Archive for the ‘Debt Crisis’ Category
Englishman Robert Skidelsky, author of the monumental three-volume biography of John Maynard Keynes, notes (correctly) that deficit reduction is the centerpiece of most governments’ current fiscal policy. The rationale, in his words (and correctly stated) is that
“A government with a “credible” plan for “fiscal consolidation” supposedly is less likely to default on its debt, or leave it for the future to pay. This will, it is thought, enable the government to borrow money more cheaply than it would otherwise be able to do, in turn lowering interest rates for private borrowers, which should boost economic activity. So fiscal consolidation is the royal road to economic recovery.”
This very “plausible” narrative, he says, has five “major fallacies.” He makes some good points, but Skidelsky’s counter-narrative has at least two major fallacies:
- First, while the assumption that there is always an interest rate on sovereign debt that’s high enough to attract investors is — in theory, at least — true, he ignores the possibility — as we’ve seen in various eurozone countries — that the interest rate that equilibrates supply and demand may, with the passage of time, result in sovereign bankruptcy.
- Second, after admitting that sovereign default is “bad,” he says that “life after default goes on much as before.” This statement, offered without explanation or example, ranks rather high on the all-time list of heroic assumptions.
Here’s the narrative with which he disagrees. I’ve highlighted those parts with which I’m in agreement.
“First, governments, unlike private individuals, do not have to “repay” their debts. A government of a country with its own central bank and its own currency can simply continue to borrow by printing the money which is lent to it. This is not true of countries in the eurozone. But their governments do not have to repay their debts, either. If their (foreign) creditors put too much pressure on them, they simply default. Default is bad. But life after default goes on much as before.
Second, deliberately cutting the deficit is not the best way for a government to balance its books. Deficit reduction in a depressed economy is the road not to recovery, but to contraction, because it means cutting the national income on which the government’s revenues depend. This will make it harder, not easier, for it to cut the deficit. The British government already must borrow £112 billion ($172 billion) more than it had planned when it announced its deficit-reduction plan in June 2010.
Third, the national debt is not a net burden on future generations. Even if it gives rise to future tax liabilities (and some of it will), these will be transfers from taxpayers to bond holders. This may have disagreeable distributional consequences. But trying to reduce it now will be a net burden on future generations: income will be lowered immediately, profits will fall, pension funds will be diminished, investment projects will be canceled or postponed, and houses, hospitals, and schools will not be built. Future generations will be worse off, having been deprived of assets that they might otherwise have had.
Fourth, there is no connection between the size of national debt and the price that a government must pay to finance it. The interest rates that Japan, the United States, the UK, and Germany pay on their national debt are equally low, despite vast differences in their debt levels and fiscal policies.
Finally, low borrowing costs for governments do not automatically reduce the cost of capital for the private sector. After all, corporate borrowers do not borrow at the “risk-free” yield of, say, US Treasury bonds, and evidence shows that monetary expansion can push down the interest rate on government debt, but have hardly any effect on new bank lending to firms or households. In fact, the causality is the reverse: the reason why government interest rates in the UK and elsewhere are so low is that interest rates for private-sector loans are so high.”
The author is the chairman of Goldman Sachs Asset Management.
The key quote from the following document:
. . . some might describe the fiscal compact as more like “compost” as, without some offsetting measures elsewhere, all indebted countries tightening fiscal policy further simply to satisfy some new numerical target doesn’t seem like sensible economics, especially for those with large youth unemployment and members of a union that, never massively popular, is increasingly regarded as a problem.
To complicate matters, some Euro Area policymakers realize the potential insanity of the above and have inserted an“escape clause” into the fiscal compact discussions that allows countries to avoid tightening further “in periods of severe economic downturn”. This strikes me as sensible in principle, but whether Berlin and Frankfurt will agree remains to be seen. The early signs from ECB members is that they worry it will be an excuse for countries to avoid structural challenges.
From a big picture perspective, there is a lot of evidence that major fiscal tightening, especially if it includes reductions in government spending, is rather key to raising countries economic growth potential. If you throw in supply side reforms, and – what might normally be the case – easier monetary conditions such as a decline in the exchange rate and lower interest rates, this is the classic recipe for a nice long-term outcome. However, given the constraints of a monetary union, and one seemingly dominated by Germanic caution, it is not so obvious that we can get there. [My emphasis]
If you’ve wondered why I haven’t proffered a “solution” to the eurozone crisis, this post should suffice. Here we have experts far more knowledgeable than I who reach diametrically opposed conclusions regarding the fate of the eurozone and, by implication, the futures of economies and financial markets. The optimistic argument is that the euro will be saved because everyone realizes that the consequences of it not being saved are so dire. The pessimistic argument is that, while the euro’s collapse would have serious negative consequences, these consequences are preferrable to the political and financial costs of preventing the collapse.
The optimistic argument smacks of idealism (a.k.a.wishful thinking); the pessimistic of realism (a.k.a., defeatism). At the bottom of it all lies this question, which always arises at times of crisis: are there forces at work that are beyond the keen of even the most well-intentionned, hard-working, knowledgeable people?
The economic and financial problems in the euro area are clearly serious and plentiful. An increasing number of commentators and economists have begun to question whether the euro can survive. There are only two alternatives. Europe can jettison the monetary union or it can adopt a complementary economic union. Every policymaker in Europe knows that the collapse of the euro would be a political and economic disaster for all and thus totally unacceptable. Europe’s overriding political imperative to preserve the integration project will surely drive its leaders to ultimately secure the euro and restore the economic health of the continent.
The key is to observe what Europe does rather than what it says. At each critical stage of the crisis, both Germany and the European Central Bank have demonstrated they will pay whatever is necessary to preserve the euro area and avoid defaults (except possibly Greece). But neither can say they will provide unlimited bailouts because this would alleviate the pressure on the debtor countries to reform and weaken the bargaining position of each creditor group (northern European governments, ECB, private lenders, IMF) vis-à-vis the others as they allocate the costs of the bailouts. Europe’s key political actors in Berlin, Frankfurt, Paris, Rome, Athens, and elsewhere will thus quite rationally exhaust all alternative options in searching for the best possible deal before at the last minute coming to an agreement. For all this turmoil, however, Europe is well on its way to completing a true economic and monetary union, and will emerge from the crisis much stronger as a result.
The eurozone has fallen into a spiral of downgrades, falling economic output, rising debt and further downgrades. A recession has just started. Greece is now likely to default on most of its debts and may even have to leave the eurozone. When that happens, the spotlight will fall immediately on Portugal, and the next contagious round of downgrades will begin.
Europe’s insufficient rescue fund, the European Financial Stability Facility, now also faces a downgrade because it had borrowed its ratings from its members. The way the EFSF is constructed means that its effective lending capacity will thus be reduced . . .
By downgrading France and Austria but not Germany and the Netherlands, Standard & Poor’s also managed to shape expectations of the economic geography of an eventual break-up. A downgrading of all triple A rated members would have been much easier to deal with politically. Germany is now the only large country left with a triple A rating. The decision will make it harder for Germany to accept eurozone bonds. The ratings wedge between France and Germany will make the relationship even more unbalanced.
[...] The conclusion of the fiscal treaty, which is the top priority of EU politics right now, is at best an irrelevant distraction. Most likely, it will enhance the trend towards pro-cyclical austerity of the kind we have seen in Greece . . .
[...] With each turn of the spiral, the financial and political costs of an effective resolution increase. We have moved past the point where electorates and their representatives are willing to pay the ever-rising costs of repairing the system. Last week a couple of senior parliamentarians from the ruling CDU party, whom I had previously considered voices of moderation, argued that a Greek exit from the eurozone would not be such a big deal. Expectations are changing quickly, and so is the acceptance of a violent ending.
And no, the European Central Bank’s huge liquidity boost is not going to fix the problem either. I do not want to underestimate the importance of that decision. The ECB prevented a credit crunch and deserves credit for that. The return of unlimited long-term money might even have a marginal impact on banks’ willingness to take part in government debt auctions. If we are lucky it might get us through the intense debt rollover period this spring. But a liquidity shower cannot address the underlying problem of a lack of macroeconomic adjustment.
Even economic reforms, necessary as they may be for other reasons, cannot solve this problem. This is another European illusion. We are now at a point where effective crisis resolution would require a strong central fiscal authority, with the power to tax and allocate resources across the eurozone. Of course, it will not happen.
This is the ultimate implication of last week’s ratings downgrades. We have moved beyond the point where a technical fix would work. The toolkit is exhausted.
Papandreou (waking up): Great gods! Will these nights never end? Will daylight never come? I heard the cock crow hours ago, but my indolent and totally corrupt people are still snoring away! Curses on this debt crisis! Curses on Pasok! I can’t even sack my own public servants.
The spotlight switches to the top floor of Papandreou’s home and reveals the Troika of Creditors, who are armed with iPads and studying a pile of dusty Greek ledgers.
First Creditor: It really is quite remarkable. Until last month more than 1,000 dead pensioners were receiving payments from Greece’s biggest pension fund.
Second Creditor: And what about this? The Greek state considers 637 types of job to be so arduous that the people doing them get early retirement.
First Creditor: What sort of people?
Second Creditor: Steam bath attendants. Radio technicians. Hairdressers.
First Creditor (thoughtfully): One could look at things another way. International civil servants such as us get generous pensions and early retirement, too.
Second Creditor (stiffly): We’re not in Athens to look at things another way.
Third Creditor: Absolutely right. We’re here to look into the questions that really matter. For example, the difference between who owns swimming pools and who declares ownership of swimming pools in their tax returns. (He displays a Google Map.) The two categories do not exactly overlap – at least, not in the suburb of Ekali.
Second Creditor: Let me guess. Ten thousand swimming pools and only 1,000 owners.
Third Creditor: You underestimate the addiction to fiction of the pool-loving Greek. Ekali has 16,974 pools. But according to the tax returns there are only 324 owners.
The spotlight switches to Papandreou.
Papandreou (despairingly): Who do we owe all this money to? How much do we owe? Let me add up the interest … It’s a nightmare, these debts are deeper than the Bay of Salamis! Sometimes I wish I were back at Amherst, playing Bob Dylan songs on my guitar. But I mustn’t give up! It was Andreas, that father of mine, who got my country into this mess. I’m not like him. I’m not really a socialist at all. But it’s my duty to save Greece. I know! I’ll call a referendum!
The spotlight switches back to the Troika of Creditors.
First Creditor: Did someone say the word “referendum”?
Second Creditor: No, we’re not in Ireland.
Leader of the Chorus: Oh, mortal central bankers, you who wish to instruct yourselves in our great wisdom, take heed that you must know how to hold your own, how to withstand extreme market pressures, and how to press on without admitting to fatigue. Then you will enjoy the greatest of blessings, to live and think more clearly than the common herd and to shine in the contests of words.
Trichet (briskly, to Draghi): So, we’re clear about the first rule of central banking.
Draghi: Buy Greek bonds and call it the removal of impediments to the transition mechanism of a price stability-oriented monetary policy.
Trichet (stares at Draghi): All right, then, the second rule. It is, mon cher Mario, that one should never speak ill of one’s colleagues, especially at the European Central Bank. Here in Frankfurt we have done more than any institution in Europe, or in the entire world, to keep the euro alive. Every single one of us deserves credit.
Draghi: With that sentiment I am in complete, utter and total agreement.
Trichet: All the same, I have my doubts about old Axel.
Draghi: Me, too. What on earth is he playing at?
Trichet: I don’t mind him opposing the bond purchase programme. You expect nothing less from a Bundesbank president.
Draghi: It’s natural.
Trichet: But he shouldn’t express his opposition in public.
Draghi: It’s unnatural.
Trichet: He’s having a terrible effect on German opinion. He’s making our job twice as difficult.
Enter a slave bearing a tray.
Slave: A letter from Axel Weber, master.
Trichet (opens letter and reads): Well, he has solved our problem. He’s resigning.
Draghi: Not before time.
Trichet: He’ll be lecturing in America before you can say Schuldenbremse. (Thinks.) Of course, this will clear the way for someone else to step into my shoes here.
Draghi (innocently): What’s your size?
Leader of the Chorus (to Draghi): Tell us boldly what you want of us. Then you cannot fail to succeed. When we have finished teaching you, your glory among mortals will reach even to the skies.
Draghi: Well, there is a rather delicate business in Rome …
Slave: The nurses’ uniforms are ready, master.
Berlusconi: Grazie. Here, Vlada, you’re good with figures. Answer me a question.
Vlada the Heart-Stealer: What is it, Papi?
Berlusconi: Why is the number eight so significant in my life?
Vlada the Heart-Stealer: Well, you once said you did eight of us in one night.
Berlusconi: Brava! But tonight that’s not what I have in mind. The reason is that there were eight traitors in my party who deserted me in parliament. My enemies are like bedbugs, advancing on me from all corners. They are biting me, they are gnawing at my sides, they are drinking my blood, they are yanking at my coglioni, they are digging into my backside! Now I must make the supreme sacrifice for the good of my nation. Now I must fulfil my destiny as the Jesus Christ of politics. Now the curtain will fall on the greatest premiership that Italy has known.
Vlada the Heart-Stealer: Come, come, Papi, no giving up! The thing to do is to find an ingenious way through.
Berlusconi: A way through? I only wish one would come to me.
Vlada the Heart-Stealer: Are you holding something?
Berlusconi: No, nothing whatever.
Vlada the Heart-Stealer: Nothing at all?
Berlusconi: Nothing except … The Italian people know what I have done for my country. The restaurants, the beauty salons and the private jets are all full. I’m not finished yet. Mark my words, if my enemies think they can destroy my entire career, they will be sorely disappointed. I am the most persecuted man in the history of the world, but they will never get me.
Enter the Chorus of the Clouds.
Leader of the Chorus: Old man, we counsel you, if you have a successor, send him to us to learn in your stead.
Berlusconi: He’s called Mario Monti.
Leader of the Chorus: Can you make him obey you?
Berlusconi: If he refuses, I’ll turn him out. I’ve got the numbers in the Senate.
Vlada the Heart-Stealer: Eight?
Berlusconi (wearily): Not tonight, Vlada.
Merkel: What delicious cheese!
Sarkozy (to himself): That’s her second helping.
Merkel: You really should try some, David, it will calm you down.
Cameron: I tell you, I will not hold a referendum, I will not agree to a new treaty, I will not support a financial transactions tax, and I will not listen to lectures from that ventriloquist’s dummy of yours!
Merkel (producing dummy from her handbag): Oh, I think Herman’s rather sweet. (To dummy). Give us one of your haiku.
Herman Van Rompuy (speaking through Merkel):
The fiscal compact
Is agreed. But Belgium still
Lacks a government.
Merkel (puts dummy back in bag): We’ve been practising all week.
Sarkozy (fawningly): He has a most accommodating nature, Angela.
Merkel (pleased): Even when he was quite little, he amused himself at home with making horses, carving boats and constructing small chariots of leather. He had a wonderful understanding of how to make frogs out of pomegranate rinds.
Cameron: I tell you, I will not hold a referendum, I will not join the eurozone and I will not give money to the European rescue fund! (Sighs.) It was a lot more fun with Boris in the Bullingdon Club. Killing foxes with chilled bottles of Taittinger Brut …
Merkel (to Sarkozy): You and I need to get down to business. So tell me the truth, Nicolas, was DSK set up?
Sarkozy (sweetly): As you have put it so eloquently, Angela, there is no Europe without the euro. (To himself.) Merde, she must have been gossiping with Carla.
Merkel: Well, that’s that, then, I’m glad to say we have an agreement. Europe will have a fiscal union in 250 years’ time, and I’ll have a bit more cheese.
Cameron: I tell you, I will not hold a referendum, I will not …
Merkel (turning to Cameron): What, are you still here?
Sarkozy (pausing before he deals): What about your ante, Mario?
Draghi: Oh, sorry.
Draghi places a €10 note on the table. Sarkozy inspects it.
Sarkozy: The serial number begins with a Y.
Merkel: Mein Gott, it’s Greek!
Sarkozy: Throw it away.
Draghi: How can I? They’re still in the eurozone, you know.
Merkel: Tell me about it.
Leader of the Chorus: What a thing it is to love making mistakes! For this old Europe, having loved its mistakes, now wishes to withhold the money that it borrowed.
Sarkozy continues dealing.
Merkel (to the Leader of the Chorus): Why didn’t you warn us earlier?
Leader of the Chorus: We always do this to those whom we perceive to be lovers of mistakes. We precipitate them into misfortune, so that they may learn to fear the gods.
Draghi (folds hand): I’m out.
Merkel (aghast): You can’t be!
Sarkozy: It’s you and me alone, Angela. What’s it to be? Eurobonds or the end of the euro?
Merkel (to Draghi): I sometimes think he’s worse than Chirac.
Enter Cameron, running wildly.
Cameron: Oh, Europeans, do not be angry with me! Do not destroy me! Pardon me, I’ve gone crazy through babbling. Bring me a torch, someone!
Sarkozy and Merkel: In the name of the gods, what are you doing?
Cameron: What am I doing? What does it look like? (Cameron sets the house on fire.)
Merkel: You’ll destroy us!
Sarkozy: He’ll never destroy us. I’m raising you a million euros, Angela.
Merkel (slowly folding her hand): You’ve won this round, Nicolas. But I’ll win the war.
The House of Thoughts is ablaze.
Leader of the Chorus: Lead the way out, for we have sufficiently acted as Chorus for today.
From marketobservation.com, a great graph showing how easy money, deregulation, reckless leveraging and market failure led t0 crisis, collapse and bailouts.
Earlier this month, the European Central Bank announced an emergency loan program known as “longer-term refinancing operations,” or LTROs. The program will become operational tomorrow (Wednesday). The Financial Times says that the ECB expects strong demand for the loans, which will be available in “unlimited” quantities.
The purpose of the program, which enables banks to avail themselves of three-year loans at extremely favorable interest rates, is to ease the severe strains in the eurozone’s financial system. If demand for the loans is strong, it should reduce the likelihood that banks will substantially shrink their balance sheets (by selling assets and reducing new loans to their customers) to meet their funding needs (which are especially large in early 2012). The hope, then, is that the LTRO will improve the economic performance of countries in the eurozone. It’s important to note, however, that this provision of additional liquidity doesn’t attack the eurozone’s fundamental problem: severe and persistent balance-of-payment imbalances among its members.
The funding problem that the LTRO is aimed to ease is having a contagion effect. Asset sales by European banks have put pressure on securitized mortgage prices in the U.S. Instead of selling distressed assets in their home markets, the banks are selling assets elsewhere (as encouraged by their governments).
- The ABX, an index of prices for securities backed by 2006 vintage subprime mortgages, has fallen 29 per cent since the start of the year, to trade at levels not seen since late 2009.
- European banks alone hold about $100 billion in US mortgage-backed securities that are not backed by Fannie Mae and Freddie Mac, according to data from Deutsche Bank.
In combination with the sharp drop in Spanish short-term interest rates that took place today, the imminent start of the LTRO program may be responsible for the sharp rally in the U.S. equity markets. If demand is as strong as the ECB expects, contagion fears could ease, allowing for a short-term bounce in the stocks of financial institutions holding mortgage-backed securities.
Excerpts from an FT editorial:
Europe’s economic prospects are deteriorating frighteningly fast, and the world outlook is darkening in step with the Old World’s woes. Unless the world’s leaders manage to pull together soon, we should brace ourselves for a second phase of the credit crisis that will be even worse than the first.[...] A credit crunch is gaining force, and Europe’s economy grinding to a halt because of it. This is making the twin crises – bank and sovereign – harder to resolve and is hitting emerging economies whose credit is drying up and whose export markets are withering. If the ECB cannot stimulate growth, governments must do so, and fast.
Today the whole world badly needs Europe to grow. Long-term growth and rebalancing are sine qua non for overcoming the debt crisis, but short-term recovery is a greater priority. Austerity by those who must should now be compensated by stimulus from those who can.
My sentiments, exactly.
Where there’s a will, there’s a way — at least for a while. These days, anything and everything is believable.
From the Wall Street Journal (no link):
Governments in Europe are tying themselves in knots to prop up their banks, desperate to blunt the cost and embarrassment of a fresh wave of taxpayer-funded bailouts.
In Italy, for example, the government is encouraging banks to buy public properties that the banks then can use to borrow money. As part of a broader deficit-reduction program in Portugal, the government essentially is borrowing money from bank pension funds and could use some of the funds to help state-owned companies repay bank loans.
Governments in Germany and Spain also are using unorthodox measures to support their ailing banks.
A closer look at Italy:
The Italian government has been among the most innovative at finding ways to help its banks conserve capital or come up with fresh funds.
A provision tucked into the Italian government’s budget law last month is designed to defuse some of those pressures. It allows the banks to use their government bonds to purchase army barracks, office buildings and other state-owned real estate that the government has been trying to sell.
The government would then lease the properties back from their new owners. And the banks can package the income-producing properties into asset-backed securities, which can be pledged as collateral with the ECB in exchange for loans, analysts say.
Italy’s real-estate-for-sovereign-bonds maneuver also gives a boost to the government. Not only can it rid itself of unwanted properties, but the government also will be able to retire the bonds that banks use to purchase the real estate—thereby reducing Italy’s heavy debt load.
. . . and Germany:
Commerzbank AG is in talks with the finance ministry to transfer part or all of its troubled real-estate finance unit Eurohypo into a government-owned “bad” bank. The bank and government are in talks about ways to structure the deal so it isn’t considered a bailout, possibly by protecting the government against some losses or paying the government a nominal fee, according to people familiar with the matter.
That is an important stipulation. Commerzbank executives have repeatedly promised they won’t take more taxpayer money, following a 2009 bailout that still has the bank 25%-owned by the government. But Commerzbank needs to come up with €5.3 billion in new capital by next summer in order to meet the demands of European regulators.
. . . and Portugal:
the government is planning an intricate financial maneuver that could give the country’s banks some relief from the mountains of unpaid loans they hold from Portugal’s state-owned companies. The state just closed a plan to transfer banks’ future pension responsibilities to the state balance sheet in exchange for €6 billion in assets, which include cash, stocks and bonds. Most of the money will help the government meet deficit targets.
But about €2 billion may be shifted to struggling government-owned companies, such as transport providers. Under the plan, these companies would use the funds to pay off debts to Portugal’s banks.
. . . and Spain:
In Spain, the government used €5.2 billion in funds from the country’s deposit-guarantee plan to clean up nationalized lender Caja de Ahorros del Mediterraneo and broker its sale to Banco Sabadell SA earlier this month.
Instead of raising more money through a Spanish government bailout fund, a central-bank spokesman said that tapping the deposit-insurance plan would leave the country’s budget goals this year intact. The deposit-guarantee fund will be refilled early next year, and the government will provide a back-stop in the meantime.
“Those who do not remember the past are condemned to repeat it.”
– George Santayana
Few quotes are more frequently mentioned than this one. Keep it in mind while taking a few minutes to read (and ponder) this article from the Economist’s December 10th issue.
In 2008 the world dodged a second Depression by avoiding the mistakes that led to the first. But there are further lessons to be learned for both Europe and America
“YOU’RE right, we did it,” Ben Bernanke told Milton Friedman in a speech celebrating the Nobel laureate’s 90th birthday in 2002. He was referring to Mr Friedman’s conclusion that central bankers were responsible for much of the suffering in the Depression. “But thanks to you,” the future chairman of the Federal Reserve continued, “we won’t do it again.” Nine years later Mr Bernanke’s peers are congratulating themselves for delivering on that promise. “We prevented a Great Depression,” the Bank of England’s governor, Mervyn King, told the Daily Telegraph in March this year.
The shock that hit the world economy in 2008 was on a par with that which launched the Depression. In the 12 months following the economic peak in 2008, industrial production fell by as much as it did in the first year of the Depression. Equity prices and global trade fell more. Yet this time no depression followed. Although world industrial output dropped by 13% from peak to trough in what was definitely a deep recession, it fell by nearly 40% in the 1930s. American and European unemployment rates rose to barely more than 10% in the recent crisis; they are estimated to have topped 25% in the 1930s. This remarkable difference in outcomes owes a lot to lessons learned from the Depression.
Debate continues as to what made the Depression so long and deep. Some economists emphasise structural factors such as labour costs. Amity Shlaes, an economic historian, argues that “government intervention helped make the Depression Great.” She notes that President Franklin Roosevelt criminalised farmers who sold chickens too cheaply and “generated more paper than the entire legislative output of the federal government since 1789”. Her book, “The Forgotten Man”, is hugely influential among America’s Republicans. Newt Gingrich loves it.
A more common view among economists, however, is that the simultaneous tightening of fiscal and monetary policy turned a tough situation into an awful one. Governments made no such mistake this time round. Where leaders slashed budgets and central banks raised rates in the 1930s, policy was almost uniformly expansionary after the crash of 2008. Where international co-operation fell apart during the Depression, leading to currency wars and protectionism, leaders hung together in 2008 and 2009. Sir Mervyn has a point.
Look closer, however, and the picture is less comforting. For in two important—and related—areas, the rich world could still make mistakes that were also made in the 1930s. It risks repeating the fiscal tightening that produced America’s “recession within a depression” of 1937-38. And the crisis in Europe looks eerily similar to the financial turmoil of the late 1920s and early 1930s, in which economies fell like dominoes under pressure from austerity, tight money and the lack of a lender of last resort. There are, in short, further lessons to be learned.
Riding for a fall
It was far easier to stimulate the economy in the 2000s than in the 1930s. Social safety nets—introduced in the aftermath of the Depression—mean that today’s unemployed have money to spend, providing a cushion against recession without any active intervention. States are more relaxed about running deficits, and control much larger shares of national economies. The package of public works, spending and tax cuts that President Herbert Hoover introduced after the crash of 1929 amounted to less than 0.5% of GDP. President Barack Obama’s stimulus plan, by contrast, was equivalent to 2-3% of GDP in both 2009 and 2010. Hoover’s entire budget covered only about 2.5% of GDP; Mr Obama’s takes 25% of GDP and runs a deficit of 10%.
Roosevelt raised spending to 10.7% of output in 1934, by which point the American economy was growing strongly. By 1936 inflation-adjusted GDP was back to 1929 levels. Just how much the New Deal spending helped the recovery is still debated. Some economists, such as John Cochrane of the University of Chicago and Robert Barro of Harvard, say not at all. Fiscal measures never work, they say.
Those who think that fiscal measures do work nonetheless tend to believe that, in the 1930s, spending was less important than monetary policy, which they see as the prime cause of suffering. In a paper in 1989 Mr Bernanke and Martin Parkinson, now the top civil servant in Australia’s finance ministry, wrote that rather than providing recovery itself “the New Deal is better characterised as having ‘cleared the way’ for a natural recovery.” Others, such as Paul Krugman, would ascribe a more positive role to stimulus spending.
Whatever relative importance is assigned to monetary and fiscal policy, though, there is little doubt that their simultaneous tightening five years into the Depression led to a vicious relapse. Spurred by his treasury secretary, Henry Morgenthau—who worried in 1935 that “we cannot help but be riding for a fall unless we continue to decrease our deficit each year and the budget is balanced”—Roosevelt urged fiscal restraint on Congress in 1937.
By that point the national debt had reached an unheard of 40% of GDP (huge by the standards of the day, but half what Germany’s debt is now). Congress cut spending, increased taxes and wiped out a deficit of 5.5% of GDP between 1936 and 1938. That was a larger consolidation than Greece now faces over two years (see chart 1), but is much smaller than what is planned for it in the longer term. At the same time the Federal Reserve doubled reserve requirements between mid-1936 and mid-1937, encouraging banks to pull money out of the economy. The Treasury began to restrict the money supply in step with the level of gold imports. In 1937 and 1938, the recession within a depression brought a drop in real GDP of 11% and an additional four percentage points of unemployment, which peaked at 13% or 19%, depending on how you count it.
The Snowdens of yesteryear
Today’s monetary policy hasn’t turned contractionary, as America’s did in the 1930s. As The Economist went to press, the European Central Bank (ECB) was expected to announce a further reduction in interest rates. But in many places fiscal policy is moving rapidly in that direction. Mr Obama’s stimulus is winding down; state- and local-government cuts continue. Republican candidates for the presidency echo the arguments of Mr Morgenthau, claiming that deficit-financed stimulus spending has done little but add to the obligations of future taxpayers. Mr Obama, like Roosevelt, has started to stress the need for budget-cutting. If the current payroll-tax cut and emergency unemployment benefits were to lapse, growth over the next year would be reduced by around one percentage point of GDP.
America is not alone. Under David Cameron, Britain’s hugely indebted government introduced a harsh programme of fiscal consolidation in 2010 to avert a loss of confidence in its creditworthiness. The rationale was similar to that for chancellor Philip Snowden’s emergency austerity budget of 1931, with its tax rises and spending cuts. On that occasion confidence was not restored, and Britain was forced to devalue the pound and abandon the gold standard. On this occasion the measures have indeed boosted investor confidence, and thus bond yields; that the country still faces a second recession is in large part due to the euro zone’s woes. That said, the possibility of such shocks should always be a counsel for caution when a government embarks on fiscal tightening.
Some say tightening need not hurt. In 2009 Alberto Alesina and Silvia Ardagna of Harvard published a paper claiming that austerity could be expansionary, particularly if focused on spending cuts, not tax increases. Budget cuts that reduce interest rates stimulate private borrowing and investment, and by changing expectations about future tax burdens governments can also boost growth. Others doubt it. An International Monetary Fund (IMF) study in July this year found that Mr Alesina and Ms Ardagna misidentified episodes of austerity and thus overstated the benefits of budget cuts, which typically bring contraction not expansion.
Roberto Perotti of Bocconi University has studied examples of expansion at times of austerity and showed that it is almost always attributable to rising exports associated with currency depreciation. In the 1930s the contractionary impact of America’s fiscal cuts was mitigated to some extent by an improvement in net exports; America’s trade balance swung from a deficit of 0.2% of GDP to a surplus of 1.1% of GDP between 1936 and 1938. Now, most of the world is cutting budgets and not every economy can reduce the pain by boosting exports.
The importance of monetary policy in the 1930s might suggest that central banks could offset the effects of fiscal cuts. In 2010 the IMF wrote that Britain’s expansionary monetary policy should mitigate the contractionary impact of big budget cuts and “establish the basis for sustainable recovery”. Yet Britain is now close to recession and unemployment is rising, suggesting limits to what a central bank can do.
The move to austerity is most dramatic within the euro zone—which can least afford it. Operating without floating currencies or a lender of last resort, its present predicament carries painful echoes of the gold-standard world of the early 1930s.
In the mid-1920s, after an initially untenable schedule of war reparations payments was revised, French and American creditors struck by the possibility of rapid growth in the battered German economy began to pile in. The massive flow of capital helped fund Germany’s sovereign obligations and led to soaring wages. Germany underwent a credit-driven boom like those seen on the European periphery in the mid-2000s.
In 1928 and 1929 the party ended and the flow of capital reversed. First, investors sent their money to America to bet on its soaring market. Then they yanked it out of Germany in response to financial panic. To defend its gold reserves, Germany’s Reichsbank was forced to raise interest rates. Suddenly deprived of foreign money, and unable to rely on exports for growth as the earlier boom generated an unsustainable rise in wages, Germany turned to austerity to meet its obligations, as Ireland, Portugal, Greece and Spain have done. A country with a floating currency could expect a silver lining to capital outflows: the exchange rate would fall, boosting exports. But Germany’s exchange rate was fixed by the gold standard. Competitiveness could only be restored through a slow decline in wages, which occurred even as unemployment rose.
As the screws tightened, banks came under pressure. The Austrian economy faced troubles like those in Germany, and in 1931 the failure of Austria’s largest bank, Credit Anstalt, triggered a loss of confidence in the banks that quickly spread. As pressure built in Germany, the leaders of the largest economies repeatedly met to discuss the possibility of assistance for the flailing economy. But the French, in particular, would brook no reduction in Germany’s debt and reparations payments.
Recognising that the absence of a lender of last resort was fuelling panic, the governor of the Bank of England, Montagu Norman, proposed the creation of an international lender. He recommended a fund be set up and capitalised with $250m, to be leveraged up by an additional $750m and empowered to lend to governments and banks in need of capital. The plan, probably too modest, went nowhere because France and America, owners of the gold needed for the leveraging, didn’t like it.
So the dominoes fell. Just two months after the Credit Anstalt bankruptcy a big German bank, Danatbank, failed. The government was forced to introduce capital controls and suspend gold payments, in effect unpegging its currency. Germany’s economy collapsed, and the horrors of the 1930s began.
It is all dreadfully familiar (though no European country is about to elect another Hitler). Membership in the euro zone, like adherence to the gold standard, means that uncompetitive countries can’t devalue their currencies to reduce trade deficits. Austerity brings with it a vicious circle of decline, squeezing domestic demand and raising unemployment, thereby hurting revenues, sustaining big deficits and draining away confidence in banks and sovereign debt. As residents of the periphery move their money to safer banks in the core, the money supply declines, just as it did in the 1930s (see chart 2). High-level meetings with creditor nations bring no surcease. There is no lender of last resort. Though the European Financial Stability Facility (EFSF) has got further off the ground than Norman’s scheme, which it chillingly resembles, euro-zone leaders have yet to find a way to leverage its €440 billion up to €2 trillion.
Even if they succeed, that may be too little to end the panic. Investors driven by turmoil in Italian markets are pre-emptively reducing their exposure to banks and sovereign bonds elsewhere in the euro zone. Even countries with relatively robust economies such as France and the Netherlands have not been spared. No matter how secure an economy’s fiscal position, a short-term liquidity crunch driven by panic can drive it into insolvency.
History need not repeat itself. Norman’s Bank of England was created in the 17th century to lend to the government when necessary; central banks have always been obliged to lend to governments when others will not. The ECB could take on this role. It is prohibited by its charter from buying debt directly from governments, but it can purchase debt securities on the secondary market. It has been doing so piecemeal and could declare its intention to do so systematically. Its power to create an unlimited amount of money would allow it credibly to announce its willingness to buy any bonds markets want to sell, thus removing the main cause of panic and contagion.
This week France and Germany proposed the adoption of legally binding budgetary “golden rules” by euro-zone members, ahead of a summit of European leaders in Brussels on December 8th-9th. Mario Draghi, the ECB’s new president, has hinted that were a fiscal pact to be agreed, the ECB might buy bonds on a larger scale. What scale he has in mind, though, is unclear. Jens Weidmann, president of Germany’s Bundesbank and an influential member of the ECB’s governing council, has clearly stated that the ECB “must not be” the euro zone’s lender of last resort.
Where this path leads
On the present course, conditions in developed economies look like getting worse before they get better. Growth in America and Britain will probably be less than 2% in 2012 on current policy, and in both recession is quite possible. A euro-zone recession is likely. The ECB could improve the euro zone’s economic outlook by loosening its monetary policy, but widespread austerity and uncertainty will be difficult to overcome. As in 1931 and 2008, a grave financial crisis may cause a large drop in output. That, in turn, would place more pressure on euro-zone economies struggling to avoid default.
As panic built in 1931, country after country faced capital flight. The effort to defend against bank and currency runs prompted rounds of austerity and plummeting money supplies in pressured economies, helping generate the collapse in output and employment that turned a nasty downturn into a Depression. It took the end of the gold standard, which freed central banks to expand the money supply and reflate their economies, to spark recovery. Today the ECB has the tools needed to salvage the situation without breaking up the euro. But the fact that the ECB and euro-zone governments have options does not mean that they will take them.
The collapse of the gold standard led to recovery, but caused terrible economic damage as countries erected trade barriers to stem the flood of imports from those that had devalued their currencies. Governments elected to fight unemployment experimented with wage and price controls, cartelisation of industry and other interventions that often impeded the recovery enabled by expansionary monetary and fiscal policies. In the worst-hit countries long-suffering citizens turned to fascism in the false hope of relief.
The world today is better placed to cope with disaster than it was in the 1930s. Then, most large economies were on the gold standard. Today, the euro zone represents less than 15% of world output. In developed countries unemployment, scourge though it is, does not lead to utter destitution as it did in the 1930s. Then, the world lacked a global leader; today, America is probably still up to the job of co-ordinating disaster response in troubled times. International institutions are much stronger, and democracy is more firmly entrenched.
Even so, prolonged economic weakness is contributing to a broad rethinking of the value of liberal capitalism. Countries scrapping for scarce demand are now intervening in currency markets—the Swiss are fed up with their franc appreciating against the euro. America’s Senate has sought to punish China for currency manipulation with tariffs. Within Europe the turmoil of the euro crisis is encouraging ugly nationalists, some of them racist. Their extremism is mild when compared with the continent-wrecking horrors of Nazism, but that hardly makes it welcome.
The situation is not yet beyond repair. But the task of repairing it grows harder the longer it is delayed. The lessons of the 1930s spared the world a lot of economic pain after the shock of the 2008 financial crisis. It is not too late to recall other critical lessons of the Depression. Ignore them, and history may well repeat itself.
“Returning to the mean” is a simple, powerful and frequently-applied concept. It says that departures from long-term levels (e.g. equity price-earnings ratios) and rates of growth (e.g., housing prices) are inevitably reversed.
Deutsche Bank’s Jim Reid has applied this concept to the duration of business cycles. His conclusion is that shorter business cycles will become the norm.
FT/Alphaville comments on and quotes from the bank’s report:
It’s not inconceivable that 2012 could go down in the history books as the year the Euro broke up or at least moved much closer to it. In anything resembling a free market this would have already happened. The alternative scenario is that 2012 sees the ECB’s balance sheet expand dramatically to accommodate the extraordinary debt levels that the free market has limited appetite re-financing.
We don’t think the latest EU summit is a game changer and market pressure may build ahead of a challenging Q1 redemption schedule for Euro sovereigns and banks. We think this may force a reluctant ECB to become more aggressive early in the year. The market may then start to become slightly more relaxed about the stresses in the system. However, we think widespread austerity will mean that the European recession intensifies as 2012 progresses. Our shorter cycle theory has always targeted 2012 as a recession year…
The idea is that business cycles used to be a hell of a lot shorter. In the last few decades though, we’ve experienced a handful of much longer cycles. As we have learned to our peril, the elongating factors were not sustainable.
The below figure plots the number of months of expansion for each business cycle in the US since 1854:
About the ‘Golden Age’ expansions in the above:
We think that the three ‘super-cycles’ between 1982-2007 were the exception rather than the norm and existed largely because of a near 30 year secular global decline in inflation that transcended the business cycle. This was perhaps caused by Globalisation and the reduction in cost pressures that it facilitated. We think that the Western authorities ‘maxed out’ on the benefits of this inflationary decline by pumping monetary and fiscal stimulus into their economies whenever they had an economic problem. Given the lack of inflationary pressures they had a rare ability to do this without the normal subsequent price rises.
So every business cycle threatening incident was dealt with using aggressive intervention. This led to more and more confidence in the ability of the authorities which coupled with lower and lower interest rates increased public and private leverage to previously unthinkable levels.
And concerning where we find ourselves now:
Unfortunately the end of this period and the onset of our “Grey Age” era has left us out of traditional ammunition to manage the business cycle. Governments were/are up against their fiscal limits and are actually being forced into austerity at exactly the wrong time economically. We also have interest rates across the Western World that remain close to zero with little room to be lowered further. While we have money printing, we are close enough to a liquidity trap that flooding the market with printed money doesn’t have the same immediate impact on the economy as a cut in interest rates did in the long leveraging stage of the super-cycle.
Given lack of policy flexibility with which to address structural problems, the team at Deutsche Bank argue that business cycles will start to decrease in length, back to previously observed norms. This does not bode well for 2012.
For one, even with the “incredible level of stimulus that has been thrown at it”, the latest recovery, from the 2009 trough, has been weak relative to other expansions:
For another, the latest expansion is now over the median length:
Reid and team don’t mean to say that the above chart is enough to base a prediction of a recession on, but (and we’ll leave you with this festive cheer):
…it has and does serve as a template for how we think about the business cycle in a post ‘Golden Era’ Developed world where chronic levels of debt will force significant deleveraging pressures for years to come.
If I get my hands on the full report, I’ll post it.