Open Thinking

What would you say if more and more countries were being struck by the financial markets’ lack of confidence? You know. The bond markets are selling off. Depositors are leaving the banks. Not from caprice — from genuine worry. Worry over the high indebtedness of the private and/or sovereign sector. The poor growth outlook, thanks to a seriously overvalued currency. The serious people said: Stay in the currency at all costs. Push down domestic prices and wages. Give us an austerity budget to show you mean it. And that is precisely what they did:

Cabinet Memo, British Prime Minister’s Office, Sept 1931

Many decades later, the serious people reflected on that period, and pronounced something altogether different: austerity in defence of unrealistic monetary arrangements is masochism. For the synopsis of this view — and very much the standard-bearer — read Golden Fetters. Read just the introduction if you must. And to his credit, the author of this canonical work, Barry Eichengreen, is today the most honest of the serious people who say the euro-area members must defend the unrealistic monetary arrangements (i.e. stay in the euro). He is calling for a grand debt write-down for the affected euro-area sovereigns, and those yet to be affected. It’s honest and it’s intellectually coherent. Whether the euro-area non-leadership are equal to this challenge is another matter. They are not inferior, as policymakers go. They are just subject to the normal game-theoretic problems that beset us all.

Which is why I see Eichengreen’s proposal, meritorious though it is, as a non-starter. The exit route lay in devaluation. But please note: devaluation need only entail unilateral restructuring of debt if the sovereign comes out of the euro (which would entail forcibly re-denominating the debt). There is another way to devalue without upsetting debt contracts. Germany could come out of the euro. The rest of the euro-area would get the devaluation they desperately need.

Currency union requires the abandonment of a great deal more sovereignty than has so far taken place in the euro-area. They haven’t had to abandon sovereignty much yet because the zone has not significantly been tested till now. There is a reason why the US states were eventually relieved of the ability to run budget deficits, having given up their own currencies and joined the USA currency union known as the dollar. What we’re seeing now is the moment of truth in the euro-area. For this to be a sustainable currency zone, some aspects of sovereignty need to flow from the members to the area authority, dominated though it is by the paymaster, Germany.

So watch Ireland closely. It has a very low tax rate on corporations. And the present government has sworn this is not something that should be changed. Yet the rest of the euro-area would very much like to see it changed. After all, Ireland’s ultra-low corporate tax rate undercuts their own economies as places to set up European operations. The present crisis is the irresistible opportunity for Ireland’s neighbours to insist on a change in Irish corporate tax policy. So who wins? It’s a test case of sovereignty.

There’s a larger aspect of sovereignty here. It goes to the heart of policymaking in response to the current financial recession in Europe. If they wish to remain in the euro-area, the authorities in these benighted economies have to pursue limitless austerity. And even when they do — as Ireland has unquestionably already done — they fail. And sovereignty has to be relinquished, to some extent — as the price of the inevitable financial ‘assistance’ from the neighbours. What kind of assistance is this? If it’s there to keep you locked into perpetual deflation, austerity, and unemployment, is it really assistance? I have no doubt that in one or all of these economies, the exercise of sovereignty will be preserved and put to use. In the form of departure from the currency union. No one is beholden to stay inside the euro (although new members of the EU are obliged to aspire to joining the euro-area, and most still want to do so, despite the current difficulties).

There’s an opening here for a reasonable political stand on sovereignty and the return of national monies. It will be greeted with hysteria, scaremongering and opprobrium, much of it based on sheer dogma. Beware these dogmas. When next you read that leaving the euro would be cataclysmic, ask for the reasoning. And analyse it critically. What do you think the Argentine people were told in the waning days of their “irrevocable” peg to the dollar? Sure: “Exit is cataclysmic”. In the event, although devaluation (and default) were not pain-free, they did unleash growth — strong growth, indeed, after years of deflation and recession.

The bottom line is this: Show me an economy that made it through the travails of overvaluation via internal deflation (rather than currency devaluation) and I’ll show you a small and very unique economy. Hong Kong is the example par excellence, but none of the euro-area members can even remotely compare to it, in terms of price flexibility and the generally laissez-faire economic arrangements needed to allow a restoration of competitiveness on the back of internal deflation. The policy prescription for the overvalued euro-area members today is exactly what it was 80 years ago for the overvalued European economies in the opening years of the Great Depression: Don’t devalue, deflate. It didn’t work then just as it isn’t working now. When internal deflation/recession/austerity failed 80 years ago, the politicians who pursued it were swept from office and replaced with bolder ones, many of whom were able to defy the received policy wisdom and to exercise sovereignty.

Breathe deeply: we are not headed for monetary chaos. We do not need to return to the gold standard. The story of money is one of evolution; the gold standard came along at a specific point in that journey. We have outgrown it — in practice. Psychologically, its grip is likely to be rather more formidable.

Gold was a natural anchor for the new era of national currencies which only really emerged in recent history, as far as humanity and civilisation go. Monies for most of history were supra-national things. Monopolization of them by banks, and then by the nation-state, is quite recent. A few disasters with paper monies (see: French assignat) compelled the search for a more responsible way to manage these national monies, and the precious metals were a natural place to turn. Gold has been a precious metal going back into the mists of time (see: Carl Menger, ca 1892). Anchoring national money on gold (and sometimes combined with silver) seemed a good way to prevent the abuse of state-monopolised monies.

While it might have constrained the abuse of paper money (i.e. the over-issue of paper money to finance government expenditure), the burden the gold standard placed on the real economy was often very great. So great, in fact, as to upend the system itself. Even at its apex, the ‘classical’ gold standard of 1870-1914, the system was so deflationary that it began to push marginal countries into insolvency, and with them probably the rest of the world were it not for the accident of a discovery of new gold fields and new mining processes (on the near-collapse of the classical gold standard, see: Flandreau, ‘Stability without a pact’). And the gold standard of the interwar years (1919-1939) had a central role in the Great Depression (see: Eichengreen, ‘Golden Fetters’).

The gold standard was a stage in the evolution of money. It is not an end-point or idyll to which we must return.We’ve learned how to manage money without resort to such a primitive — not to mention, capricious — anchor. Yet such calls can be heard from those concerned about central banking today, not least in respect of the US dollar. Such concerns are overdone. It is flat wrong to assume that the Fed’s expansion of its own balance sheet can only lead to monetary chaos / inflation. These worries betray confusion about what money ‘is’ and ‘does’. Most of all, people are confused about where the value in money comes from. I can list a lot of places it doesn’t come from (correcting many misapprehensions), but the main thing is to say where it does come from: money provides a transactions use. That function is enough to make it valuable, quite apart from what physical medium it has.(In fact, it is this property of money that has given gold much of its value, not the other way round!)

So I’m not a fan of gold. But there’s a catch. It seems difficult to believe that we — humanity — have shrugged off millennia of monetisation of gold. What I can’t figure out is how a role for it can be resurrected in a world as globalised as our own. Convertibility of the currency into a specific weight of gold simply seems a non-starter. This is a capricious system; it forces adjustments onto domestic prices and wages, and the gold price itself is too volatile; its movements up and down would render an economy one day competitive, one day overpriced. Gold would have to be monetised on a much bigger scale than by one small economy. The big ones would have to be linked to gold (at whatever price they want). This might stabilize the gold price but it would not stabilise gold’s value. When gold and currency are in a fixed relationship, the gold value is measured not by the currency but the economy’s price level. (Indeed the same is true of currency; its internal value is measured by the overall price level.)

Gold convertibility looks distinctly unlikely. But there is another dimension of the gold standard worth thinking about. Central banking statutes formerly required that part of the assets backing the monetary base (see previous post) be gold (or gold-convertible foreign currency). These statutes were maintained even when the central bank was relieved of the obligation to convert notes into gold. This was a ‘collateral’ function for gold; it provided collateral against a portion of the note issue. It also constrained central banks to issue currency only up to a multiple of their gold holdings. Perhaps some countries will choose to limit their central bank’s base money emission to some maximum multiple of gold holdings. This is the same as saying that a part of foreign reserves will be required to be composed of gold.

I think any such moves would be disastrous in proportion to the geographical spread of their usage. But ‘normative’ and ‘positive’ analyses are separate issues.

From domestic critics to foreign governments, Ben Bernanke is taking heat for QE2. At the centre of domestic criticism is fear that the Federal Reserve’s endlessly growing balance sheet can only end in tears. Also unhappy are US trade partners and emerging markets whose domestic interest rates make their currencies irresistible to US and other rich-world investors.

To see why Bernanke is doing the right thing, and will need to do much, much more, we need to get to grips with ‘money’. Of the easily spendable money we use every day there are two kinds, though the public do not distinguish between them. The first is ‘central bank money’ (synonyms: high-powered money, base money, monetary base). The second is ‘bank money’. The easily spendable money perceived by the public consists partly of some central bank money (currency in circulation) and partly of bank money. This combination is ‘broad money’. (Be clear that broad money is not a type of money. It is an ‘aggregate’, a measure, a compilation of two types of highly liquid monies.)

Central bank money includes cash in circulation plus the deposits of the banking system at the central bank.

Bank money is money that is created by, well, banks. If someone wants a loan, and the bank sees fit to grant the loan, then it creates the funds to do so, of which it holds only a fraction in central bank money. Think of it this way: the bank does not hand over wadges of cash when you get a loan. But sure enough, you, the loan recipient, have new money. It just happens to be in the form of a bank account. You can easily spend it by debiting that account. (And you can even transform some of it into cash.) As you go along merrily debiting this account, paying for all the home-improvement projects you’re executing, you’re injecting this money into the economy. That plumber you paid should thank you for being so good as to ‘create’ money for the economy in the first place!

It should be clear to you now that when the banking system is writing lots of credit, the supply of money in the economy is growing. That’s pretty handy. Because if you like prosperity, then you like the idea of more people (both at home and around the world) going to work, more people enjoying better incomes, etc. All of which means rising output of goods and services. And if this is all to take place, then the money supply had better grow. Why must the money supply grow? Can’t we just make do with a constant amount of money? Think what that would require: it would require deflation. More stuff + same money = less money per stuff a.k.a. deflation. Think what this requires: that people are indifferent to falling wages. That your creditors are happy to renegotiate your loan. In short, it requires that money is ‘neutral’.

‘Monetary neutrality’ is an assumption of pure theory. It is what allows Austrian-school economists to be comfortable with deflation. It is what allowed many mainstream economists in days past to say that ‘money doesn’t matter’. It allowed serious analytical models to be built and heeded, describing an economy which lacks money entirely. The trouble is, monetary neutrality does not apply in the real world. Ben Bernanke knows this. Ben Bernanke is an expert on the non-neutrality of money. An important part of his research as an academic was devoted to understanding why money patently failed to be ‘neutral’ at a time when such neutrality was needed most: the Great Depression, and the (sinister) deflation that accompanied (/caused) it.

It is not complicated. If people have trouble accepting a decline in wages that matches the decline in prices generally, they price themselves out of the labour market. =unemployment. Remember that the employer’s income (i.e. sales) is falling right along with the price level. The employer needs to pay the workers an equally diminished salary, otherwise the workers become unaffordable. It turns out that money is especially non-neutral in respect of the ‘factors of production’. This includes labour and capital alike. Consider the bank loan. Does the bank send you a letter stating that you now owe less because your wage (along with the price of everything else in the economy) has fallen? Nah. And that means debtors are crushed by deflation. And capital seizes up, because, like labour, it is priced out of the market. (When prices are falling, the rate of interest you are anticipating to pay is not only the nominal rate quoted to you on the loan document, but also the rate of decline in consumer prices generally. This is the real interest rate and it rises during deflation, making capital too expensive.)

If you are really worried about Bernanke’s stewardship of the money supply, consider that he is operating in an environment where credit is contracting. The fear is that this eventually becomes a contraction in the money supply. This would be deflationary. That’s a problem, because of money’s non-neutrality; it cannot simply be wished away. It was a central feature of the Great Depression.

This also puts into context the grumbling of US trade partners. Yes, failure to embark on new QE would buoy up the dollar, because a smaller supply of it would be hitting the foreign exchange market. But does the United States need a buoyed-up dollar? Certainly not. On the contrary, it needs a much weaker dollar. It needs for the economy to start configuring itself around the traded sector. Come to think of it, why does the US administration robotically cling to the ‘strong dollar’ mantra? (Could it have to do with the political power of the financial services industry?) Anyway, the US economy was the buyer of last resort for the rest of the world for a very long time. It is now time for others to pick up that mantle. And what good would it do US trade partners anyway if the US were to tip into deflation and depression?

Emerging markets are in the unique position of having to cope with highly desirable currencies. This is because their economies offer interest rates unavailable in the rich world. The worry for them is that rising currencies price their traded sectors out of the market, killing off their very enviable growth dynamic. This is a genuine policy challenge. But it is manageable. Put crudely, it is a ‘high-class’ problem. These countries can try tightening the access of foreign investors to assets in their economy. They can institute disincentives to investment in short-term securities, and guide investment into long-term projects. They can discourage capital inflows altogether. They can do such things unilaterally, and already are. They can exercise their sovereignty. And that does not make this a beggar-thy-neighbour scenario. (Equally, if Brazil, for example, wants less appreciation in the currency, it needs to examine from where come the very high interest rates it offers. The answer has much to do with an out-sized government budget. But that is a lot more difficult than pointing the finger at another country.)

The truth is that QE2 is a  minimal step. The Fed will need to do much more. It will need to re-visit the funding of private-sector securities from the early days of the post-Lehman crisis. To see why, consider the mechanics. ‘Quantitative easing’ means what it says. With the policy short-term interest rate already set to zero, the balance sheet is used to operate on longer-term securities. The central bank’s money, already mentioned, is ‘base money’. It is contained on the liability side of the Fed’s balance sheet. (However, it is crucial to be clear that this money is nobody’s liability — not even the Fed’s. And that’s OK.) Base money — the liabilities on the Fed’s balance sheet — is backed by assets on the Fed’s balance sheet. In the Fed’s case, these assets are domestic securities. (For the moment, never mind what kind of securities.)

The Fed creates new central bank money by purchasing securities. When it does so, it is buying a security with a newly created quantum of central bank money. It buys securities from the banking system; it pays the bank from which it buys the security by crediting its account at the Fed. Banks keep money at the Fed and it is these holdings, in part, which determine how much ‘bank money’ banks can create. Banks cannot write bank money indefinitely; they can only write it up to a certain multiple of the bank’s holdings of central bank money. In this way is bank money tied to base money, and in this way is base money considered ‘high-powered’ money: it can be pyramided upon by the banking system.

It is this very potency of central bank money that has the critics worried. For every dollar the Fed credits to the banking system, a multiple lies in wait. But the key in this potency is the word ‘potential’. Critics see this as dangerous. In fact, it is at the root of the limited effectiveness of QE2. All the Fed is doing is pushing more money into the banking system. The banking system has little desire to spin this into new money for the economy, and the economy has little desire to be further ‘spun’. Banks are risk-averse and the public is credit-shy. This makes QE2’s usefulness mostly in the area of pushing down the government’s borrowing costs. But about half of the purchases under QE2 will be at less than five years’ maturity, where the borrowing cost is already very low. And even at the longer end of the yield curve the government can already borrow incredibly cheaply. The same goes for many corporations.

The Fed will need to liquefy the private sector and to do so it will need to purchase assets directly from it. If you were worried about QE and QE2 then you’ll be terrified by what’s in store. I personally will find it a great comfort. And I’ll be thanking my lucky stars that by some fluke Bush Jr chose an expert in the Great Depression to be the steward of the US money supply. Do keep in mind that when the Fed starts buying bonds directly from the private sector, it will merely be returning to standard operating procedure under the Fed’s original statutes. (The Fed when it was created could count only such securities as qualified domestic assets backing its liabilities.)

source: OECD, open-thinking.com

Global growth has experienced what economists call a ‘structural break’: the centre of growth is moving steadily toward final demand in the developing world. This is a profound change. Unlike most episodes of broad growth in middle- and low-income economies, the developing world’s growth today is not limited to one region. It is generalised even to the poorest continent, Africa. The investment industry now compiles league tables of ‘frontier markets’, which will soon take the place of today’s emerging markets, and will cede their own spots to countries not yet on the radar.

How should rich countries cash in? Finance is one answer. Pension funds and other institutional investors in the rich world should be, and increasingly are, investing in the growth of the developing world. This approach has limits. The ascendant development model emphasizes a role for national savings. Its appeal is that it has proven resilient to shocks, whereas previous models — emphasizing not national savings but imported capital — have often collapsed in the face of a shock. The new development model is at minimum ambivalent to the role of imported capital. Best practice is to accumulate reserves to maintain a competitive currency and to ‘self-insure’ against crisis. Obviously, a lot of these countries need imported capital to grow. But they can now find it from the developing world itself, on terms the rich countries cannot match, whether for political or other reasons. Some of the biggest investors in Africa are Chinese, Indian and Brazilian private and state-owned multinationals. Their impact on the poorest economies is unmistakable. 

If finance is not the West’s path to capitalising on the new centre of gravity in global growth, then what is? Trade. What should a rich economy trade with the developing world? Centuries of consideration on this topic yield the conclusion that the economy should sort out its own specialisation. Failures in the industrialised world’s efforts to ‘pick winners’ in the 1970s and 80s are a recent vindication of this viewpoint. Yet specialisation does not occur in a vacuum; policies play a role. South Korea had no particular endowment when it emerged from the Korean War in 1953, least of all in human capital (education), in which it is currently very well endowed. It was a poorer country than Ghana in per-capita GDP. The United States was founded with a stupendous resource endowment. Yet it did not specialise in this, as did a similarly endowed, similarly wealthy economy at that time: Argentina. As it happens, the US from an early stage as a new republic eschewed comparative advantage and pursued industrialisation behind the highest tariff walls anywhere in the world. It arguably set an example for Germany and for the industrialisation of economies down to the Asian NICs of today.

Here’s the thing. Specialisation is shaped by ‘relative prices’. This mundane term hides one of the most powerful analytical tools in international finance. Relative prices are the comparison of prices exhibited in the non-traded sectors of the economy to those in the traded sectors. The latter are pinned down by global trade, meaning that the two categories can follow sharply divergent price paths. This matters for specialisation because prices dictate resource allocation. Growth in non-traded prices relative to traded prices is a type of ‘real’ appreciation in the currency, i.e. an appreciation in terms that matter for the economy, i.e. price signals and resource allocation. An  important nontraded (NT) sector is construction. Its relationship to relative prices is symbiotic. Construction, like other NT sectors, thrives on appreciated real currency values, in part because this keeps a lid on traded prices and wages, including inputs into the NT activity. Yet the rising resource allocation to construction in turn abets overvaluation, by raising prices in NT relative to traded sectors. The latter are left to cope with a chronically overvalued currency, and often wither.

Finance is another key NT sector. Like construction, it thrives under conditions of real currency appreciation. This is in part because the real appreciation gives it an advantaged cost of capital. Growth in financial services relative to other sectors in the economy also abets the real appreciation, as an increasing proportion of resources are diverted to the sector, pushing up its prices. The housing bubble in the most overbuilt OECD economies has burst. And, notwithstanding administrative efforts to keep it aloft, further price declines are likely. Only in Ireland has this sector retrenched appreciably from its peak. The financial sector appears to be a different story. There is a sense in which the policy consensus favours reinstatement of the status quo ante. The social sciences concept of path dependence seems apropos here:  shifting the economy away from the heavy emphasis on financial services faces extreme inertia. 

Bear with me. The Netherlands discovered the Groningen gas field in 1959, currently the tenth-largest in the world. As its export basket became dominated by gas, its terms of trade (i.e. the price of exports relative to imports) rose steadily. A rise in the terms of trade, like a rise in relative prices, is a real appreciation of the currency. There is, in fact, an interplay between them. A consequence of the rising terms of trade is that only sectors sheltered from global trade are able to thrive at the appreciated real exchange rate. Resources are then disproportionately allocated to non-traded activities, further exacerbating the currency overvaluation. Traded sectors, starved of resources, shrink or disappear entirely. The Netherlands was not the first to experience this phenomenon, but it is now generally termed ‘Dutch disease’.

Dutch disease is afflicting economies with outsized exposures to the financial services industry. Rather than gas or oil, the natural resource being exploited is ‘reserve currency’. Countries which issue a currency in whose value investors set some store, particularly central banks, are able to exploit this demand for the currency through financial intermediation. The United States and United Kingdom have both had or are having a long spell of issuing the world’s reserve currency. It is not possible to say anything empirically sound about the consequences of this status, because there are so few data points. (In the twentieth century there were really only two: the dollar and sterling.) But the growth in size of financial services in these countries is unmistakable.

The upshot is this: the rich countries which have avoided Dutch disease (of whatever origin) are in a good position to gain from the unprecedented growth of the developing world. Most specialise in manufacturing or other value-added activities. The United States and Britain, as heavily externally indebted economies, need to do likewise. A necessary start is to get relative prices right. To do that, financial services need to shrink. Politically, that is going to be tough.

source: World Bank, IMF, open-thinking.com

The 50 countries above have annual income per capita of USD 5000 or greater. Correlation does not equal causation. But there’s sure some intuitive sense here. On balance, why would the rich pay for the education of other people’s children? Sure, plenty of enlightened ones would know this is sensible. But enlightenment is exceptional. It seems plausible that the higher the income skew, the lower the overall spending on education, because most education is public.

I asked someone from one of the more-egalitarian data points about this. Why does your country provide lots of social services and fund education highly? One hypothesis was size: small countries have no imperial legacy tying them up in expensive strategic commitments or pretensions. Using military spending as a proxy for imperial entanglements generally, the relationship to social spending is roughly as you would expect.

source: as above

The fit is not great. But maybe size is important in other ways. Does small size make social consensus easier to achieve? If a small nation comes to a consensus around high taxes and high social spending, then that’s what it will feature. In a larger polity perhaps the dissenting minorities are loud and strong enough to block any such consesnsus, resulting in drift, or ‘path dependence’: you continue doing what you’ve always done. Which, if true, suggests that opportunities to forge a new direction in national priorities might be rare, only appearing in the wake of crisis. For the USA, one such window opened in 2001, and there’s no mistaking the change in priorities. Arguably, another arrived in 2008 with the financial meltdown. It has not been exploited with quite the aplomb of the earlier one. For those in favour of new priorities, the words ‘missed opportunity’ ring loudly.

source: as above

 The scatterplot above includes countries with annual per capital income equal or greater than USD 13000. The true outliers here are Japan and Germany: both very big countries in the sense we’re discussing (population) and yet very highly ranked in equality (lower Gini numbers are meant to indicate more equal societies). What they have in common is total defeat. Meaning the social order was wiped clean and started over.

The article appears to be freely available.

It’s the UK, Greece, Spain and Ireland that have withdrawn demand support from the EU27. GUKIS? Their combined imports from fellow EU27 economies at the top of the boom (2006) were 657 billion euros. In 2010, that figure is likely to be 546 billion euros, making a decline of 112 billion euros or 17%.

Where is that void being made up? The northern economies. Germany, Benelux, and France will be importing about 143 billion euros more in 2010 than in 2006, marking a rise of about 10% (from a much higher base).

Contrary to conventional wisdom, Portugal and Italy will import more in 2010 than in 2006. Mind, these are nominal figures. But import growth in 2010 alone will be 10% and 20% in Portugal and Italy respectively. Yes, this is flattered by a trough in 2009, but this forecast probably underestimates the whole-year outturn as final demand in the northern economies begins ticking up sharply in the second half.

So it’s northern Europe to the rescue. Perhaps the better out-turn in their economies will soften the way politically for a more amenable approach to Greece and Spain (read: friendly restructuring). But in any case, those problems look like being isolated, so long as the EU27 growth dynamic is sustained. I think that is a good base case, in part because the economies in this part of Europe are complementary to the growth dynamic in the emerging economies, seeking northern Europe’s capital goods and luxury items.

It’s been said that China’s economic development is a qualified ‘win’ for developing countries, particularly the poorest. That’s almost a stylized fact. I’d say it’s a ‘factual’ fact too. At least if the Pew Global Attitudes survey is anything to go by.

As interesting as the slope of this relationship are the outliers. We can discount India’s position for historical reasons. That leaves Malaysia and Uganda as the key outliers. Malaysia is “too rich” to like China this much, whereas Uganda is “too poor” to be so negative on China.

Country specialists do weigh in …