A week ago, in the wake of its continuing financial crisis and in response to the panicked imploring of Mr. Jean-Claude Trichet, the increasingly anxious President of the European Central Bank, the leaders of the European Union adopted a package of measures intended to stabilize financial markets and support the adjustment of the weaker European economies toward sustainable growth. European bond markets and the euro have been under intense pressure amid concerns about high fiscal deficits and debt levels not only in Greece but other European countries, most notably Portugal, Spain and Italy. In support of the new European Financial Stabilization Mechanism announced on 9 May, the Federal Reserve agreed to reactivate temporary liquidity swap lines to provide foreign banks with access to dollar funding and the Executive Board of the International Monetary Fund approved a €30 billion three-year loan for Greece. These measures are expected to be supplemented at both the European government and IMF levels in a rescue package worth $1 trillion. For its part, after Mr. Trichet repeatedly said it never, ever would, the ECB has been purchasing Spanish, Portuguese, Greek and Irish bonds to prop up their prices and will no doubt continue to do so.
At the national level, Spain and Portugal announced new austerity measures intended to bring their fiscal deficits in line with the 3 per cent of GDP limit mandated by the Maastricht Treaty. These include tax increases, budget cuts, and across-the-board pay cuts for government workers. Other countries with large deficits will no doubt follow these two. Once implemented, these actions will increase already high unemployment and further depress already low levels of economic activity and any impetus these countries might have transmitted to their trading partners, including the U.S. While the euro aid package appears to have calmed global financial markets, conditions remain unsettled and a double-dip recession in Europe could well be on the way.
With these efforts, European leaders have made clear their choice to try and save the euro and their monetary union, even at the cost of a deepening downturn. They fear the repercussions of a Greek default not only on the future of the euro but on the very stability of the other countries of the eurozone. Their decision to support Greece and the other highly indebted countries is an immense gamble, immensely unpopular in much of Europe and it will be immensely costly whether it succeeds or not. These costs will not be limited to Europe and the directly affected countries.
The approach taken to dealing with the problems before Europe, I must say, do not inspire confidence. The immediate response has been to treat the financial crisis of Greece and other heavily-indebted countries as a one of liquidity, not of solvency. But Greece is clearly insolvent, meaning that it cannot conceivably pay back the debts it has incurred. Greece’s public debt is about 125-150 per cent of their GDP. Until recently, when the average rate of interest was 4 to 5 per cent, Greece had to pay out some 5 or 6 per cent of its GDP in interest payments just to avoid further debt, most of it, let me add to foreigners. But because of Greece's continuing fiscal deficits the debt-to-GDP ratio has been rising rapidly, meaning that even if the interest rate it had to pay were steady, a larger and larger share of the country’s production would have to be transferred abroad to finance its growing external liabilities. Moreover, when questions about the possibility of debt repayment were raised, the interest rate on the debt rose. Recently, the interest rate on Greek debt rose to a point where 10 to 15 per cent of its GDP would have to be transferred abroad to meet its obligations, clearly something that is not possible. While the recent stabilization measures and purchases by the ECB of low-grade securities have reduced the interest rate on Greece's debt, it is simply is not possible to continue this kind of support over the longer-term for Greece or for any other country.
Alternatively, if Greece were treated as a case of insolvency rather than illiquidity, it would immediately “restructure” the debt, that is, write off a good part of it, my guess 50 per cent or more of its value. The losses inherent in defaulting on the debt would have to be shared by the banks and investors in Greece bonds, those foreigners who purchased Greek bonds, and Greek taxpayers, government workers, and nationals who would find their taxes raised, jobs cut, and cost of imports much higher. Greece would also have to undertake, as it has promised to do, strong measures to bring its internal and external deficits under control and reduce its domestic price level. By abandoning the euro, it would have gained full control of its monetary policy and be able to design a recovery program tailored to its specific problems and a future path to policy that recognizes that Greece -- like Spain, Portugal and Italy -- does not have a tradition of balanced public budgets and controlling the tension between the desire for more public spending and the willingness to pay for it. I suspect in the end Greece will leave the eurozone. It faces not only the immediate costs of maintaining the euro but a longer-term struggle of keeping its domestic costs in line with the other eurozone countries, something that appears to be beyond its ability.
But the Greek authorities and European leaders have decided for the moment to keep Greece in the eurozone. Rather than dealing with the insolvency of Greece, they (tried to -- to my knowledge the agreement is still somewhat up in the air) put into place a three-year program of financing, as if Greece would be able to carry the burden of the debt after a period of respite.
Why did they do this, knowing full well that Greece will not be able to pay back this debt? First of all, because the leadership of Europe is totally committed to the idea of European integration, regardless of the costs and regardless of the possibilities of success. To this end, they are hoping against hope that somehow Greece will gain the capacity to service its debt. But more importantly and realistically they are bailing out Greece because Greek bonds are held by French and German banks that are themselves on the edge of bankruptcy. If the Greek bonds are written down now, then many European banks become insolvent, with all the implications that has for the wider European economy and the rest of the world, not the least of which is another collapse of world trade. (And, let me add, American banks, many of which are in fact in a state of unacknowledged insolvency today, own securities of the European banks.) It is hoped, with time and a recovery in economic activity, the capital position of the banks will strengthen and they will be better able to absorb losses.
So, the “rescue” program being put in place has as its purpose transferring the losses from the eventual Greek restructuring to the taxpayer, both in Europe and, through the IMF, to the rest of the world. Greece, of course, will nonetheless suffer tremendously from the “adjustment” program imposed by the IMF, but in their view it must undergo this adjustment anyway. Moreover, they also recognize that there must be a substantial fiscal-tightening across the euro area, and beyond, if financial markets are to be convinced that growing sovereign debt levels will not create another worldwide financial crisis.
Needless to say, the entire approach is fraught with great problems. It presumes the governments involved will cobble together an acceptable rescue package and financial markets will agree that the “bailout” will be sufficient in the short-term to stabilize the market and lower interest rates. It assumes governments will implement much tighter fiscal regimes and a wide range of policies intended to rebalance their economies toward fiscal sustainability over the medium-term. It implies these countries will undergo a difficult restructuring of their patterns of production and consumption which over the longer-term results in a sustainable pattern of domestic economic activity and trade. It trusts that the flood of liquidity injected into system will not trigger inflation in Europe and the global economy. It puts in play unprecedented moral hazard because no one -- not the governments spending recklessly and issuing bonds to cover their deficits nor the banks and investors buying and speculating on them -- will be allowed to fail and suffer from the bad decisions they made. It does not address the underlying problem of fiscal sustainability that permeates all the countries of Europe, not just those facing debt problems today. It insists without reason that European countries will adhere to the requirements of the Stability and Growth Pact that underlies Europe's Economic and Monetary Union. It means that major reforms in government finances will have to be accompanied by a major revamping of the financial system, with the “Big Banks” being downsized and greatly reduced in influence. And, finally, it is all predicated on a rapid return to a pace of economic growth that is nowhere in sight.
The steps taken at the Brussels summit in reaction to the pleadings of Mr. Trichet, like those of Treasury Secretary Henry Paulson when the U.S. financial system came close to collapse in 2008, are understandable as a reaction to an immediate crisis and the need to deal with it. It is an assertion of faith and intentions. In this sense, it is not surprising that an approach taken under the pressure of the moment lacks the depth and comprehensiveness required to deal with long-standing and fundamental problems. As was the case of the American response to its financial crisis, such is the case with the European Financial Stabilization Mechanism the European Union will try and implement in the weeks to come. But no one should think that it is anywhere near adequate to manage much less overcome the real problems of the long-run solvency of Greece and other European countries. Until a real and determined program of comprehensive reform and restructuring is undertaken Europe will remain in a constant state of crisis and with little potential for economic growth, political stability, and social advance. The same can be said about the United States.
22 May 2010
Can Europe Save Itself?
"Turning and turning in the widening gyre
The falcon cannot hear the falconer;
Things fall apart; the center cannot hold;
Mere anarchy is loosed upon the world,
The blood-dimmed tide is loosed, and everywhere
The ceremony of innocence is drowned;
The best lack all conviction, while the worst
Are full of passionate intensity."
William Butler Yeats (1919)
In a recent speech to the Council on Foreign Relations, Jean-Claude Trichet, President of the European Central Bank, called for strengthen "global governance" to deal with financial problems that now plague Europe and the other more economically advanced countries of the West. In his view, the existing
set of rules, institutions, informal groupings and cooperation mechanisms are not adequate to the great problems now before the world economy. Those international agencies concerned with the governance of the international capital flows, in particular, must be strengthened in order to improve the resilience of the global financial system and deal with the unknown and unpredictable impact short term capital movements have on the domestic stability of even the largest of the world's economies. Given the very high degree of interdependency that now characterize the international economy, Trichet believes a stronger framework for global governance would yield better crisis management, especially if emerging economies could be brought into the process of global decision-making.
Without question, economic policy in the case of Europe has been turning and turning in a widening gyre with little to show for the efforts of the policy-makers at the ECB in terms of an improvement in the economies or the finances of the region. Indeed, policy throughout Europe has been late and ineffective, and Germany at the center, for all its economic power and financial strength, cannot hold back the more than 100,000 Greek protestors now rioting at the edge of the eurozone. Trichet and the other leaders of Europe are beginning to realize that the EU is falling apart, with anarchy in the streets of Greece and utter confusion in the policy-making offices and board rooms of its governments, corporations and banks. Their innocence drowned by what Hayek called The Fatal Conceit, the best of Europe lack the conviction of their heritage while the worse call louder and louder for a bailout that, in the end, is merely a stay of execution and not a pardon from the harsh demands to be made on each and every European. Yeats would not be surprised by the events and reaction of the best and the worst in Europe, and he would understand that the promises made by a privileged elite mean little to those who must bear the burden of their decisions.
Like many who have devoted their lives to the study and practice of international finance, Trichet is a true believer in European integration and coordination -- indeed, the setting -- of macroeconomic policy at the international level. He and other leaders in the European community are determined to see the EU and the Eurozone succeed as a mechanism of supranational governance. For them, it is an article of faith that, somehow, people in authority far removed from a problem and not directly involved in creating it can best set the policy course for overcoming it. To them, national problems necessarily require supranational solutions. Even this is not enough. Not content with the results of efforts toward greater European integration, from his speech we can now conclude Trichet thinks that the failures of the Eurozone can only be remedied by asking the next level of international authority to solve the problems the EU created for itself.
This of course is nonsense. If Europe is to be "saved", no one but the Europeans can save it. The reason European leaders are failing in this responsibility is that they have abdicated their role as leaders. The call for global governance is simply an acknowledgement of their own failure to lead and an insistence that others (read the IMF or the UN or the "international community") make the difficult decisions they were elected to make. They know very well Europe has been living well beyond its means and yet is unwilling to change in the face of the reality that the welfare state they erected is not sustainable and never was. Europe was built on a peace imposed and paid for by the United States through a half-century of Cold War and intra-European tensions. This allowed Europe to focus on its internal development as it cut back on its defense expenditures and built up its welfare state. All of Europe adopted universal health care, introduced a shorter workweek and longer vacations, a higher minimum wage with greater job security, and earlier retirements and generous pensions. All that mattered to the self-focused Europeans was consumption, supported by overspending and overborrowing. Europe never built the necessary capacity to sustain the generous entitlements and large public sector its appetite demanded, and it refused to acknowledge the disastrous incentives toward self-destruction it was building into its economy and polity.
Over time, in response to these incentives, an ever-increasing share of the labor force left the private sector for the security of the public sector and its less demanding job requirements. Special interests grabbed hold of the public purse in the name of “the poor and the elderly and the needy” and efforts to bring “fairness” to the distribution of income resulted in large-scale and expensive entitlements and a shrinking share of the population acting as taxpayers. Contraception, the pill, abortion on demand, and the greater acceptance of homosexuality brought with it lower natality and nuptiality and rising illegitimacy, and with failed family formation many children raised in single parent households without the needed direction of both a father and a mother. Large-scale immigration, combined with a cowardice to defend European culture, further sapped vitality from the Europeans.
In this environment, European political and social culture declined markedly as its population aged and the young abandoned the faith and ideals of their forefathers. The demands on the public sector for unemployment insurance, old-age assistance and publically provided health care rose while its ability to meet those demands fell. Fiscal deficits widened as the willingness to pay for government programs shrank. Now the crisis is at hand. It is too late to save Greece, which will have to undergo severe hardships as its unemployment soars, public benefits are slashed, taxes become oppressive, and the economy declines markedly. Europe is scurrying to cobble together a rescue package to support the other highly indebted countries of the EU, that is to say, a rescue package designed to bail out German and French banks, which hold massive amounts of Greek debt. If the German and French financial systems collapse, there is no possible way to avoid a deep and long-lasting worldwide depression.
It is important to realize that however difficult the proximate and pressing economic and financial problems before Europe are they must be seen as mere reflections of much more fundamental troubles rooted in its declining culture and its unwillingness to defend itself and its civilization. Europe and the EU and its monetary union can of course can be saved, if that is what the people of Europe really want. But if it is to overcome the crisis now at hand, Europe must take charge of its own faith and reject the call of Trichet and other European leaders for global governance as a substitute for its own need to sacrifice in defense of its own future. If the present leadership of Europe refuses to make the difficult decisions necessary to save Europe, they should step aside and make way for a new generation of Europeans committed to restoring the grand culture and authentic and true faith that brought it to greatness in the past.
Thanks to John Mauldin for the pointer to Yeat's poem.
Schooling and economic growth
Received a note from Dr. Larry Willmore, an economist with an interest in education and the economy at the International Institute for Applied Systems Analysis in Vienna, bringing to my attention a recent paper by Harvard economist Lant Pritchett on the relationship between schooling and economic growth. Professor Pritchett is famous for holding the view that there is no evidence whatsoever for a connection between schooling and economic growth. Here are three excerpts from the paper ("Does Schooling Help Explain Any of the Big Facts about Growth?" (24 January 2009)), which can be found at his Harvard web site, http://www.hks.harvard.edu/fs/lpritch/:
I must say that like Pritchett I am somewhat skeptical of the idea that many years of formal education does much to enhance the overall process of economic growth. While education at the primary level is critically important for a modern economy, once the basics of reading, writing, math, history and so forth are mastered the foundation necessary for the demands of most jobs are met for most people. Needless to say, professions such as medicine, the law, and science- and specialized-knowledge occupations require more formal training than provided by secondary schools but the percentage of the work force engaged in these activities is relatively small. And it is also true to say that on-the-job training and apprenticeships in a wide variety of skills, from plumbing and welding through bricklaying and bookkeeping to general business management and office administration, are needed to carry out needed tasks in the economy, but not necessarily in formal educational settings and again not for a high percentage of the population.
In any event, acquiring the broad liberal arts kind of education many students receive in college may be valuable to them in terms of personal enrichment but I for one am not sure it raises the economic productivity of the nation as a whole very much. I would go as far as to say that given the weak curriculum of the public schools (and, let me admit, higher education) much of the population is over-schooled but under-educated. I have the impression that many schools today place far to much emphasis on "socialization skills" and far too little on what education should really be about, namely, reading, writing, mathematics, science and history.
As Professor Pritchett maintains, general purpose higher education may be overrated as a source of overall economic growth and raising living standards. In fact, at a time when the working age population is shrinking in relation to the very young and the elderly, we may have too many young adults in college or university and not enough in the work force.
Thanks to Larry for bringing this paper to my attention.
"If what I have said is interpreted as saying "education does not have any impact on growth" then this is automatically rejected by every audience of academics and policy makers, for several reasons. First, claiming "education has no impact" is completely at odds with their own lived experience: people who have PhDs are relatively rich and/or powerful and know that this is because they have high schooling. So to deny that schooling has an economic impact is not scientifically wrong, it is just silly, it contradicts their own internal narrative of not just economic causation but their own life. And of course they have huge amounts of evidence that their own experience—education leads to more earnings/utility—is generalized. There are, by now, thousands and thousands of Mincer regressions from countries all over the world which show that people with more education have higher earnings . An upward sloping earnings/education profile rivals Engel's law as the most consistently and robustly demonstrated fact in economics. In fact , there are many who would wonder why, if we are interested in the returns to education, we are even bothering with all of this messy aggregate data like GDP, why not stick to the micro evidence, which is solid and secure and be done with it? The reason is that there is no way to infer the macro-economic impact of increases in schooling from the micro-economic earnings profile. (pp. 27-28)"
"Bad, corrupt, autocratic governments that had terrible economic policies and crappy institutions—e.g. Haiti— expanded schooling. Good pro-growth, strong institution countries also expanded schooling a ton. The OECD countries already leading the pack also, in absolute terms expanded schooling a ton. (p. 38)"
"The way forward is to figure out what there is inside of education policy that does make a difference for growth (and for other benefits of education as well) and get out of a simple-minded ‘expand the number of little bottoms in seats and the economy will grow’ mentality. Part of the answer is ... an emphasis on actual learning achievement (ideas in heads rather than butts in seats), part of the answer is ... the composition of education across levels at various stages of economic growth, part of the answer is the labor market conditions in which schooled people are able to work. But we are only to get to these more sophisticated, complex, and interactive theoretical and empirical research once we are able to leave the conventional platitudes behind. (p. 42)"
I must say that like Pritchett I am somewhat skeptical of the idea that many years of formal education does much to enhance the overall process of economic growth. While education at the primary level is critically important for a modern economy, once the basics of reading, writing, math, history and so forth are mastered the foundation necessary for the demands of most jobs are met for most people. Needless to say, professions such as medicine, the law, and science- and specialized-knowledge occupations require more formal training than provided by secondary schools but the percentage of the work force engaged in these activities is relatively small. And it is also true to say that on-the-job training and apprenticeships in a wide variety of skills, from plumbing and welding through bricklaying and bookkeeping to general business management and office administration, are needed to carry out needed tasks in the economy, but not necessarily in formal educational settings and again not for a high percentage of the population.
In any event, acquiring the broad liberal arts kind of education many students receive in college may be valuable to them in terms of personal enrichment but I for one am not sure it raises the economic productivity of the nation as a whole very much. I would go as far as to say that given the weak curriculum of the public schools (and, let me admit, higher education) much of the population is over-schooled but under-educated. I have the impression that many schools today place far to much emphasis on "socialization skills" and far too little on what education should really be about, namely, reading, writing, mathematics, science and history.
As Professor Pritchett maintains, general purpose higher education may be overrated as a source of overall economic growth and raising living standards. In fact, at a time when the working age population is shrinking in relation to the very young and the elderly, we may have too many young adults in college or university and not enough in the work force.
Thanks to Larry for bringing this paper to my attention.
The IMF and World Bank Meetings and International Monetary Reform
Original draft: Mid April 2010.
The Spring meetings of the International Monetary Fund and the World Bank will take place later this week and next.
On the agenda are a review of the state of the world economy, the prospects for a recovery in world output and trade, and, of course, the impact of the global financial crisis and measures that could be taken to strengthen the global financial system.
The main G-20 Summit of national leaders will take place directly after the joint Fund-Bank meeting. In preparation for this meeting finance ministers of the G-20 countries will meet on 23 April to discuss the impact on national policies on the global economy and other options for dealing with any future financial crisis, including the possible imposition of a global bank tax.
It is reported that as part of the G-20 finance minister discussions, leaders of Brazil, Russia, India and China intend to press for major reforms of the international financial system to reflect their growing influence in global affairs. This question has been a background issue for many years. Among the most important questions to be raised by these countries are quota allocations determining representation in the governance structure of the IMF. Presently, quota shares are allocated according to economic weight in the global economy but these have not been updated to reflect fully the changing economic and financial importance of emerging countries. More substantively, poorer countries would like to increase the basic quota allocation for all developing countries in order to gain more influence in decisions related to access to finance. It has also been suggested that European seats on the IMF's board be consolidated to make way for greater representation by developing countries in international financial institutions. There is of course deep resistance to these suggested changes and the implied loss of standing in the international system implied by reductions in voting shares and representation at the IMF.
Seen in longer-term perspective, these changes represent more than the shuffling of seats around the Board of Governors' table at the IMF. It is not only that changes to the Board will involve increased influence of developing countries in day-to-day decision-making but a fear that the rules and institutions of the international system will be fundamentally changed in ways inconsistent with the open international economy created at the end of the Second World War. Broadly speaking, the international system now in place was built on “Western” thinking, that is, a commitment to constitutional or limited government, freedom of the individual as the root of human rights, dedication to the rule of law, faith in free markets and private property and enterprise, and, in greater or lesser degree, a policy of free trade or at least openness to the world economy. These were the ideas (one might say, ideals) that drove the unprecedented expansion of the world economy in the post-World War II period. They were imposed on the world by the United States in the form of the United Nations as the political center of the international community and the Bretton Woods institutions as the economic centers for reshaping the international economy. The intellectual premise of the system was that an open international economy would enhance incomes and productivity through specialization in production and diversification in consumption and that widening prosperity would promote peace and development.
From the 1950s into the new century these ideas were in fact the basis of policy decision-making at international organizations. They were imperfectly implemented, of course, and were overlaid with much too much emphasis on the role of government in human affairs, but it is fair to say the set of rules and regulations, increased emphasis on treating people equally, gradual removal of impediments to domestic and international commerce, and general strategy of democracy and markets brought about a truly extraordinary period of progress for all mankind. In this sense, the dimensions of human progress made since 1950 have been enormous and much of this progress can be traced to the possibilities unleashed by the ideas and values that originated in Greece, spread to Rome, became the culture of the West, and formed the foundation on which the advances of the modern world were built.
As the momentum of world commerce increased and the prosperity spread to the far corners of the globe, the importance of developing countries, especially countries in Asia, increased as the loci of world production and engines of world growth shifted to that region. Asia and developing countries in other regions not only account for a growing proportion of world output but have become huge exporters of capital, with the U.S. and Europe largely absorbing their excess saving. While both the global savers and the global users of capital are dependent upon one another, it is the savers who provide the resources on which policy is based and hence it is the savers that in the end have key influence in setting international policy. Simply because the U.S. has a persistent deficit and borrows heavily abroad its influence has weakened and it can no longer shape international policy they way it once did.
History reflects many different international orders where the rules and norms of the international economy vary greatly. The present Western-oriented order established at Bretton Woods stresses market openness and nondiscrimination across countries and for that reason promotes participation and spreads its benefits widely to all countries that embrace the spirit of its goals and objectives. No set of countries has benefitted more than China and other developing countries that chose to operate within the Bretton Woods system. At the same time, the very rise of these countries raises questions about whether they will use their growing influence to change the system fundamentally to better serve what is seen by many observers as their more nation-centric orientation with its greater sympathy to policies of internal dirigiste and external protectionism.
The challenge of bringing China and other emerging countries into the international economic system is more than the granting of additional voting power and more seats around the table of decision-makers at international institutions. It is also ensuring that the principles of the expansive and open international order that has served the world so well in the past are not compromised as the system accommodates to the large-scale and long-term changes now taking place in the world economy. This, let me add, is not simply a matter of ensuring that emerging countries embrace the Western rules and norms on which the present system was built but that the countries of the West, especially the United States, remain true to their own ideals and history.
The Spring meetings of the International Monetary Fund and the World Bank will take place later this week and next.
On the agenda are a review of the state of the world economy, the prospects for a recovery in world output and trade, and, of course, the impact of the global financial crisis and measures that could be taken to strengthen the global financial system.
The main G-20 Summit of national leaders will take place directly after the joint Fund-Bank meeting. In preparation for this meeting finance ministers of the G-20 countries will meet on 23 April to discuss the impact on national policies on the global economy and other options for dealing with any future financial crisis, including the possible imposition of a global bank tax.
It is reported that as part of the G-20 finance minister discussions, leaders of Brazil, Russia, India and China intend to press for major reforms of the international financial system to reflect their growing influence in global affairs. This question has been a background issue for many years. Among the most important questions to be raised by these countries are quota allocations determining representation in the governance structure of the IMF. Presently, quota shares are allocated according to economic weight in the global economy but these have not been updated to reflect fully the changing economic and financial importance of emerging countries. More substantively, poorer countries would like to increase the basic quota allocation for all developing countries in order to gain more influence in decisions related to access to finance. It has also been suggested that European seats on the IMF's board be consolidated to make way for greater representation by developing countries in international financial institutions. There is of course deep resistance to these suggested changes and the implied loss of standing in the international system implied by reductions in voting shares and representation at the IMF.
Seen in longer-term perspective, these changes represent more than the shuffling of seats around the Board of Governors' table at the IMF. It is not only that changes to the Board will involve increased influence of developing countries in day-to-day decision-making but a fear that the rules and institutions of the international system will be fundamentally changed in ways inconsistent with the open international economy created at the end of the Second World War. Broadly speaking, the international system now in place was built on “Western” thinking, that is, a commitment to constitutional or limited government, freedom of the individual as the root of human rights, dedication to the rule of law, faith in free markets and private property and enterprise, and, in greater or lesser degree, a policy of free trade or at least openness to the world economy. These were the ideas (one might say, ideals) that drove the unprecedented expansion of the world economy in the post-World War II period. They were imposed on the world by the United States in the form of the United Nations as the political center of the international community and the Bretton Woods institutions as the economic centers for reshaping the international economy. The intellectual premise of the system was that an open international economy would enhance incomes and productivity through specialization in production and diversification in consumption and that widening prosperity would promote peace and development.
From the 1950s into the new century these ideas were in fact the basis of policy decision-making at international organizations. They were imperfectly implemented, of course, and were overlaid with much too much emphasis on the role of government in human affairs, but it is fair to say the set of rules and regulations, increased emphasis on treating people equally, gradual removal of impediments to domestic and international commerce, and general strategy of democracy and markets brought about a truly extraordinary period of progress for all mankind. In this sense, the dimensions of human progress made since 1950 have been enormous and much of this progress can be traced to the possibilities unleashed by the ideas and values that originated in Greece, spread to Rome, became the culture of the West, and formed the foundation on which the advances of the modern world were built.
As the momentum of world commerce increased and the prosperity spread to the far corners of the globe, the importance of developing countries, especially countries in Asia, increased as the loci of world production and engines of world growth shifted to that region. Asia and developing countries in other regions not only account for a growing proportion of world output but have become huge exporters of capital, with the U.S. and Europe largely absorbing their excess saving. While both the global savers and the global users of capital are dependent upon one another, it is the savers who provide the resources on which policy is based and hence it is the savers that in the end have key influence in setting international policy. Simply because the U.S. has a persistent deficit and borrows heavily abroad its influence has weakened and it can no longer shape international policy they way it once did.
History reflects many different international orders where the rules and norms of the international economy vary greatly. The present Western-oriented order established at Bretton Woods stresses market openness and nondiscrimination across countries and for that reason promotes participation and spreads its benefits widely to all countries that embrace the spirit of its goals and objectives. No set of countries has benefitted more than China and other developing countries that chose to operate within the Bretton Woods system. At the same time, the very rise of these countries raises questions about whether they will use their growing influence to change the system fundamentally to better serve what is seen by many observers as their more nation-centric orientation with its greater sympathy to policies of internal dirigiste and external protectionism.
The challenge of bringing China and other emerging countries into the international economic system is more than the granting of additional voting power and more seats around the table of decision-makers at international institutions. It is also ensuring that the principles of the expansive and open international order that has served the world so well in the past are not compromised as the system accommodates to the large-scale and long-term changes now taking place in the world economy. This, let me add, is not simply a matter of ensuring that emerging countries embrace the Western rules and norms on which the present system was built but that the countries of the West, especially the United States, remain true to their own ideals and history.
Krugman and Lessons from the Greek Debt Crisis
Original draft: Early April 2010.
In an article published yesterday in the New York Times Paul Krugman discussed the debt crisis in Greece and what he regards as its implications for the U.S. He pointed out the crisis in Greece seems to have reached the point of no return, as he put it, and this small country is going to pay a steep price for its past irresponsibility.
He also noted that while the U.S. also has a large and growing national debt, its policy options are very different from those before Greece and consequently the U.S. response to its problems of recession and debt should be very different from the stern approach followed by the Greeks.
To Professor Krugman, the difficult situation Greece finds itself in is more than a problem of high debt. It is also a problem of policy inflexibility caused by the fact that Greece does not control its own currency and cannot conduct its own monetary policy. If Greece were not linked to the euro, he points out, its options for dealing with its debt would be more than steep spending cuts and large tax increases: It could inflate its currency, thereby reducing the real burden of its debt. In its present circumstances, however, leaving the euro would trigger terrible consequences, so Greece must endure harsh austerity measures intended to sharply reduce its output and employment, with their painful social consequences.
For Krugman there are lessons in the Greek crisis for the United States. While he says "Of course, we should be fiscally responsible" and take "on the big long-term issues, above all health costs", he also seems to suggest that the way to become more fiscally responsible is to spend more money, incur more debt, inflate the currency, and only pay attention to the immediate problems before us. In his own words:
In short, the way to become more fiscally responsible is to become even more fiscally irresponsible and short-term oriented than we have been in the past.
We can do this because, unlike the Greeks, we "own" our own currency and therefore can use our monetary policy to support whatever fiscal policy seems opportune at the moment. It seems in his view we can also do this with no expectation of a response on the part of capital markets, even though we conduct our policy with the goal of manipulating our interest rate, money supply and exchange rate so as to reduce deliberately the real value of the debt we are incurring. Somehow, investors are not going to take into account in their purchase of Treasuries the impact of the policies the government says it is going to follow.
Moreover, it seems that in Professor Krugman's view we can continue to sell our escalating debt to American and foreign investors on the expectation that the economy will quickly return to rapid growth and the means to pay the higher debt will be strengthened. Supposedly, this rapid growth will be achieved even though he proposes we put in place high energy and health care taxes and remove more and more low-income households from the tax rolls.
I suppose anything is possible. But frankly I do not think many people would be encouraged to buy U.S. debt if they thought the government was simply going to be guided by short-run considerations divorced from the longer-term impact its policies will have on the economy's performance and capacity to pay back the real value of its debt it owes.
In an article published yesterday in the New York Times Paul Krugman discussed the debt crisis in Greece and what he regards as its implications for the U.S. He pointed out the crisis in Greece seems to have reached the point of no return, as he put it, and this small country is going to pay a steep price for its past irresponsibility.
He also noted that while the U.S. also has a large and growing national debt, its policy options are very different from those before Greece and consequently the U.S. response to its problems of recession and debt should be very different from the stern approach followed by the Greeks.
To Professor Krugman, the difficult situation Greece finds itself in is more than a problem of high debt. It is also a problem of policy inflexibility caused by the fact that Greece does not control its own currency and cannot conduct its own monetary policy. If Greece were not linked to the euro, he points out, its options for dealing with its debt would be more than steep spending cuts and large tax increases: It could inflate its currency, thereby reducing the real burden of its debt. In its present circumstances, however, leaving the euro would trigger terrible consequences, so Greece must endure harsh austerity measures intended to sharply reduce its output and employment, with their painful social consequences.
For Krugman there are lessons in the Greek crisis for the United States. While he says "Of course, we should be fiscally responsible" and take "on the big long-term issues, above all health costs", he also seems to suggest that the way to become more fiscally responsible is to spend more money, incur more debt, inflate the currency, and only pay attention to the immediate problems before us. In his own words:
"What worries me most about the U.S. situation right now is the rising clamor from inflation hawks, who want the Fed to raise rates (and the federal government to pull back from stimulus) even though employment has barely started to recover. If they get their way, they’ll perpetuate mass unemployment. But that’s not all. America’s public debt will be manageable if we eventually return to vigorous growth and moderate inflation. But if the tight-money people prevail, that won’t happen — and all bets will be off."
In short, the way to become more fiscally responsible is to become even more fiscally irresponsible and short-term oriented than we have been in the past.
We can do this because, unlike the Greeks, we "own" our own currency and therefore can use our monetary policy to support whatever fiscal policy seems opportune at the moment. It seems in his view we can also do this with no expectation of a response on the part of capital markets, even though we conduct our policy with the goal of manipulating our interest rate, money supply and exchange rate so as to reduce deliberately the real value of the debt we are incurring. Somehow, investors are not going to take into account in their purchase of Treasuries the impact of the policies the government says it is going to follow.
Moreover, it seems that in Professor Krugman's view we can continue to sell our escalating debt to American and foreign investors on the expectation that the economy will quickly return to rapid growth and the means to pay the higher debt will be strengthened. Supposedly, this rapid growth will be achieved even though he proposes we put in place high energy and health care taxes and remove more and more low-income households from the tax rolls.
I suppose anything is possible. But frankly I do not think many people would be encouraged to buy U.S. debt if they thought the government was simply going to be guided by short-run considerations divorced from the longer-term impact its policies will have on the economy's performance and capacity to pay back the real value of its debt it owes.
Hayek and the Health Care Legislation
Original draft: March 2010.
I have been re-reading parts of Friedrich von Hayek's Road to Serfdom.
Hayek is so right about how government actions become increasingly demanding and outside the normal bounds of decency and law once a government starts to mandate things. We are only at the beginning of the takeover of health care in the U.S. and the Congress is already focused on the need to put in place strong measures to control everything people do in a key area of their life. One can already see some of the profound changes this legislation will cause.
Once this legislation is approved (actually, silly me, I still think -- hope springs eternal -- it may not pass), not only the nature of the government's relationship with the governed will change but the nature of politics will change. In the first instance, health care and its demands on society will come to dominate every discussion of what the government does and does not do. This is what has happened in Britain and elsewhere and this is what will happen in the U.S. Health care will be regarded as costless to everyone who needs health care (and even many that don’t) and the constant complaint on their part will be “The government promised to give health care to me and I’m not getting what I need”. The usual concerns of government -- matters like defense and public order and maintenance of society's infrastructure -- will be seen by all those who do not pay taxes as insignificant and unimportant. Instead of seeing their role as contributing to the common support of the administrative apparatus of government and special needs of those who cannot support themselves, many will see government as the source of goods and services they regard as essential to their lives.
In the second instance, this legislation, and the accompanying education act and the cap and trade regulations to come, really do represent in some sense a march into socialism with its attendant shift in decision-making from the private sector to the public sector. Of course, many of the supporters of the health care bill cannot see this and do not understand how this causes a debasement of the political process. But it will. Slowly and inevitably, the focus of political discourse will shift from common issues of national affairs and eternal questions of international relations to the particularistic and contentious problems of satisfying the insatiable demands of special interest groups and never ending fights between those who gain benefits from government and those who carry the burdens of government. Moreover, once the public sector suppresses the market and become accountable for actually delivering goods and services previously allocated in the private sector, it must control not only channels of distribution but means of production. As Hayek emphasized, each step down the road to serfdom is never seen in terms of the full set of consequences that lie ahead. Instead of discussing how the nation as a whole can prosper and how the common defense can be marshaled, once Congress usurps the decision-making functions of the private sector the nature of politics changes from promotion of the general welfare to the looting of the public purse by special interests.
An unthinking desire to engage in the large-scale engineering of the lives of people is also typical of the socialist mentality reflected in the health care bill. One Democratic Congressman interviewed on TV said that, yes, it is sweeping legislation and many elements in the bill are ill-defined and less than ideal and no doubt will create problems as they are put into place. But Congress will fix the problems as we go along, he said, constantly improving how health care is delivered, once the legislation is implemented and we see the problems that arise. He did not seem to understand that implementing untested legislation of this magnitude would inevitably destroy the jobs and disrupt the lives of hundreds of thousands and perhaps millions of people as Congress “experiments” with large-scale programs that inevitably fail in unforeseeable ways. That the elements of the bill should be tested in small pilot programs first to see what impact they might have never entered this Representative’s mind. How many doctors will have their practices destroyed by bureaucrats who have absolutely no idea of what they are doing? How many patients will have health care arrangements they regard as satisfactory interrupted and adversely affected by the new rules and regulations governing who provides their health care and how it is financed? This Representative has not given one iota of thought to the recklessness and irresponsibility of what is being done and how it will affect millions of Americans.
Friedrich Hayek's great book is about the dangers of central planning and the threat administrative controls of government present to the individual liberties of a free people and their collective prosperity. One cannot help but feel that the health care bill now before Congress, with its goal of a government-directed far-reaching transformation of a critical part of the U.S. economy, represents a menace to limited government and the success Americans have enjoyed in lifting their incomes and health status over the decades. If this bill should pass the Congress, dissatisfied Americans can take solace in that an election approaches where they can express their views and reverse what many of us believe to be a dangerous step down the road to serfdom. For some of us, that election cannot come soon enough.
I have been re-reading parts of Friedrich von Hayek's Road to Serfdom.
Hayek is so right about how government actions become increasingly demanding and outside the normal bounds of decency and law once a government starts to mandate things. We are only at the beginning of the takeover of health care in the U.S. and the Congress is already focused on the need to put in place strong measures to control everything people do in a key area of their life. One can already see some of the profound changes this legislation will cause.
Once this legislation is approved (actually, silly me, I still think -- hope springs eternal -- it may not pass), not only the nature of the government's relationship with the governed will change but the nature of politics will change. In the first instance, health care and its demands on society will come to dominate every discussion of what the government does and does not do. This is what has happened in Britain and elsewhere and this is what will happen in the U.S. Health care will be regarded as costless to everyone who needs health care (and even many that don’t) and the constant complaint on their part will be “The government promised to give health care to me and I’m not getting what I need”. The usual concerns of government -- matters like defense and public order and maintenance of society's infrastructure -- will be seen by all those who do not pay taxes as insignificant and unimportant. Instead of seeing their role as contributing to the common support of the administrative apparatus of government and special needs of those who cannot support themselves, many will see government as the source of goods and services they regard as essential to their lives.
In the second instance, this legislation, and the accompanying education act and the cap and trade regulations to come, really do represent in some sense a march into socialism with its attendant shift in decision-making from the private sector to the public sector. Of course, many of the supporters of the health care bill cannot see this and do not understand how this causes a debasement of the political process. But it will. Slowly and inevitably, the focus of political discourse will shift from common issues of national affairs and eternal questions of international relations to the particularistic and contentious problems of satisfying the insatiable demands of special interest groups and never ending fights between those who gain benefits from government and those who carry the burdens of government. Moreover, once the public sector suppresses the market and become accountable for actually delivering goods and services previously allocated in the private sector, it must control not only channels of distribution but means of production. As Hayek emphasized, each step down the road to serfdom is never seen in terms of the full set of consequences that lie ahead. Instead of discussing how the nation as a whole can prosper and how the common defense can be marshaled, once Congress usurps the decision-making functions of the private sector the nature of politics changes from promotion of the general welfare to the looting of the public purse by special interests.
An unthinking desire to engage in the large-scale engineering of the lives of people is also typical of the socialist mentality reflected in the health care bill. One Democratic Congressman interviewed on TV said that, yes, it is sweeping legislation and many elements in the bill are ill-defined and less than ideal and no doubt will create problems as they are put into place. But Congress will fix the problems as we go along, he said, constantly improving how health care is delivered, once the legislation is implemented and we see the problems that arise. He did not seem to understand that implementing untested legislation of this magnitude would inevitably destroy the jobs and disrupt the lives of hundreds of thousands and perhaps millions of people as Congress “experiments” with large-scale programs that inevitably fail in unforeseeable ways. That the elements of the bill should be tested in small pilot programs first to see what impact they might have never entered this Representative’s mind. How many doctors will have their practices destroyed by bureaucrats who have absolutely no idea of what they are doing? How many patients will have health care arrangements they regard as satisfactory interrupted and adversely affected by the new rules and regulations governing who provides their health care and how it is financed? This Representative has not given one iota of thought to the recklessness and irresponsibility of what is being done and how it will affect millions of Americans.
Friedrich Hayek's great book is about the dangers of central planning and the threat administrative controls of government present to the individual liberties of a free people and their collective prosperity. One cannot help but feel that the health care bill now before Congress, with its goal of a government-directed far-reaching transformation of a critical part of the U.S. economy, represents a menace to limited government and the success Americans have enjoyed in lifting their incomes and health status over the decades. If this bill should pass the Congress, dissatisfied Americans can take solace in that an election approaches where they can express their views and reverse what many of us believe to be a dangerous step down the road to serfdom. For some of us, that election cannot come soon enough.
Arnold Kling on the financial reform bill
“My instinct is to call the proposed legislation a "blame deflection bill" rather than financial reform. But I admit that I have not read the whole bill. Has anyone?
My impression is that the following things are not in it.1. No exit strategy from government support for subsidized, lenient mortgage credit. No curbs on Freddie and Fannie, whose market share has skyrocketed in the past year and a half. No increase in down payment requirements for FHA, which is in deep doo-doo.
2. No change to the role of credit rating agencies, as far as I know. It seems to me that one thing that everyone, left and right, can agree on is that the regulators outsourced their function to the credit rating agencies, and this worked out badly. As far as I know, the bill does not correct this flaw. Perhaps it tries to, but other provisions have gotten more attention.
3. Nothing to address the issue of "cognitive capture." The regulators will still get their analysis of the financial sector from the CEO's of the largest banks.
4. Finally--and this will get me in big trouble--I have to rant about the notion of a consumer financial protection agency. I know that it's axiomatic that poor people are helpless victims. But in the case of these mortgages, that is a really hard sell. The banks did not take from poor people. They gave to poor people. If you were lucky enough to get one of these exotic mortgages when house prices were still going up, then you got to reap a nice profit on your house. If you were not so lucky, you lost...close to nothing. I'm sorry, but if you borrowed up to 100 percent of the value of the house or more, then all you really lost were your moving expenses.
What about predatory lending? As I understand it, the idea of predatory lending is to saddle the borrower with an expensive mortgage so that you can foreclose on the property and sell it at a profit. How many times did that happen? Have you read of a single instance in the past three years where the bank made a profit on a foreclosure?
I am always ready to feel sorry for poor people because of their poverty. But I cannot feel sorry for somebody who was given a basically free option on a house and the option didn't happen to come into the money.
The reason that those of us on the right are left somewhat speechless by the financial reform bill is that it seems to us to be based on premises that strike us as preposterous.”
Arnold Kling, “What I think about financial reform”, Econlog Blog (22 April 2010).
http://econlog.econlib.org/archives/2010/04/what_I_think_ab.hmtl
Arnold Kling is a noted economist who has worked for the Federal government for many years in different capacities and as a professor at several universities. He is a founder and co-editor of EconLog, a popular economics blog that reflects Libertarian thinking.
As Dr. Kling implies, the financial reform now being cobbled together in Congress is yet another example of legislation with tremendous ramifications for the country being rammed through the legislative process with little real discussion and no chance for the vast majority of Americans to understand what the bill will do and how it will affect them. The bill is being pushed by Senator Chris Dodd, who in his own way is a genius at crafting legislation that appears to be strong but in the end, despite his words, does little but entrench the powers-that-be in the financial community. He lost a closure vote in the Senate today, but he will be back tomorrow and the next day and the next until some bill is passed.
Comprehensive, sensible reform requires a full discussion of the issues and a step-by-step approach to dealing with the myriad of problems surrounding the reform of the financial sector. It would, at the very least, begin by strengthening the banks and other financial institutions on main street, and then work its way up to the “Big Guys” on Wall Street and the even affect the Megabank conglomerates that spread themselves across the world. It would be concerned with the question of why the financial industry has a strong tendency toward consolidation and merger and how legislation might channel these tendencies in other directions so as to at least mitigate the rise of Megabanks regarded as “too big to fail”. The problem is beyond economics in the sense that these banks have become powerful political actors, too powerful for the political health of the nation. They are also at the very center of the implementation of our monetary policy. It is foolish to think that the regulation and institutional oversight approach to reform pushed by Dodd will constrain them in any significant way.
Moreover, it is foolish to think that the problem of a large and too powerful Wall Street is caused by Wall Street alone. Obviously, the executives of these banks push their contacts with government officials and elected officials in the way that all cronies do, and in doing so gain access to information and influence over policy. But equally, those on the government side regard their contacts with major players in the financial arena as providing them with the information and leverage they need to carry out their responsibilities. In the end, the two sides need each other and in the reform process each side fears loss of what they regard as inside information and influence on the other. For Wall Street enormous profits and great power can be derived from their connections and interactions with the government. What, one might ask, does the government derive from its close cooperation with and support of the Banking Titians of New York?
To understand this, one must go back to the time of Andrew Jackson and his fight with Nicholas Biddle and the Second Bank of the United States. Jackson hated the national debt and did everything he could to rid the country of it. Whether this was wise is the subject of another day. Beyond his dislike of debt was the desire to rid the country of paper money backed by federal bonds and the influence of large, powerful banks over the financial system. Real money to Jackson was specie -- gold and silver coins -- and paper money -- currency, bills of exchange, promissory notes, bank checks, and the like -- was a form of speculation and fraud. But by closing down the Second Bank and not issuing Federal bonds the country lost control of its money supply and a period of extreme financial instability and deep depression ensued. Instead of the stability real money was supposed to bring, the country found an explosion of shady dealings and rampant speculation. In its wake, a wave of bank failures occurred, ninety per cent of the nation’s factories closed and Federal revenues fell by half. Decades of financial turmoil followed as the country gradually learned the importance of a sound monetary framework and the need for close cooperation between the banking system and the monetary authorities. Today, the monetary authorities at the Fed and the Treasury understand full well that their success in maintaining a stable financial environment – not just at home but globally -- depends on their relationship with the “Big Guys” and on knowing what they are up to and influencing their decisions, both formally and informally. Anything that upsets this relationship weakens what they perceive to be a key instrument of their monetary control.
Add to this the problem of financing the Federal deficit. One must understand the Treasury is utterly dependent on the big banks in New York to finance its huge deficits. These banks are the way the Treasury raises money, and weakening them through possibly injudicious reforms threatens the sale of its bonds. The absolutely huge flow of capital required to support the deficit spending of the Federal government necessitates that New York remain the world’s leading banking center so Washington can draw upon the liquidity of the world. If the New York banks go down, the government goes down. It is as simple as that. For this reason the “Big Guys” will always be bailed out. The cronyism, the lax regulation, the unspeakable bonuses, the shoddy handling of mortgages, all these mean nothing against the ever present and ever pressing need to sell Treasuries for a good price at the next auction. And do not think that because the banks have a central position in the drama of government finance that they are all that powerful. They know that if they do not perform their assigned function Washington will come down on them like a ton of bricks. Yes, they are essential to Washington. But in Washington’s eyes, their only role is to sell government bonds and bring in capital from the rest of the world, and anything they do that weakens this role and raises questions about the credibility of the U.S. financial system will be dealt with harshly.
The unholy alliance between Washington and New York will end when the fiscal deficits end. When the Treasury has no great need to sell its bonds and the Federal government no longer depends on foreign sources of finance, then real reform can be undertaken. Reducing the political power of Wall Street is another reason why it is so important to reduce the deficit.
Dr. Kling is right to point out that the proposed legislation contains many gaps and has many weaknesses and fails to focus on what is really important but rather deals with the trivial. I for one am not surprised.
The problem of seigniorage in the European Union
"This may not be obvious, but, creating money in a currency union is no simple task. In any single country, central banks usually restrict themselves to buying government bonds, and making loans to regulated commercial banks. Net purchases of these securities by central banks creates what is called “high-powered money” [currency and deposits of commercial banks with the central bank]; this feeds into the financial system and results in the creation of what we all use to make payments and store value, i.e., money, plain and simple.
However in the European Monetary Union there are now 17 nations and a plethora of banks. So, to put it crudely, there is sure to be a fight to decide who gets the newly printed funds. The ECB [European Central Bank] resolved this by what seemed like a fair rule: All commercial banks can borrow from the ECB if they provide collateral, in the form of highly rated government and other securities, to the ECB. So, for example, a Greek bank can gain liquidity by depositing Greek government bonds with the ECB – as long as those bonds are “investment grade”, i.e., highly rated.
This simple and seemingly reasonable rule created great dangers for the eurozone, which have come back to haunt Mr. [Jean-Claude]Trichet[, president of the ECB]. The commercial banks in the zone are able to buy government bonds, which “paid” 3-6% long term interest rates (for all the sovereign bonds of members) over the last decade, and then deposit them at the ECB. They could then borrow from the ECB at the ECB financing rate, which today is 1%, against this collateral so pocketing a profit — and then buy more sovereign bonds with the funds. Mr. Trichet recognized this system had inherent dangers of turning into a new Ponzi game: if nations spent too much, and built up too much debt, eventually the system would collapse. So at the foundation of the eurozone, Mr. Trichet led a contingent within the EU that demanded all nations live by a “Growth and Stability Pact”, whereby each nation could only run deficits of 3% of GDP, and they had to keep their debt/GDP ratio below 60% of GDP.
Of course, politics trumped Mr. Trichet – as it always must – and the Greeks, along with the Portuguese, used their new found cheap lending system to run large deficits and build up debt. The cheap access to money also helped feed the real estate booms in Ireland and Spain."
Peter Boone and Simon Johnson, "Greece And The Fatal Flaw In An IMF Rescue", The Baseline Scenario (6 April 2010).
http://baselinescenario.com/2010/04/06/greece-and-the-fatal-flaw-in-an-imf-rescue/
Peter Boone, a Canadian, is chairman of the charity Effective Intervention and a research associate at the Center for Economic Performance at the London School of Economics. Simon Johnson is the Ronald A. Kurtz (1954) Professor of Entrepreneurship at MIT's Sloan School of Management, a position he has held since 2004. He is also a senior fellow at the Peterson Institute for International Economics in Washington, D.C. From March 2007 through the end of August 2008, Professor Johnson was the International Monetary Fund's Economic Counsellor (chief economist) and Director of its Research Department.
One of the most difficult questions at the intersection of monetary theory and practical politics is who should receive the benefit of seigniorage, that is, who should gain the purchasing power derived from issuing currency or expanding the stock of money. In a world of government-issued fait currencies, where the cost of "printing money" -- that is, expanding the money supply -- is almost nothing, governments can and do usurp and spend newly created money to command real goods and services from private markets with no matching provision of anything in return for the resources they obtain. In doing so, governments receive valuable real resources in exchange for issuing mere sheets of newly printed paper called government bonds, which they "sell" to their central bank and receive in return new currency and electronic blips representing additional deposits of money in some government bank account. Rather than simply giving it to the government, some of this valuable seigniorage can be "transferred" to the economy as a whole by the central bank through the influence of monetary policy on the operation of the banking system.
One of the purposes of the modern, independent central bank is to ensure that the value of the currency is not debased by an overexpansion of the money supply, that is, by the purchase of such a large volume of government bonds that the increase the stock of money is more rapid than the rise in domestic production and the corresponding demand for money. If the money supply expands faster than the transactions demand for money, inflation will result, and the wealth of people who hold cash or bank deposits will decrease as the wealth of the ultimate issuer of the currency, i.e., the government through its central bank, increases. This theft of purchasing power by the government is often called "the inflation tax".
Needless to say, the temptation to issue currency in excess of the economy's immediate need for additional money is great. Governments are always under pressure to spend more and tax less and it is easy to rationalize the need for an "easy money" policy to support objectives such as the promotion of economic growth or a reduction in unemployment. For this reason, once governments gained control of the money supply under modern fait-money systems, the price level has at times risen rapidly and then fallen rapidly whereas inflation and deflation were generally low or nonexistent in the United Kingdom and the United States for centuries under the gold standard. Since the creation of the Federal Reserve in 1913, the U.S. dollar has fallen to a twentieth of its former value, with annual increases and decreases in the price level sometimes approaching 10 per cent. Experience has shown that controlling increases and decreases in the stock of money under a fait-money system is difficult for both technical and political reasons.
In addition to the question of how much to expand the money supply is the question of exactly who should benefit from the seigniorage associated with any increase in the money supply. If the Treasury or finance ministry directly sold a newly issued bond to the central bank and received in return newly printed money, the government would then gain the full benefit when it spent the proceeds from the sale of the bond. Alternatively, in the fractional reserve banking systems of the United States and Europe, some (much?) of the benefit from seigniorage is captured by the banking system (not any one bank, but the system as a whole through bond purchase rules and the operation of the money multiplier). Basically, the new money issued by the central bank when it purchases an old government bond eventually takes the form of new loans made by banks on the basis of their expanding deposits. To their benefit, banks can borrow low and lend higher and as they do the economy benefits through greater liquidity and lower credit costs than would otherwise prevail. Everyone also benefits from a more buoyant economy and faster economic growth brought about by the creation of bank credit.
Needless to say, there is a debate about whether governments should appropriate the entire benefit from seigniorage or allow its benefits to be spread to the economy through the banking system. Right now, in the case of the U.S., this decision is made by the Open Market Committee of the Federal Reserve in light of its assessment the state of the economy and its objectives for monetary policy. This of course could change, and some members of Congress urge reforms that would in effect center seigniorage on the Treasury.
As noted by Boone and Johnson, for the European Union the question of seigniorage is much more complex than in the U.S. The Federal Reserve buys and sells only U.S. Treasuries and the seigniorage from its open market activities either benefit the U.S. Treasury directly by providing it with cash or indirectly with higher tax revenues from a more buoyant economy. The European Central Bank must deal in the sovereign bonds of the 17 member-states of the European Monetary Union. When it buys a newly issued bond from one member-state, the ECB provides purchasing power to that country's government not available to the others. Similarly, when it augments bank reserves in one country, their availability to banks in other member-states is of a lesser degree. These problems are in addition to those associated with the over-issuance of sovereign debt by these countries mentioned by Boone and Johnson.
The euro has brought many benefits to the European Union and its member-states. It has eliminated the costs associated with currency conversions among its members and fixed the internal exchange rate among their major trading partners. It has also allowed them to harmonize their domestic policies in ways not possible before and provided a stable exchange rate to the rest of the world. In these ways, and more, the euro has been helpful to European prosperity and peace.
But the longer-term viability of any monetary union depends on a degree of discipline among its members. Greece and some other members of the EMU simply have not been able to bring their national budgets under control, and given this reality the monetary union generates more instability than stability. Until the countries of the EMU work out acceptable rules for determining national budgets, Greece will be only the first in a long line of problem countries.
In a larger sense, the problem goes beyond budget discipline. Simply because there are so many independent fiscal policies and only one common monetary policy, it is difficult to see how the EMU can work. The question of seigniorage and who gets it will always be in the background, and it is the key issue because it reflects both money creation and sovereign bond finance. The Greeks can argue that if they had access to the euro's seigniorage, i.e., if the ECB would just buy their bonds, the burden on them would be far lighter, and they would be right. Other countries can argue that because they have been disciplined with regard to their finances, their bonds are of the highest quality and therefore they are more deserving of its benefits. For all countries, the question of an appropriate expansion in their money supply is critical to their economic future; however, an expansion rate appropriate to a fast growing economy is not for a slow growing one.
Until the problem of money creation and seigniorage and its distribution among the countries of the EMU is satisfactorily worked out, it is difficult to see how the euro can survive.
The bubble that is Greece and the disaster to come
“Bubbles are back as a topic of serious discussion, as they were before the financial crisis. The questions are: (1) can you spot bubbles, (2) can policymakers do anything to deflate them gently, and (3) can anyone make money when bubbles get out of control?
Our answers are: Spotting pure equity bubbles may sometimes be hard, but we can always see unsustainable finances supported by cheap credit. But policymakers will not act because all great (and dangerous) bubbles build their own political support; bubbles are invincible, until they collapse. A few investors can do well by betting against such bubbles, but it’s harder than you might think because you have to get the timing right – and that’s much more about luck than skill.
...
To think about this more specifically, consider the case of Greece today. It might seem odd to suggest there is a bubble in a country so evidently under financial pressure – and working hard to stave off collapse with the help of its neighbors – but the important thing about bubbles is: Don’t listen to the “market color” (otherwise known as ex post rationalization), just look at the numbers.
By the end of 2011 Greece’s debt will around 150% of GDP (the numbers here are based on the 2009 IMF Article IV assessment; we make some adjustments for the worsening economy and the restating of numbers since that time – for example, the fiscal deficit in 2009 will likely turn out to be about 8 percent, which is double what the IMF expected until recently). About 80 percent of this debt is foreign owned, and a large part of this is thought held by residents of France and Germany. Every 1 percentage point rise in interest rates means Greece needs to send an additional 1.2 percent of GDP abroad to those bondholders.
What if Greek interest rates rise to, say, 10% – a modest premium for a country which has the highest external public debt/GDP ratio in the world, which continues (under the so-called “austerity” program) to refinance even the interest on that debt without actually paying a centime out of its own pocket, and which is struggling to establish any sustained backing from the rest of Europe? Greece would need to send at total of 12% of GDP abroad per year, once they rollover the existing stock of debt to these new rates (nearly half of Greek debt will roll over within 3 years).
This is simply impossible and unheard of for any long period of history. German reparation payments were 2.4 percent of GNP during 1925-32, and in the years immediately after 1982, the net transfer of resources from Latin America was 3.5 percent of GDP (a fifth of its export earnings). Neither of these were good experiences.
...
If such measures are not taken, we are clearly heading for a train wreck. The European politicians have been tested, and now we know the results: They are not careful, they are reckless.”
Peter Boone and Simon Johnson, "The Coming Greek Debt Bubble", The Baseline Scenario Blog (11 March 2010).
http://baselinescenario.com/2010/03/11/the-coming-greek-debt-bubble/
Peter Boone is chairman of the charity Effective Intervention at the London School of Economics' Center for Economic Performance. Simon Johnson is Ronald A. Kurtz Professor of Entrepreneurship at the Sloan School of Management at MIT. From March 2007 through the end of August 2008 Professor Johnson was Chief Economist of the International Monetary Fund.
Let us be clear on this: The Greek debt situation is unsustainable and sooner or later the entire mess will come crashing down. So the question is who will pay.
Why should the Greeks pay? Creditors in France and Germany have known for a decade that the Greeks were living well beyond their ability to repay any loans, and yet they loaned the money to Greece anyway. Even now, the French and German governments in an act of continuing stupidity are encouraging their financial institutions to buy Greek bonds. Any idiot can see where this is all heading. Granted, abandoning the Greeks in their hour of need would be a disaster. But any idiot can also see that if the Greeks are bailed out an even greater disaster is on the horizon, one that could engulf the entire European Community. Better to cut the losses now, not just in Greece but elsewhere in the EU, rather than risk the much greater disaster to come. Given the stupidity of the French and Germans, and the terribly high price -- a overwhelmingly crushing price -- the Greeks will have to pay if they try to pay back the debt, maybe the Greeks ought to just repudiate the debt and tell the French and Germans to eat the debt as the price they must pay for lying to their citizens about the creditworthiness of the Greek government. While this is not good for Greece, it is much better than many years as a slave to French and German financial interests, transferring a significant and growing percentage of its GDP to foreigners.
Why should the French and the Germans pay? Creditors in France and Germany made loans to the Greeks in good faith, with assurances that Greece would change its ways and guarantees they would be paid back. In this sense, these were not reckless loans but extended in the expectation that conditions for sustainability were being established and the rules of the Maastricht Treaty, mandating sensible macroeconomic policies, would be enforced. French and German banks, pension funds, and other investors were encouraged -- nay, virtually told by their governments – to buy these bonds, because their governments, in an act of delusion we call a Ponzi scheme, saw the continued financing of Greece as a way to pay the interest on the previously issued bonds. But surely Greek politicians were knowingly at the center of this scheme to defraud the French and the German financial sector; even now, they continue to promote this dishonest scheme for their own benefit, forcing the French and the Germans to become slaves to the Greek standard of living. It is the Greek politicians, manipulating and lying to their French and German counterparts and acting on behalf of the Greek government and a selfish Greek people, that caused this problem, so the Greeks must pay as their debt collapses under the weight of their deception and greed.
We do not know how this will play out. But play out it will, and however it does it will not be pretty. For the moment, the Ponzi scheme that is Greek debt builds before our eyes as governments, rather than bursting this bubble, encourage an ever-increasing flow of money into what in the end will be a black hole of financial ruin. But do not forget that because governments are orchestrating this disaster as they blindly try and run away from its consequences, many of those throwing even more money into this bottomless pit expect to be bailed out in the end. So it is likely to continue for a while.
And less us note that Greece is not the only country led by reckless and irresponsible politicians that base its national budget on a Ponzi scheme. That country, too, is on a course that cannot end happily.
Greece still awaits a bailout that may not come
“The EU, led by France and Germany, appears to have some sort of financing package in the works for Greece (probably still without a major role for the IMF). But the main goal seems to be to buy time – hoping for better global outcomes – rather than dealing with the issues at any more fundamental level.
Greece needs 30-35bn euros to cover its funding needs for the rest of this year. But under their current fiscal plan, we are looking at something like 60bn euros in refinancing per year over the next several years – taking their debt level to 150 percent of GDP; hardly a sustainable medium-term fiscal framework.
A fully credible package would need around 200bn euros, to cover three years. But the moral hazard involved in such a deal would be immense – there is no way the German government can sell that to voters (or find that much money through an off-government balance sheet operation).
Alternatively, of course, the Greeks could make much more dramatic cuts to their primary deficit – the government budget balance if you take out interest payments – in order to stabilize their debt-GDP ratio.
But with no significant resurgence of growth in the eurozone coming for a long time, that would really mean moving from last year’s 7.7% GDP primary deficit to around a 6% GDP primary surplus (assuming they face a real interest rate of 5%, i.e., below what they are paying today).
The government won’t (or can’t?) do that. In 2009 Greek wages and pensions rose by 10.5% – an amazing spending spree. In the 2010 budget they are forecast to rise by 0.3%. Where is the austerity? No wonder the prime minister is popular – they aren’t really cutting much.
The bailout package is really just an opportunity for European banks to get out of Greek debt. The Greeks can’t really collapse until they lose access to funding, so the hope is that this prevents the problems from spreading – and the prospects of such a “rescue” will keep bond yields down for Portugal, Spain, and others.
Our baseline view is that Greece enters into quite a bad recession this year, their banks and corporates continue to have trouble raising financing – thus causing broader liquidity issues, and it all comes to a head again as we near the time the government needs to take ever harsher measures next year, when there is again no bilateral funding in place.
This is the new Greek cycle.”
Peter Boone and Simon Johnson, “An Underfunded Program For Greece”, The Baseline Scenario (1 March 2010).
http://baselinescenario.com/2010/03/01/an-underfunded-program-for-greece/#more-6619
Despite all the talk, I for one do not believe in the end the Germans will bail out the Greeks. Could be wrong, but I think the EU is stringing along the Greeks in hopes that somehow something will happen that will avert disaster. Perhaps the EU (that is, the Germans) might offer something should things get out of control with very bad and prolonged riots, but it will be peanuts compared to the problem and given only to calm the moment. In my view, the only hope the Greeks really have is the IMF, and I don’t think the IMF will help them any time soon. My prediction is drift in policy and drips of aid this year, with the real reckoning coming next year when Greece is forced out off the euro.
The reason I hold this view is that whatever Germany does for Greece it must do for Spain, Portugal and the other weak countries of Europe. It cannot afford to go down this road. So Greece will have to undertake the adjustment more or less on its own or with minimal support from the outside. Because immediately implementing a full-scale austerity program in Greece to establish competitiveness with the outside world would be extremely painful, it will have to be introduced over time. Hence, some program of minimal support allowing a difficult 2010 to become an even more difficult 2011 may be in the cards. If an EU program actually emerges I would expect it to be financed through the IMF, with just enough financing to survive 2010.
The root problem before Greece and the rest of Europe is demographic, not economic. Greece’s entitlement state with its huge public sector is not close to sustainable when the fertility rate is 1.3 children per woman and declining. Workers in Greece can retire at 58 and these workers, like those in the U.S. and elsewhere, have no intention of giving up their benefits, even if it bankrupts the state, which of course it already has. Greece has now run out of Greeks, and the remaining Greeks are looking to the EU (read the Germans) to support their welfare state in the style to which they have become accustom.
Germans, who have their own demographic problems and must work until 67, will never agree to supporting current income levels of countries with the level and increases in benefits available to Greeks. So reality is coming to Greece, sooner than they expected. The question is whether the contractionary policies that are on their way, not only in Greece but in Spain and Portugal and the other overextended states completely upset the economic and political stability of Europe. Expect large-scale emigration out of Greece and these other countries as the economic deteriorates with little prospect of recovery.
Similar imbalances describe the fiscal accounts of the U.S. and the U.K. and other large countries. Nothing is being done to address these problems, indeed, current policy efforts only aggravate them. Greece, in a sense, is a prelude to what is to come here if present policy continues and the Administration refuses to focus on jobs and the deficit.
While Greeks can run to the U.S. to escape a collapsing economy, where will the Americans run to?
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