Open Thinking

From the Financial Times, 28 May 2010:

But the alternative to [Greek debt] restructuring [i.e. default/re-profiling/haircut/etc.] will probably be grim too. If Greece staggers on, without a miracle, fears about future “haircuts” will continue to poison the bond markets and interbank world. That will essentially produce a pattern similar to Japan in the late 1990s: a world of gnawing, half-concealed anxiety, where asset prices keep stealthily slipping because investors cannot shrug off their fears of more bad news to come. 

This is an extract from my post of 29 May 2010 — critiquing Europe’s ‘Plan A’ for Greece. 

Plan B starts from the assumption that Plan A won’t work; that Greece will arrive at year 2013 still insolvent. The economy has contracted sharply so the external debt is even less sustainable. These adverse dynamics all the while send out destabilizing signals about the outlook for other indebted euro-members, creating a permanent euro-anxiety problem in the markets. Since markets prize certainty, Plan B gives it to them. Retained from Plan A are as much of the structural reforms as possible. To make these feasible, they take place in a growth environment. (Flexible labour markets in a contracting economy flexibly shed labour.) To make growth feasible, the drachma is re-introduced 1:1 with euro; its subsequent depreciation in the fx market ensures a positive external balance for the economy by reducing domestic costs. To ensure the latter, labour unions agree not to index wage demands to expectations of inflation, for some fixed period e.g. four years. This devaluation makes debt unpayable in euros; it is therefore decreed by force majeure to be payable in drachma. This is a unilateral default. Because the economy is generating an external surplus, it is not tapping external finance anyway. Such force majeure abrogations have been done many times; not least in the United States by FDR and Congress. The Greek public can hang on to euros if they wish, but they must pay taxes in drachma. Moreover, public sector pay will be in drachma.

It’s easy to find this revolting. But what are its virtues? Well, it crystallizes the problem now, not later, and frees the economy to begin growing again. Markets are no longer wondering what’s down the road. “What about the capital position of Greece’s external creditors?” you might ask. These banks will need a capital injection from official sources. Convert the EU loan package into exactly this recapitalisation fund. (Perhaps use the IMF credits to provide interim financing for Greece.) “Is this a breakup of the eurozone?” No. It’s a restructuring of the euro-zone. Each member has to assess the costs and benefits of membership at the present juncture. Greece is unlikely the only member to be best served by exit, but neither is it true that all members will exit. Moreover, this could be seen as an intermediate step toward a longer-term reunification of the EMU on much more solid fiscal foundations.

Plan C is really the alternative to Plan B, because Plan A is not an alternative at all. No democracy will put up with interminable austerity with little relief in sight. And it’s not clear that Greece’s concessionary creditors (German taxpayers) will be in the mood to continue providing exceptional financing after 2012 even though it is clear that this will be required. Germany (unwisely) has its own austerity law to comply with. OK, so what is the real alternative to Plan B? Let’s call Plan A “Fiction” because it’s no plan at all. Plan B is “Growth” because that is the emphasis. Plan C is “Shelter”. You end up with Plan C if the emphasis is on avoiding default. If the overriding goal is to make the creditors whole, then there is every reason to stay on the euro (why re-pay in a depreciated currency?). So Plan C keeps the euro. But since wages can’t be compressed enough to produce an internal devaluation adequate to generate an external surplus, and since that would anyway just blow out the debt/GDP ratio, and since there is no recourse to currency devaluation (vis a vis euro-zone neighbours), then the only choice is to devalue through trade and financial controls. Specifically: levy a special tax on imports and provide a special rebate to exports. Forbid all cross-border financial transactions except those cleared through a centralised external debt repayment agency.

As it happens, Plan C was pursued by many central European nations caught up in the Great Depression. They instituted exchange and trade controls to ensure that adequate foreign exchange was available for debt repayment. Naturally they kept the ex-ante pegged exchange rate, since this made the burden of repayment lighter than would a depreciated exchange rate. The point is that you had to get permission to transact. Far-fetched for a modern nation? Not really. Britain rationed foreign exchange for decades after the Second World War. In fact the very post-war international monetary system was designed explicitly with restrictions on foreign-exchange transactions, in order to help governments preserve their exchange-rate pegs. This collapsed not too long ago (late 1960s). And keep in mind that many modern-day economies ration foreign exchange for non-trade purposes; this is the definition of “capital controls”. Know too that inroads are already being madein that direction in Europe.

Europe’s choice is Growth or Shelter. Fiction is not a solution. 

UPDATE

A point about Plan C. It isn’t really compatible with the freedom of citizens in any sustainable way. Since euros are rationed for cross-border transactions, one or more parallel currencies will materialise domestically, because the squeeze on domestic liquidity will be too fierce. Of course, the increasing emission of the parallel currency will drain euros out of the system, as we know from Gresham’s law. The only way to prevent this is for ever-more draconian steps to enforce the rationing of euros.

I’ve argued since May 2010 that Greek travails — the debt dynamics, the dogmas, the policy response — revealed a situation all-too-similar to the breakdown of the interwar period’s fixed-rate monetary regime. The very short story of that episode is that, when capital flows to some European economies suddenly halted, the troubles which beset euro-area policy today (mostly, lender-of-last-resort) arose in spades in Europe. Because exchange-rate fixity was considered sacrosanct, heaven and earth were moved to keep the monetary order together. What this achieved was a desperate search for relief, which culminated in a turn to illiberal policy. The point here is that such illiberalism was more a consequence of the downturn and the policy course than a cause. In this judgement I am supported by contemporaries and by modern historians and economists alike.

No matter how understandable and predictable, it is nonsensical to believe that the policy solution to today’s travails is to “keep trade open”. As if open trade is a solution to imploding demand. Open trade is a consequence of economic growth, and can be synergistic with it, obviously. Repeat: if your goal is to keep trade open, then you need a pro-growth policy. If countries are being pushed deeper and deeper into austerity, you can preach to the skies about the virtues of open trade, but you’ll be missing the point. You are courting closed trade by conspiring in, or even outright advocating, slow/no growth. With enough pain, illiberal policy will materialise.

Now for the key differences between ‘then’ and ‘now’. One: the rest of the world can be more supportive than it was in the interwar episode. Back then, other countries were as committed to exchange-rate fixity as were the continental Europeans. This meant (a) they easily were swept up in the downdraught when serious implosion struck continental Europe, and (b) their own policies ramified the initial negative impulse to global demand. This time, non-eurozone economies can respond in more helpful ways, from the point of view of global demand. Even if their governments are dysfunctional or deeply confused about the proper path for policy, their monetary authorities are free to provide some heft. In the interwar period, central banks were beholden to an extremely cautious line, for fear of (a) the exchange rate and (b) some statutory limitations on the size of the balance sheet. How the Austerians would love to have lived in those ages!

But the biggest difference is that if continental Europe wanted to save the euro, it can do so in a way that was much more difficult to imagine in the interwar period. Back then, the ultimate limit on money creation was the supply of gold. (Again, how the Austerians would relish life in that heyday.) No such limit confronts the Creator of the euro-zone’s currency, the European Central Bank. The key to rescuing the eurozone lay precisely in the hands of the ECB and its new governor, Mario Draghi. It can commit to supplying unlimited funds for the procurement of euro-area sovereign debt. It can do this in an accord with Berlin the political authorities of the eurozone to create a centralised authority whose remit is to assist with members’ structural adjustment and fiscal consolidation on a long term basis. Talk about solidarity!

I’d be remiss if I didn’t mention a key disadvantage of the euro-area vis-a-vis the interwar fixed-rate monetary arrangement (1/). In the latter situation, national currencies still circulated and central banks still managed them. They just had to ensure that exchange rates did not deviate from an initial start-point. When it came time to engage with the set of illiberal policies aforementioned, one option was simply to let the exchange rate go. (2/) If you did this alone, you got a lift from better prices for domestic output, i.e. you ‘crowded in’ demand for your own economy’s output. (There is a misconception that these interwar central banks could additionally have expanded the money supply. Not so. They were still beholden to statutory limitations on the size of their balance sheet. Although these limitations were loosened, they nevertheless were an empirically demonstrable constraint on open-market expansion.)

1/ As you’ve probably realised, “fixed-rate monetary arrangement” is code for “gold standard”. I’ve learned through hard experience that these two words are simply too emotionally charged to use today. For example, when I explained to the chief economist of one of the eurozone’s largest investment banks that the interwar gold standard is a useful template for thinking through the euro-area travails, he responded something along the lines of, ‘In all due respect, I consider gold to be a kind of metal that lay in the ground and is dug up and is sitting around and really has no use.’  Sure, I agree. And that is relevant to this discussion how? The point is that he fixated on the term, with no connection to the way it had been used. The opposite happens with the Austerians, of course. Their eyes become trance-like at the mention of the gold standard.

2/ As the exchequer himself, or a parliamentarian (I can’t remember which), said, upon learning that the Bank of England had unilaterally left the fixed-rate monetary arrangement on 21 Sept 1931 (and civilisation did not collapse), “I didn’t realise we could do that.”

Judging from comments on a popular right-wing UK newspaper blog, efforts to rescue the euro augur something  sinister. The essence of this view is that, in order for the common currency area to be sustainable, the sovereignty of the member economies must be sharply curtailed. The deal agreed at the EU summit last week indeed calls  for greater surveillance of member-state budgeting, as well as for stricter punishments of fiscal profligacy.

This meme sees national electorates as unhappy about supra-sovereign intervention in their budgetary and regulatory affairs (whereas the modernization meme sees some local support for extra-national intervention, in the view that such intervention is needed to modernize the state and the economy). Hence, over the will of the domestic electorate, Brussels will usurp authority over normally sovereign matters. In order to make it work, disaffected local electorates will have to be browbeaten. Euro-consolidation is a road to tyranny.

The argument here is that some countries in Europe are further from the liberal-democratic, social-market end-state than others. Crudely: some states have not reached the ‘end of history’, as Fukuyama put it. When you read about the Greek crisis exposing sub-optimal tax collection, inefficient bureaucracy, state corruption, closed-shop professions, inflexible or under-the-table labour markets, you are reading about the modernization meme. One could cite myriad indicators to illustrate this meme; I’ve used global competitiveness (source: IMD) and corruption perceptions (Transparency International).

The euro crisis is the catalyst through which these economies become modern. It’s a tough row to hoe, but eventually they emerge with more efficient labour markets, better bureaucracies, higher competitiveness, higher employment, and better living standards. Think of it this way: if Greece were to become more German, this is the way to do it. Already, the European Commission has parachuted a crack team of EU civil servants into Athens to help it reform some of the basic functions of state, such as tax collection. While some grumble about their presence (especially about the Teutonic flavour of the squad), others welcome it as a means to modernize.

Another way to think about this process is Germany itself. Only a decade ago, observers wondered what, if anything, would reduce German unemployment and restore growth? It appeared as if the European ‘core’ were condemned to sluggish growth and low utilization of labour (high unemployment). Well, Germany set about reforming its labour markets and clawed back global competitiveness through wage restraint (in part), emerging as a stronger exporter and a high-growth economy, well placed to benefit from the emergence of the BRICs.

As the modernization meme goes: What’s wrong with making Greece (or Italy or France for that matter) a little more German?

Italian bond yields reflect decisions announced at the 27 October EU summit — namely, that new Italian bond issues might carry first-loss insurance. If that’s the case, investors would rather hold those new bonds than the existing secondary market bonds. Which means there will be a wedge between the secondary market Italian bonds and the new issues. Check the yields on the latter before pronouncing on Italian sovereign debt sustainability.

Glossary: A bond yield tells you the return you get from buying the asset (the bond) and holding it till it matures. At that point, it pays the face value of the bond. En route, you will have also collected the ‘coupon’, or periodic interest payment, associated with the bond. So, there’s a principal repayment and an income stream, not unlike a bank loan. Here’s the catch: you can buy the asset for less than it’s face value. It should be obvious that the lower the price you have to pay to obtain the asset (the bond), the higher the total return to you. This is why bond prices and yields move inversely.

Just heard Simon Johnson at the IMF conference on Iceland (webcast). He’s (still) very worried about overleveraged financial institutions and especially about the euromess. I’ll have a lot more to say on the latter in an upcoming post. For now, I just wanted to report the terrifying proclamation of Johnson. Paraphrase: ‘The European banking system is going to unleash major shockwaves into the global economy’. Caveat emptor: Johnson has been decrying ‘financialization’ of the economy since 2009 at least, and I think he’s obsessed with this theme in a way that we all can develop obsessions (see: open-thinking.com 2010 May-June archives re: the Greece plan is going to fail).

Paul Krugman

… then you might be pretty confused about what’s happening to our world, economically.

I recently finished a mid-career break to study globalization. When I started — 2005 — I wanted to explore something which was the common question among clients:  ‘Where is globalization heading?’  Rather than reply with an uninformed hunch, I decided to examine an episode of globalization going into reverse: the 1930s.

Little did I know that before I would finish, our own period of globalization would fall victim to the afflictions that ultimately strangled globalization before. The disease then was partly endogenous (a Minskyian boom/bust cycle) and partly exacerbated by deeply regrettable policy choices. History might not repeat itself but it sure does rhyme: we’re making some of the mistakes committed 75 years ago.

Note: The left panel is 1997, the right panel is 2009.

I’ve been reading the Macroeconomic Review of Singapore’s central bank (the new edition will be published in October), from which the above ‘heat maps’ are lifted. Read down the Y-axis for the exporting country, and the X-axis for the importer.

China is still a big importer of capital equipment — from Japan, Korea, Taiwan and the USA (the charts cover only East Asia and the USA). Now it’s also a big exporter to them.

The policy brief can be found here.

The current recession has brought to the fore two key schools of thought regarding economic policy, in a rehearsal of earlier and probably ageless debates. One school is Keynesian and the other can be called an ‘Austrian’ viewpoint because many of its founding figures in fact studied and theorized in pre-war Austria.

The main purpose of this essay is to discuss whether it makes sense for the government to spend money in excess of tax receipts (i.e. to borrow and spend) in the midst of a recession. But I need to start with the concept of money. Anyone worried about central banking and gold, and in need of some clear exposition, has come to the right essay. Be warned that if you came here to discover why gold makes more sense than paper money, you’ll be disappointed. But I hope at the very least you’ll find something worth thinking about.

Reasonable people disagree about the concept of ‘money’. For me, money is a transactions device. Humankind need it to carry out business — to fulfil their inclination “to truck and to barter” as Adam Smith put it. This is a statement about what gives money value. It’s a hugely debatable question and the key to disagreement between Keynesians and Austrians. Many people would at this point hasten to add that money serves as a “unit of account” and a “store of value”. These are not un-true but they do not account for money’s value to society; it’s really the transactions function which money satisfies that gives money its value. This matter was settled by an obscure legal scholar named Arthur Nussbaum in the mid-20th century, in my view.

Someone of the Austrian persuasion would disagree completely, and say that money as we know it has “no value” and is just intrinsically worthless paper. They would say that only gold is money and this paper stuff is a huge fiction and, worse, a con. I acknowledge their fervor around this issue, but fervor alone does not make their argument correct. In fact, their confusion around money is profound: whereas they think only gold can give value to money (e.g. when gold is used directly as money or when gold is officially convertible into paper money at a guaranteed rate, as in the ‘gold standard’), in fact it is money which has given value to gold. Gold’s intrinsic usefulness is much less than would explain its value were it not for its monetisation. 

Money is intrinsically valuable because it satisfies a transactions utility among the participants in the economy. If you can accept this point, then I’d like you to consider a further one: falling prices and wages present an especially difficult problem. For the Austrian viewpoint, it is absolutely crucial to believe that falling prices and wages are not a problem; both schools agree that there will be falling prices and wages in the circumstances of a “de-leveraging” recession of the type we’re seeing today, which is the kind we saw in the Great Depression.

What I mean by a de-leveraging recession is a recession where the private sector overall is trying to reduce its debt. This has a big implication for the supply of that useful transactions-technology called money. Most ‘money’ is debt. People of the Austrian persuasion are up in arms about the US central bank — the Federal Reserve — creating money (I think Texas Governor Rick Perry just recently criticized the Fed for creating too much money). They seem oblivious to the fact that ‘money’ in the economy is comprised of many things, most of it created by the financial system itself and very little of it created by the Federal Reserve. I’ve written about the difference here. In fact, the Fed’s actions to expand money are like King Cnut holding back the tide: swamped by the great de-leveraging of the private sector. (Again: most money is not that stuff created by the Fed, but the stuff created by the financial system, i.e. the credit it writes.)

This contraction in the money supply necessarily creates downward pressure on prices and wages. If we have the same amount of ‘stuff’ (including services) but less money, then the money-per-stuff amount must by definition be less. That’s deflation. But recall what I posited about deflation being especially problematic. We just don’t work with it very well. Daylight savings time provides a useful analogy (hat tip to Milton Friedman). Why don’t we all just agree to wake up earlier in the summer rather than set our clocks forward by an hour? Because it’s hard to organize. Consider someone selling a house today. They paid x amount for it a few years ago. They’ll take a little less now, but nothing like the discount which the market demands to clear the transaction. They might take a 25% discount if they know for sure the person over in the next state (to which they are moving) will be offering a 25% discount. But who’s going to organize such a thing?

It’s even worse. What private debt is contracted to take account of falling prices and wages? The store owner who cuts her prices is going to make less money. Does her bank reduce the amount of debt owed by her? No. Do her employees take a pay cut? Actually yes they do. But they can’t afford to take a pay cut that’s big enough to make their employer whole — because their own mortgages and other personal obligations won’t be cut by the bank to account for their new, lower salaries. So these workers become too expensive for the store owner.

Here we are in a great dysfunction of the capitalist economy. The private sector is racing to cut its debts, and in the process is shrinking the money supply. The central bank is impotent to expand the money supply because in a modern financial system most money is created by the financial system. And anyway blowhards like Rick Perry are threatening violence against the central bank for the little it is doing, completely oblivious to the fact that Ben Bernanke, the central bank chairman, is mostly powerless to stop what’s happening.

What to do? There are four spending streams in the economy: two in the private sector (households and businesses), the foreign sector and the government. We already agreed that households are paying down their debts, which is creating the downdraft in the money supply in the first place. The Austrians think business spending will make up for it. But why would the corporate sector invest in new projects when the outlook for demand is so poor?

How about the foreign sector? Well actually this could be part of the answer. But for this to happen we need a much weaker currency. To see the difficulty in actually achieving this, consider the exchange rate as an outcome of the relative supplies of two countries’ monies. If the US money supply if falling, then this is bullish for the dollar. (And this is why, whenever the markets get confused about the Fed creating ‘too much’ money and the dollar sells off, smart people should buy it.)  Some (including Austrians, I would think) believe a country can achieve a big improvement in the export position without a change in the exchange rate. But this is fanciful — trade usually follows price differentials; exchange rates are key to relative prices. So it’s hard to see how we can get a big trade surplus without a more competitive currency (the foreign markets are there — i.e. the emerging markets, which are not in the mess we’re in). But we can’t get a more competitive currency because our money is becoming more valuable as there is less and less of it, and because the dollar is not really a free-floating currency, considering that a big share of US trade partners peg their currency to the dollar.

As you may have guessed, this leaves only the government sector able to fill the vacuum created by the de-leveraging household sector. It can do it in these circumstances at a cost lower than almost any other time in the normal life of a capitalist economy. On one hand, nobody else is borrowing, which makes it cheaper for the government to borrow. On the other hand, because these deflationary forces are making private-sector debtors a pretty risky proposition, there is periodic urgency to invest only in the most reliable borrower: the government. In other words, there is great demand for the very bonds that the government would issue if it were to borrow more. Altogether it makes vast sense for the government to step into this situation and keep the economy afloat, and this is a point which became clear to JM Keynes in the 1930s but was not understood more widely until after WW2.

Keynesianism acquired a bad name eventually because governments used it at times when the malady did not fit this cure, i.e. when there was already plenty of inflationary pressure, when resources were not lying idle being ready to be called into use, but instead when there was a dearth of spare capacity and any extra government spending only exacerbated inflationary pressure. Today is not one of those times. It’s a time like the 1930s, when there is idle capacity, when there is a lack of demand to call into use the idle humanity and machinery of the economy. There’s plenty the government could invest in as it spends this borrowed money. And these projects could easily pay for themselves in the sense of providing ‘public goods’ to the economy which otherwise are difficult to provide. Infrastructure comes to mind, of all sorts. And schools, teachers, classrooms.

The irony here is that Austrians and Keynesians both see the outlook as dim. For Austrians, the Fed is creating too much money. For Keynesians, the Fed is basically powerless to create money of the sort that circulates in the economy, and the one sector which could do this — government — is cowed into believing that it can’t. For someone who’s recently earned a PhD in the monetary dimensions of the 1930s (me), this is all very saddening.