The common European currency seems well on its way toward annihilation, and the demise is more likely to happen with a bang than a whimper. One might have thought that the looming catastrophe would elicit a sense of urgency in the statements and actions of European officials. “Depend upon it, sir,” Samuel Johnson once told Boswell, “when a man knows he is to be hanged in a fortnight, it concentrates his mind wonderfully.” So far, however, there is little evidence that minds are being concentrated, least of all the minds of those who really count, Chancellor Merkel and the European Central Bank (ECB).
As I pointed out in a previous post in August, the main cause of the debt crisis is that incomes are not growing fast enough to generate enough free cash flow to pay off the fixed nominal obligations incurred by the insolvent, nearly insolvent, or potentially insolvent Eurozone countries. Even worse, stagnating incomes impose added borrowing requirements on governments to cover expanding fiscal deficits. When a private borrower, having borrowed in expectation of increased future income, becomes insolvent, regaining solvency just by reducing expenditures is rarely possible. So if the borrower’s income doesn’t increase, the options are usually default and bankruptcy or a negotiated write down of the borrower’s indebtedness to creditors. A community or a country is even less likely than an individual to regain solvency through austerity, because the reduced spending of one person diminishes the incomes earned by others (the paradox of thrift), meaning that austerity may impair the income-earning, and, hence, the debt-repaying, capacity of the community as a whole.
I reproduce below a new version of the table that I included in my August post. It shows that from the third quarter of 2009 to the first quarter of 2011, NGDP for the Eurozone as a whole increased at the anemic rate of 2.95%. Eight countries (Luxembourg, Malta, Austria, Finland, Belgium, Slovakia, Germany, and the Netherlands) grew faster than the Eurozone as a whole, and eight countries (France, Italy, Portugal, Cyprus, Spain, Slovenia, Greece, and Ireland) grew less rapidly than the Eurozone as a whole. Guess which of the two groups the countries with debt problems are in. I have now added NGDP growth rates for the first, second and (where available) third quarters.
Comparing NGDP growth rates in Q1 with growth rates in Q2 and Q3 is instructive inasmuch as the ECB raised its benchmark interest rates by 25 basis points at the start of Q2 (April 13). In Q1, Eurozone NGDP rose by 5.01%, but in Q2, Eurozone NGDP growth fell to just 2.17%, with Q2 NDGP growth less than Q1 growth in every Eurozone country except Slovakia and Cyprus (Greece not yet reporting NGDP for Q2). On July 13, the ECB raised its benchmark interest rates by another 25 basis points. For the five countries (Austria, France, Germany, Netherlands, and Spain) already reporting NGDP growth for Q3, four had slower NGDP growth in Q3 than in Q1, with three reporting slower NGDP growth in Q3 than the average between Q3 2009 and Q1 2011. Rebecca Wilder has an important recent post with graph showing that the spreads between bonds issued by Belgium, Italy and Spain and bonds issued by Germany began increasing almost immediately after the ECB announced the increase in its benchmark interest rates on April 13, with the spreads continuing to increase in Q3. The connection between monetary policy, NGDP growth and the debt crisis could not be any more plain.
Nevertheless, there are those (and not just the Wall Street Journal) that seem to find merit in the unyielding stance of the Mrs. Merkel and the ECB. In his column last week in the Financial Times, John Kay, usually an insightful and sensible commentator, compares bailing out the insolvent Eurozone countries with a martingale strategy in which a bettor increases his bet each time he loses, in the expectation that he will eventually win enough to pay off his losses. Such a strategy only works if one has deep enough pockets to sustain the losses while waiting for a lucky strike. The problem in John Kay’s view is that the other side (the rest of the world) has deeper and can raise the ante to an intolerable level. Here is how Kay sums up the current situation:
Now the players look to the only remaining credible supporter. Surely the European Central Bank can enable them to see the night through. The ECB really does have infinite resources: if it runs out of money, it can print more.
Up to a point. Money created by a central bank is not free – if it were, we could all be as rich as Croesus. The resources of a monetary agency come either directly from taxpayers or indirectly from everyone through general inflation. To fund the bet the ECB would have to stand ready to buy, not just every Eurozone government bond issued so far, but any that might be issued. And more. . . .
Of course, say the advocates of this course, if only the banker would promise to underwrite our losses he would not actually have to pay. If you will only lend me a bit more money, says the gambler, you will get it all back, and more. That is the seductive song of the martingale.
The difference, of course, is that gambling is a zero-sum game. When the ECB is asked to print more money, the point is not to lend money with which insolvent governments can place a bet in the hope of winning enough to repay what they owe; the point is to create an economic environment conducive to growth. The inflation that John Kay finds so scary is actually the last best hope for all those creditors holding the sovereign debt of five or more Eurozone countries, debt increasingly unlikely, thanks to Mrs. Merkel and the ECB, ever to be repaid.
Before leaving the subject of inflation, I will make one further comment on German inflation-phobia. It is certainly true that the German hyperinflation of 1923-24 was a traumatic event in German history, undoubtedly leaving a deep imprint on the German national memory. Although a deep aversion to inflation has been a constant feature of German economic policy since World War II, it is also true that inflation in Germany for the past three years has been at or near its lowest level since the end of World War II. Nor is there much doubt that German inflation hawkishness has increased since the creation of the ECB, Germans becoming more sensitive about the danger of inflation created by a non-German institution than they were about inflation produced by the good old German Bundesbank. Conversely, the ECB has been all too eager to show that it can be even more hawkish on inflation than even a German central bank.
But have a look at German inflation in historical context. Here are two charts presenting German CPI. The first shows the annual change in the CPI in Germany from 1951 to 2009.
The second shows the year-on-year change in the CPI by month from January 1961 to October 2011.
The charts are instructive in showing that even in the heyday of the German Wirtschaftswunder from 1950 to 1966 under conservative governments headed by Konrad Adenauer and then by Ludwig Erhard (friend and disciple of Hayek, member of the Mont Pelerin Society, and the acknowledged architect of the Wirtschaftswunder) the rate of inflation was often above 3%. For long stretches of time since 1950, Germany has had inflation above 3%, sometimes over 5%, nevertheless managing to avoid the political and economic disasters that, we are now told, supposedly follow inexorably whenever inflation exceeds 2%.
A similar story is told by the third chart showing the German GDP price deflator measured quarterly since 1971. The price deflator is now running at the lowest rates in 40 years.
Is the risk to the German economy from a rate of inflation closer to the mean rate of the last 40 years, say 3-4%, really so intolerable? What are they thinking?