Monday, July 30, 2012

Broken by the fix

What do the goldzone Great Depression (1929-3?) and the Eurozone Great Recession (2008-?) have in common? They were both created by European central banks with the US Federal Reserve (the Fed) as accessory during and after the fact. (Yes, the monetary shock which set off the Great Recession started in Europe though the responsibility of the European Central Bank [ECB] in that initial shock was a bit more indirect than that of the Bank of France in the Depression; the ECB was much more directly culpable in the subsequent monetary contraction.)

When Nobel laureate Thomas Sargent described the euro as an artificial gold standard he was zeroing in on common features--the goldzone and the Eurozone both being fixed exchange rate systems operating over institutionally divergent countries with limited labour flows, no fiscal union (so no significant fiscal transfers) nor common risk pool otherwise (in the case of the eurozone, no lender of last resort). Having the Eurozone include Mediterranean economies was not (pdf) a monetary union that conventional Optimum Currency Area (OCA) theory supported. While economist Charles Goodhart is quite correct when he points out that OCA theory cannot explain the boundaries of existing currency realms--that being a result of the operation of state power--if OCA theory is seen as providing an analysis of whether currency realms should amalgamate, it turns out to be very powerful, as the travails of the Eurozone are proceeding to demonstrate.

This surprised-by-American-scepticism paper [pdf] by European economists--scepticism largely driven by OCA theory--reads rather differently now. Though labour mobility is supposed to be one of the key differences between the US and the Eurozone, yet land-rationing in the richer US cities is seriously reducing labour mobility, making the US more like the Eurozone and undermining its macroeconomic resilience.

Inflation phobia
Milton Friedman was famously an advocate of (pdf) floating exchange rates, Frederich Hayek an advocate of (pdf) fixed exchange rates. The latter seems an odd position for a free market thinker to take. Especially when Hayek was also an advocate for the gold standard, if one was going to keep the state money monopoly. A series of fixed prices (fixed exchange rates, fixed gold price) erected on monopoly provision seems a very odd position for a free market thinker to take.

The explanation is simple: fear of inflation. A fixed price of money in gold means--given gold's scarcity--that the possibilities of inflation are greatly reduced. A fixed exchange rate means giving up the ability to domestically inflate (as Greece, Italy, Portugal and Spain are currently discovering). A monetary authority can control price stability or it can control the exchange rate, it cannot do both. Being in the goldzone means inflation will only occur if the price of gold is falling, which it is unlikely to do by much, given that stocks greatly outweigh new production.[i]

The experience of inflation is another feature in common between the goldzone Great Depression and the eurozone Great Recession. Both the great deflation of the former and the disinflation of the latter occurred after dramatic periods of inflation. In the case of the interwar goldzone; the wartime inflations, the German and Austrian hyperinflations, the French early 1920s inflation. Fear of inflation dominated the thinking of monetary authorities--indeed, paralysed their thinking. To the extent that the Fed is paying people not to spend money.
In our own time, the Great Inflation from the late 1960s to the early 1980s has profoundly affected the thinking of monetary authorities; indeed, paralysed it. The success of inflation targeting in squeezing inflation out of Western economies has made it a policy fetish that central bankers cannot see beyond, just as the gold standard was a policy fetish monetary authorities in the early 1930s could not see beyond. Not even to make adjustments necessary to save it. It has been a continuing pattern for central bank policy to respond more to the traumas of the past than the dilemmas of the present.

Been there, done that
It is a sad reflection on the ability of policy makers to find new ways of making old mistakes that if one reads either version of the paper (pdf) by Barry Eichengreen and Peter Temin, The Gold Standard and the Great Depression, and replaces 'gold standard' with 'inflation targeting', one gets an almost perfect description of the current failures of central banks and the mentality behind such. Particularly when the Eichengreen and Temin say (p.19 of the NBER paper):
policies were perverse because they were designed to preserve the gold standard, not employment.
Replace 'gold standard' with 'inflation target' and that is exactly what has been happening in our own time.[ii] Indeed, it was worse than that, as the the Fed and the Bank of France were not even "doing" the gold standard properly (pdf). Just as the European Central Bank and the Fed are now not even doing inflation targeting properly. (To the extent that the IMF is now reporting a significant risk of deflation [pdf] in Mediterranean Eurozone countries.) Just to increase the similarities between the Great Depression and Great Recession, inflation targeting that implicitly or explicitly incorporates "headline" inflation which includes oil and commodity price shocks turns into a de facto commodity standard (since a rise in commodity prices leads to monetary tightening; so the value of money is tied to commodity prices).

As for the authors' comment:
Central bankers continued to kick the world economy while it was down until it lost consciousness (p.2)
that is a fair description of the role of the ECB in the Eurozone crisis. With the added proviso that many think some beating is warranted: alas for such righteous monetary Calvinists, the policy of the beatings continuing until performance improves has long since degenerated into pointless and destructive monetary sadism.

Which makes Greece an enormously useful scapegoat for the ECB.  While people are pointing at its obvious policy dysfunctions (a country rated by the World Bank as 100 out of 183 in difficulty of doing business has considerable capacity to improve its economic performance through its state simply stopping spending money and effort getting in the way of people transacting[iii]), and the undoubted economic rigidities in other Mediterranean Eurozone countries (Italy is rated 87, Spain 44 and Portugal 30 in difficulty of doing business compared to Germany at 19), the ECB is avoiding any accountability for its actions. (Which would make it the ultimate EU creation; the EU being a construction where power without accountability is not a bug, it's a feature.)

Conversely, the worst thing for the Eurozone would be for Greece, or any other country, to leave--and promptly start to do better. Moreover, economic rigidity hardly explains the level of economic pain in the Great Recession—the UK is ranked 7, Ireland 10, USA 4 in difficulty of doing business. Nor does public debt on its own--even within the Eurozone, Spain has a lower level of public debt than Germany (pdf).

Compared to the ECB's destructive monetary austerity, the Fed is more in the situation of having belted the US economy into a TKO,[iv] then helped it sit back up a bit, and offered some water, but resolutely refuses to help the punch-drunk economy stand, proclaiming that if it cannot stand up on its own, it is not fit to, while promising that it won't let it fall to the matt again. Monetary policy matters.

Contractionary blindness
The great blindness involved in this inflationphobia is to think that inflation is the only significant monetary danger. Firstly, serious monetary-contraction deflation is worse than monetary-expansion inflation, even hyperinflation. Both undermine economic calculation, but inflation tends to promote transactions (as people spend before their money loses value), deflation to restrict them (as people defer using money that will buy more later, leading to falling spending and thus falling income). Generally, falling transactions, falling economic activity, is worse than rising.

[Read the rest at Skepticlawyer or at Critical Thinking Applied.]

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