We want to return to a theme we have recently discussed in these pages, namely the allegedly exhaustive hypotheses regarding the possible solutions to the euro area's problems that are regularly presented to us in the media.
Leading intellectuals and economists usually list a set of choices based on the views of the current economic orthodoxy, which choices they insist are all that is possible or even imaginable.
We have briefly mentioned the topic last week and so has Mish in a recent post that similar to out article looked critically at Martin Wolf's recent 'Thinking the Unthinkable' editorial at the FT.
The main problem from our point of view is of course that no-one in the mainstream has as of yet really given voice to the so-called 'unthinkable', which in a way demonstrates what it really consists of (if it weren't 'unthinkable', they would have thought of it).
Long time readers will recall that we have always been highly critical of establishment intellectuals defending what we may term the 'statist quo'.
Becoming a defender and supporter of modern-day welfare/warfare statism and adopting the economic theories that provide the scientific fig leaf for statism and interventionism is today the only sure way to a remunerative career for an economist. Anyone who decides to unequivocally support the free market must be prepared to take the risks associated with such support, i.e., he or she will actually have to depend on the free market for making a living. From the point of view of earning a salary, it is far easier to pledge allegiance to the State, especially (but not only) for the vast bulk of mediocre thinkers.
Unfortunately, many decades of propaganda – both by commission and omission – have been very effective in that they have resulted in a number of highly questionable assumptions no longer being questioned. For this reason even otherwise critical writers are frequently taking leave of their senses.
One of these is Ambrose Evans-Pritchard, who writes regularly on the euro area for the Daily Telegraph (as an aside here, Mish tells us he will also critically review Evans-Pritchard's articles in an upcoming post).
Evans-Pritchard's critical appraisement of the euro project has certainly been vindicated by the current crisis and we agree with his unwavering stance against the undemocratic nature of the 'European super-state' that Europe's politicians have tried to impose step by step over the past several decades. For instance, Evans-Pritchard recently commented on the arrival of the new 'technocratic' governments of Greece and Italy in terms that were highly reminiscent of our own comments – he too argues that in essence these were bloodless coups by the eurocracy, enacted by means of blackmail (in Greece's case it was the threat to withhold the next tranche of the bailout funds, in Italy's case the ECB used its influence on Italy's bond market to great effect).
Where he goes wrong is in his support for two of the 'crisis solutions' proposed by the statist intellectuals most often quoted in the financial press (such as the above mentioned Martin Wolf, Nouriel Roubini, Paul Krugman and even George Soros, to name a few).
He is inter alia calling for debt monetization by the ECB to avert a repeat of the alleged 'evils of the gold standard'. Below is a quote from the above cited article that is fairly typical for the remarks he often makes in connection with this particular topic:
“Chancellor Angela Merkel tells us that peace in Europe can no longer be taken for granted, and she is right. Her own Gothic actions and her inflexible imposition of 1930s Gold Standard contraction and debt-deflation on Southern Europe is itself preparing the ground for Europe’s civil war (hopefully pacific), a rebellion by the South against the North.”
In another recent article, Evans-Pritchard avers that the 'US and China should crush Germany into submission' and mentions another of the shibboleths widely held to represent a path to salvation by the chattering classes (although his support is qualified as you will see further below):
“One can imagine joint telephone calls to Chancellor Angela Merkel more or less ordering her country to face up to the implications of the monetary union that Germany itself created and ran (badly).
Yes, this means mobilizing the full-firepower of the ECB – with a pledge to change EU Treaty law and the bank's mandate – and perhaps some form of quantum leap towards a fiscal and debt union.”
(emphasis added)
Let us first address the point about the gold standard. It is important to realize that a gold standard can not protect an economy from boom-bust cycles if it is run in parallel with a central-bank-led fractionally reserved banking system. The only reason why there ever was a deflation in the early 1930's was that the system had created massive amounts of fiduciary media, i.e., deposit money against which it did not hold a commensurate amount in the form of specie. Once the economic crisis struck, depositors tried to convert their claims into what was then money proper, namely gold, and found out to their chagrin that the banks didn't have it. To be sure, the same has happened in past economic booms without a central bank helping the system to pyramid monetary claims, but the biggest booms and busts in e.g. the US in the 19th century took place when the fore-runner organizations (the first and second bank of the US) of today's Fed were active. Clearly a central-bank led banking cartel has a tendency to produce far bigger boom-bust sequences than a free banking system. It must be noted here that the booms and busts of the 19th century were by and large fairly small and the gold standard, in spite of the occasional hicc-ups, worked exceedingly well for a century. This all changed with the advent of World War I, which prompted governments to abandon gold so they could finance their war expenditures by means of inflation.
The deflation that struck the UK after the war before it abandoned the gold standard for a second time can be traced back to the decision to go back to gold at the pre-WW I parity, in spite of the fact that massive inflation had taken place in the interim. Returning to gold at the old parity required a deflation of all wages and prices, something the government actually didn't want to happen. As Rothbard notes on this in 'What Has Government Done to Our Money':
“The British pound, for example, had been traditionally defined at a weight which made it equal to $4.86. But by the end of World War I, the inflation in Britain had brought the pound down to approximately $3.50 on the free foreign exchange market. Other currencies were similarly depreciated. The sensible policy would have been for Britain to return to gold at approximately $3.50, and for the other inflated countries to do the same. Phase I [the old gold standard, ed.] could have been smoothly and rapidly restored. Instead, the British made the fateful decision to return to gold at the old par of $4.86. It did so for reasons of British national “prestige,” and in a vain attempt to reestablish London as the “hard money” financial center of the world. To succeed at this piece of heroic folly, Britain would have had to deflate severely its money supply and its price levels, for at a $4.86 pound British export prices were far too high to be competitive in the world markets. But deflation was now politically out of the question, for the growth of trade unions, buttressed by a nationwide system of unemployment insurance, had made wage rates rigid downward; in order to deflate, the British government would have had to reverse the growth of its welfare state. In fact, the British wished to continue to inflate money and prices. As a result of combining inflation with a return to an overvalued par, British exports were depressed all during the 1920s and unemployment was severe all during the period when most of the world was experiencing an economic boom.”
(emphasis added)
The UK not only returned to gold at too high a parity, but by introducing the 'gold exchange standard' in 1922, it forced other nations to do likewise. Since the gold exchange standard was not a proper gold standard, but allowed for the major currencies – the US dollar and the British pound – to be used as reserve currencies that were ostensibly 'backed by gold', both the US and the UK, as well as other nations – as long as they did not attempt to actually redeem their paper reserves – could inflate far more than was previously possible under the genuine pre-war gold standard. It was the lengthy period of inflation that ensued that eventually blew the world economy up, not the 'gold standard'.
We should also point out here that just because Hoover's secretary of finance Andrew Mellon was once overheard to call for liquidation, one would be wrong to conclude that his advice was actually followed. On the contrary, it was Hoover's disastrous interventionism, especially his attempt to hold up wage rates, that made it impossible for market forces to smoothly correct the excesses of the inflationary boom. This problem is of course repeated today in the euro-area periphery, on account of minimum wage laws and other labor market rigidities. As an aside, the Fed increased free bank reserves by 404% between late 1929 and mid 1933, so it is likewise erroneous to assert that the Fed 'failed to pump' in the early 1930's, as many mistakenly do.
The euro area certainly finds itself in a somewhat analogous situation today, even though the euro is of course a fiat currency and as such has allowed an even bigger inflationary boom to take place. The ECB's 'price level targeting' policy has led to a massive expansion in the supply of credit and uncovered deposit money over the past decade. The problem with this quasi-mechanistic approach is that it does neither alleviate the basic problem of the socialistic central planning of money (namely, that it is not possible to deliver an outcome that is superior to a free market determined outcome by letting bureaucrats set interest rates), nor does it tackle the problem inherent in the practice of fractional reserves banking, which is that the banks can and will, in concert with the central bank, expand the money supply willy-nilly. This is after all precisely what has happened in the euro area over the past 10 years. To be precise, the euro-area's true money supply has been inflated by nearly 140% since the beginning of the year 2000, an inflation that has only begun to slow down slightly over the past year (but is lately accelerating again due to the ECB's introduction of LTRO's and its covered bond monetization program).
Ironically, Evans-Pritchard is well aware of this, as he for instance writes in the first paragraph of his article on the 'technocratic' coup:
“As I long feared, the flood of cheap credit into Southern Europe and the slow death of Club Med industry by currency asphyxiation have together created such a dangerous situation for world finance that informed opinion is willing to turn a blind eye to EU sovereign trespass.”
(emphasis added)
What this 'flood of cheap credit' has done to the euro area's money supply is depicted below:
The euro area's true money supply by economic categorization (charts via Michael Pollaro) since January 2000. This inflationary boom has now turned into a major bust. Note that of the €3.914 trillion in money substitutes in the system, only €209 billion are 'covered' money substitutes, i.e., money claims for which standard money actually exists – click for higher resolution.
So what would 'mobilizing the full firepower of the ECB' amount to if not a further increase in the supply of credit and money? In other words, by pleading for the ECB to 'go out and monetize' under the guise of 'lender of last resort', Evans-Pritchard is effectively arguing that one should fight the fire by throwing gasoline on it. What pray tell would be gained by this, except that it would lay the foundations for an even bigger bust down the road?
Yes, it is true that if the ECB were to hit its 'print' button without reservation, the crisis might be temporarily defused – but it would return with even greater vengeance at a later date. Moreover, inflating away the debt troubles of the governments on the periphery would do exactly zilch to solve the problem of their lack of competitiveness. As to the 'competitive devaluations' that would become possible if they were to return to their pre-euro currencies, our view is well known: beggar-thy-neighbor devaluations have yet to make anyone richer.
In his article 'Europe's Punishment Union', Evans-Pritchard argues first for and then against a fiscal union – the pro for misguided economic reasons, the contra for good political ones. The 'fiscal union' idea is based on the notion that if only the euro-area were a full-fledged centralized transfer union, then the single currency would 'work'. Here is what Evans-Pritchard says:
“It is a "Stability Union", as Angel Merkel stated in her Bundestag speech. Chalk and cheese.
"Deeper economic integration" is for one purpose only, to "police" budgets and punish sinners. It is about "rigorous surveillance" (point 24 of the statement) and "discipline" (25), laws enforcing "balanced budgets" (26), and prior vetting of budgets by EU police before elected parliaments have voted (26).
This certainly makes sense if you want to run a half-baked currency union. As the statement says, EMU’s leaders have learned the lesson of a decade of self-delusion. "Today no government can afford to underestimate the possible impact of public debts or housing bubbles in another eurozone country on its own economy."
But none of this is fiscal union. There is no joint bond issuance, no move to an EU treasury, no joint budgets with shared taxation and spending, no debt pooling, and no system of permanent fiscal transfers. Nor can there be without breaching a specific prohibition by Germany's top court, a prohibition that could be overcome only by changing the Grundgesetz and holding a referendum.
[…]
“Europe will have to evolve into a fiscal union to make the system work, but that would be inherently undemocratic without a genuine European government, parliament, and civic union. Such a supra-national union cannot enjoy democratic vitality because there is no European demos, or shared view of the world, or indeed any popular support for such a revolutionary step. Such a union would castrate historic national parliaments, to the advantage of whom? So this "solution" leads ineluctably to an authoritarian regime. Bad situation.”
(emphasis added)
We certainly agree with the final point, namely that what adoption of a fiscal union implies – the abandonment of subsidiarity in favor of a centralized political regime – would be an extremely unsavory outcome. If the 'centralizers' get their way, there will no longer be any tax or regulatory competition between EU member nations, defeating once and for all the very purpose of the original classical liberal idea underlying the formation of the EU. It would indeed represent a giant step toward an ultimately unworkable dictatorship – something we are already getting a taste of with the recent steamrolling of Greece's and Italy's governments.
Luckily Germany's constitutional court has thrown the euro critics what has turned out to be quite a substantial bone, by making clear that the German government can not relinquish its fiscal sovereignty without changing the German constitution. Not only that, but chief judge Voßkuhle has let it be known that nothing short of a referendum would suffice before such a fatuous step could be taken. In short, it's not going to happen.
However, what about the economic argument? Is it really true that a 'fiscal union' is a sine qua non without which a monetary union can not work? Actually, no. If one thinks this through, one soon realizes that this is in fact nonsense. From about 1815 to 1915, the whole world used a single medium of exchange (namely gold) to no ill effect - without ever establishing a 'fiscal union'. How come this worked so well for an entire century, but can allegedly not work at all nowadays?
