Saturday 11 July 2015

A Union of Deflation and Unemployment

On Twitter recently, someone posted that anyone who doesn't understand the importance of the difference between a sovereign money supply and a non-sovereign money supply does not understand economics. I wholeheartedly agree with this. And the majority of comments I see on articles about the Greek situation confirms that most people don't understand economics.

I don't even know where to begin with criticisms of the idea of a shared currency without shared government. There are three main problems:

Problem 1: It is very easy to get into debt: 

A country in the Euro has no control of its monetary policy. Therefore when Greece had negative real interest rates during the boom time, there was nothing it could do to prevent people borrowing money. When added to a government also borrowing to appease special interests, this can be disastrous. But Spain had this problem even whilst running government budget surpluses. 

A country in the Euro has very little control over fiscal policy due to the rules determining how much governments can borrow and save. So even if a government wanted to combat loose monetary policy with correctly tight fiscal policy, it couldn't. There was literally nothing within the rules that Spain could have done to prevent the situation it is in now, with around 25% unemployment. 

The powers that be were very worried about government money creation as they did not want to debase the Euro. But they didn't bother worrying about private bank money creation. So when Ireland's banks built up huge books of loans, greatly increasing the money supply, nothing was done to stop them. Until it was too late. And the ECB forced Ireland's taxpayers to pay for it rather than the banks' bondholders. 

To add to this, one country in the Euro made it a policy to run huge trade surpluses by reducing worker incomes to subsidise exporters. As this was the largest economy in the Eurozone, these had a large impact on the rest of the countries in the union, notably the less competitive ones. The excess savings flowed into the poorer countries and, as Michael Pettis wonderfully explains, there was little they could do other than take on debt. 

So overall, it was pretty easy to get into debt.

Problem 2: Once in debt is impossible to get out of debt: 

There are three main ways a government has historically gotten out of debt. The first is economic growth; a growing economy means that debt to GDP ratios go down as GDP rises. The second is inflation; if a government's debt gets too large it can always resort to the printing press to help it out. The third is outright default.

Debt, when taken, is not allowed to be defaulted upon as this is against the EU rules. A limited one was allowed for Greece but this was when the holders were largely Greek banks and pension funds that the government had to recapitalise anyway so it didn't help much. Recently it has been made very clear that Greece will not be allowed to default on its government debt; although this may be relaxed a little on Sunday, they have had to go through a Great Depression magnitude loss of output to reach this and it will probably be not a large reduction.

Inflation is also verbotten. Inflation in Weimar Germany is cited as the reason why Germans are so anti-inflation. Whilst that episode was horrible for people with money; it was more the collapse of the economy caused by payment of reparations that caused the damage than the inflation. In fact, the wiping out of all internal debt helped Germany recover more quickly afterwards. It seems to have been forgotten that it was the depression caused by the deflation (due to the attempt to keep to the gold standard) in the early 1930s that actually brought Hitler to power. The important lesson from the inter-war period about money supply was that deflation is bad, but people seem to remember only that inflation was bad.

In any case, for whatever reason, the German government has shown by its actions that it would watch the Eurozone starve before abandoning a low inflation target. The inflation route has therefore been eliminated.

Then there is the growth route. Unfortunately that is out of the question too. 

Problem 3: After both of these are realised, economic growth becomes very difficult:

As I discuss here in order to have economic growth, the economy needs fresh sources of money. Since 1945, typically in the West this has been provided by credit growth, both by the government sector and the private sector. Another method could be printing new money.

As I also discuss in the above post, private sector debt is extremely inefficient in that for every 100 EUR of private sector debt taken out, only 13 EUR gets added to the demand in the economy. 

Governments, chastened by the experience of Greece and knowing that they are effectively borrowing in a foreign currency, can not borrow much more. A sovereign nation would have no problem issuing 150 or 200% debt to GDP. The central bank would support them and they would know that real interest rates could not get too high. Not so a borrower of a foreign currency. As soon as there is a fear that debts can not be paid, the interest rates can skyrocket and the economy can be destroyed. Greece only had around 100% government debt to GDP in 2007 but the internal devaluation and higher interest rates made it unpayable.

So no sane government will now borrow much money. In any case, they are bound to the (what would in a sovereign currency be a ridiculously low) upper limit of 3% of GDP. Greece is bound to run a primary surplus - they are taking money out of the economy every year.

The private sector is already over-leveraged. Even in the UK and US it is difficult to encourage much borrowing, despite interest rates being at the zero lower bound. The situation is accentuated in Europe because deflation will increase the values of the loans each year and real interest rates, especially in the periphery, are very high. So the private sector will not borrow.

There is therefore very little new money added to the economy from credit and the result is low growth. 

The necessity of running a current account surplus

There is one other source of new money each year, and this is the only one available to Greece now. It is foreign trade. Countries must run a trade surplus if they are to get any growth. 

This, in fact, seems to be the German idea of a perfectly functioning Euro. One where everyone runs a trade surplus. It is certainly the only Euro that is viable without debt disasters.

This comes with a couple of catches.

The first catch is that the only way to do this, since tariffs are not possible, is by reducing internal demand. This means effective internal devaluation and reduction of wages. This is a very slow and extraordinarily painful process if done in a world of low inflation. As I show here, the stickiness of prices means that as demand is reduced, prices and wages are very slow to react. Unemployment comes first and takes most of the impact. If average Eurozone inflation is 0.5% then a 2% adjustment per year means 1.5% deflation is required. The effect on the economy of this is huge. 

The second is that Germany already has a huge trade surplus (a structural change enacted during the boom times when it was much easier) and shows no signs of giving up on it. This means that the Euro is already too high for the rest of the Eurozone and the German exports are cheap relative to the rest of the Eurozone. Therefore the level of internal devaluation required is even higher than would be required anyway.

The third catch is that the rest of the world will have to be happy running a deficit to cope with the huge surpluses of the whole Eurozone. As it is a parasitic policy, bringing debt in the countries it sucks demand out of, they may object to this and retaliate. 

The downward spiral

The fourth, and quite important, catch here is that the more that each country does this, the more that the other countries in the Eurozone (and indeed the rest of the world) will react by doing the same. As one country reduces domestic demand so that they buy fewer imports, another country must have fewer exports. That country then needs to reduce internal demand to reduce its imports. This then affects the first country that then needs to further reduce internal demand.

This leads to a spiral of internal devaluations and unemployment that could last for many years.

The Conclusion

I think I show three things here:
  1. The only policy a country can follow if it wants to avoid debt crisis is to run a current account surplus.
  2. This leads to a policy of internal devaluation and deflation.
  3. This creates a positive feedback mechanism which leads to a spiral of deflation and unemployment.
This is true certainly as long as Germany insists on low inflation and trade surpluses but possibly anyway, just by the nature of the riskiness of sovereign borrowing.

I would like to hereby offer my humble advice to the leaders in Europe; now is the time to give up on this unworkable idea before it becomes even more of a disaster.

1 comment:

Sorry, I have had to moderate comments because of an annoying pest spammer who keeps posting American football matches links.