the Great Depression — not least as detailed in Eichengreen’s masterpiece, Golden Fetters. The first to devalue (leave the gold standard) were the first to recover, almost without exception. Here’s the classic graph, where Japan is first out and France last:

Avoiding devaluation was committing the economy to long-term decline. Yet this is exactly what is prescribed for uncompetitive Europe today. Since default/restructuring won’t solve the long-term solvency concerns, the prescription is a deflationary grind — for the Greek, Ibero and Irish citizens (not to mention the longer-suffering Baltic ones). Wow. And this for a country already reporting the second-highest incidence of households with “real financial problems” and overdue on “many” credit commitments,

Efforts to keep Greece in the euro and the associated rhetoric are identical to those applied to countries on the verge of leaving the gold standard circa 1930-33. ‘Be more stringent.’ ‘Take your medicine’. ‘Roll back the credit structure’ and of course Mellon’s famous “Liquidate (everything)”. The French in particular pushed this view: the gold standard guaranteed global prosperity; defection undermined it. This stringent, orthodox prescription came from inflationary fears. And, as Eichengreen notes, “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.” (Golden Fetters, 24).

How big is the technical hurdle to euro-exit? I suspect not as big as to justify the deflationary penury of staying in. The Bank of Greece is obviously a member of the eurosystem; but this also means that it keeps in touch with the distribution of euro notes both electronically and over the counter, as mandated by EU treaty.

Euro-exit also sounds like a much better outcome for the global economy and particularly the non-euro OECD. Would Britain and Turkey rather trade with a depressed Ireland/Club Med or a resurgent one? This is not a case of ‘money is neutral’ i.e. “Club Med will devalue one way or the other, domestic deflation or a new (and weaker) currency”. The former suggests years of stagnation and import compression, while the latter suggests at least a recovery in activity.

Devaluation (in these cases via currency defection) is not a guarantee of growth, but it makes it a lot more probable. That sure was the story in the interwar departures from the gold standard, where perhaps France was the main exception when it finally did devalue (1936). What the defecting countries will need is an upside-down “inflation stabilization program”. In these programmes, the government says, ‘We are going to stabilise (the freely falling) local currency against a (solid) foreign currency, and you (labour) are going to stop indexing wage settlement to a high rate of expected inflation.’ Instead, the government will have to say: ‘We are going to *stop* pegging the currency, and you (labour) are going to promise not to build-in higher wage claims.’

Much as I love using the euro, I would see its demise (at least in Club Med) as very bullish. What shocks me is how few people are explicit about this, and instead prescribe for Club Med today the same medicine that they criticize being given to our predecessors 80 years ago.