Uneasy Money

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?

In Wednesday’s Financial Times, Nicholas Crafts, Professor of Economics at Warwick University, writes a superb op-ed “Fiscal stimulus is not our only option” explaining how an easy money policy worked for England in the 1930s, generating a 20% increase in real GDP between 1933 and 1937 despite fiscal retrenchment.  The op-ed summarizes a report (Delivering growth while reducing deficits:  Lessons from the 1930s) just published by the Centre Forum, a liberal think tank based in London.

Here is the opening paragraph:

The lessons of the 1930s are not well understood but are important. Britain enjoyed a strong recovery from the depression, with growth exceeding 3 per cent in each year between 1933 and 1937, despite a double-dip recession in 1932 and continuing turmoil in the international economy. Until 1936, growth owed nothing to rearmament. Indeed, as now, in the early 1930s the government was engaged in fiscal consolidation at a time of very precarious public finances, while from mid-1932 short-term interest rates were close to zero and could not be cut to deliver monetary stimulus. The parallels with today are clear, but today’s policymakers are unaware of the successful economic policy that revived growth. How did they pull this off 80 years ago – and could we do the same?

Crafts answers his question — correctly! — in the affirmative.

Aside from rampant pessimism about the US economy, the mini-panic now swamping international stock markets is also being attributed to worries about the eurozone and the increasing likelihood that at least five members of eurozone will default on their debt unless rescued by the other countries.  The problems of three countries, Greece, Ireland, and Portugal, have been well known for at least a year and a half.  But the problems of Spain and Italy, which had been thought to be manageable and unlikely to cause a crisis, have suddenly become critical as well.  Because of their size and the size of their debt burdens, it is unclear whether any rescue package would be feasible if the debt of all five countries had to be rescued by the eurozone governments.

It has been fashionable to blame the crisis on the fecklessness of the politicians in these countries, the greediness of their public employee unions and the overly generous pensions that they have extracted from taxpayers, overly generous welfare benefits, and an unwillingness to work hard and save like the good old solid Northern Europeans.  There probably is some truth in that assessment, though there is probably some exaggeration as well.

However, assigning blame in this way is really a distraction from the true cause of the crisis, which is a stagnation of income growth, making it impossible to pay off debts that were undertaken when it was expected that incomes would be rising.  Since the debts are fixed in nominal terms, the condition for being able to pay off the debts is that nominal income (NGDP) rise fast enough to provide enough free cash flows to service the debts.  That hasn’t happened in the five countries now unable to borrow at manageable rates.

Using official data of the European Commission, I calculated the average annual rate of growth in NGDP for each of the 15 countries in the eurozone since the third quarter of 2008 when the eurozone went into recession and for each of the 16 countries in the eurozone since the third quarter of 2009 when the recovery started (Slovakia having joined in eurozone in the second quarter of 2009) through the first quarter of 2011.

Here are the two lists arranged in order from the fastest to the slowest growth rates of NGDP

The five countries primarily implicated in the debt crisis are at the bottom of NGDP growth rates.  The only other countries in that range are Cyprus and Slovenia.  Cyprus bonds also seem to be problematic, but Slovenia bonds are still rated AA by S&P.

The European debt crisis can thus primarily be laid at the doorstep of Chancellor Merkel and Jean-Claude Trichet, President of the European Central Bank who, in their inflation fighting zeal, have spurned calls for monetary easing to speed the recovery.  We are now all reaping what they have sown.

Chancellor Merkel is following in the worst tradition of one of her predecessors, the unfortunate Chancellor Heinrich Bruning, who in his obsession with proving that Germany was unable to pay off its World War I obligations to the Allies, drove Germany mercilessly into a deflationary spiral in the early 1930s paving the way for Hitler’s ascent to power.  This time, Germany has largely been spared the pain caused by the tight monetary policy for which Chancellor Merkel has expended so much effort.  The pain has mostly been borne by others.  But Germany ultimately cannot escape the costs of its unyielding attachment to tight monetary policy.  Mr. Trichet, too, can look for inspiration to the tragically misguided Emile Moreau, governor the of the Bank of France who presided over the disastrous accumulation of gold by France in the late 1920s and early 1930s that was perhaps the most important factor in triggering the international deflation that led to the Great Depression.

UPDATE (11/25/2011):  In working on a new post about the euro crisis, I discovered that I seriously misstated the growth rates from Q3/09 to Q1/11 for the eurozone countries reported in the above table.  Although I got the numbers wrong, the general relationship among the growth rates in the various countries was not wildly off, so the mistake does not affect the central message of the post, but in my haste, I negligent in checking the numbers.  There were also a few mistakes in the column reporting reporting growth rates from Q3/08 to Q1/11,but only a few of those number were mistaken, not the whole column, as was unfortunately the case for Q3/09 to Q1/11.  Here is a revised table, which aside from correcting my own mistkaes is also based on revised data from the EU.