After my guest blogger Henry Kaspar showed us some historical lessons from the Gold standard (if you come from Krugman, this is the correct link), Ryan Avent has more. In a remarkable post he compares Europe’s current problems to the history of the 1930s and the rise of the Nazi regime in Germany. And he does a good job at it, given the length of a blog post. He writes:
There is a striking irony to the current situation in the euro zone. It’s often assumed that hyperinflation gave the world the Nazis; that’s wrong.
Well, mostly wrong. In his earlier days and attempted coup d’état (in 1923), Hitler was in part exploiting the frustrations of Germans (Bavarians, actually, as he was only active in Munich), with the hyperinflation – brilliantly captured by Lion Feuchtwanger’s novel “Erfolg” (“Success”). But the Nazi rise to power came later, when Germany was struggling: politically, as an increasingly violent and heavily divided society made any compromise very difficult. And economically, as Ryan compactly summarizes as follows:
… [During the economic crises after 1929], Germany found itself squeezed on two sides. The economy was crushed by an intense cycle of deleveraging and austerity, as the government struggled to maintain market confidence. And pressure was also applied on the monetary side, as Germany battled to fight gold outflows and keep itself on the gold standard.
… As European economies like Austria and Germany failed, America, Britain and France scrambled to assemble aid packages that might prevent a collapse, but these negotiations were inevitably characterised by petty disagreements and myopia, and the resulting aid packages were always too small and came too late.
Eventually, the system failed entirely, countries began abandoning gold, reinflating, and spending heavily on an arms buildup. The back of the Depression was broken. But it was too late to save Europe from utter catastrophe.
Then Ryan’s post culminates in what can be interpreted as a heavy criticism of European economists that did not foresee that they were about to wreck the very project that the Euro was to be the crown of:
The European Union, and its single-currency extension, were forged in the decades following the war in an effort to make sure that war never again divided and savaged the continent. But strangely enough, in the effort to tie itself together, Europe imposed some of the same fiscal and monetary constraints that precipitated the collapse of the 1930s. And here we are, watching history repeat itself. Within a Europe riven by imbalances, the fiscal and monetary screws are once again being applied to countries with no hope of escaping their financial burdens. Markets are attacking, and efforts to salvage the situation through massive aid packages are emerging too small and late to matter. The pressure within the squeezed economies is building, and that pressure will find a release, one way or another. A Europe hoping never to repeat its historical tragedies has gone and blundered into institutions that make those same tragedies more likely. The European project, as it looks now, has failed. …
One has to feel sorry for Europe, in a way. It did its best to learn from history, hoping never to repeat it. But history is a long, complex course, and there’s always a chance that the lessons you miss are the most important ones.
This contains more truth than the average (or even not-so-average) European is willing to concede.
I have repeatedly argued that we are about to destroy the brilliant and historically unique political project that is Europe. But whenever I did, I was writing against fiscal integration, something that Ryan and others seem to see as the solution. So let us recap what a useful fiscal integration will imply: transfers from Germany to other countries. Period. Anyone who denies this is utterly naïve. What is more, we will make conditional transfers out of them, of the sort: money for reforms. Reforms, mind you, that these countries were politically unable to pull off because they are spectacularly unpopular. And here comes the kicker: some of these will be loans that need to be repaid, to an already unpopular creditor. Am I the only one who thinks that this is crazy?
As much as I share Ryan’s analysis, there are important differences to the 1930s and in those can we find a better plan for the future. The Euro is like the Gold standard, but not exactly the same. First, we have a central bank printing “gold”. That is not a minor difference, it is key: the ECB sets the overall European inflation target. With a more appropriate target, given the historical lessons for such a diverse monetary union, for instance an price level target with 4-5% inflation p.a. (or better yet: a nominal spending level target of 6-7%), this central bank could be a very important building block of a fairly successful currency union. What is more, this central bank could use its powers to conduct somewhat differentiated monetary policy and force governments into counter-cyclical fiscal and regulatory responses.
And since the European debt crises is to a great extent a banking crisis – otherwise Greece and Portugal would just default and conduct an IMF programme, and Ireland would have never been in trouble in the first place – we need a central and politically independent European banking regulation authority with almost unlimited powers. Tyler Cowen argues that this is the first step to a fiscal union if it contains an FDIC-like deposit insurance, and I partly agree. But if there ever was a reasonable argument for a fiscal union, it is here.
Unfortunately, a lot of political capital was already wasted on “rescue packages” and a beginning fiscal union, that solve nothing. But what is left of the political capital needs to be spent on these three areas (an appropriate ECB target, a differentiated monetary policy and a central banking authority) and not on a fiscal union that is bound to make things worse.
Kantoos,
For some reason the goetterdaemmerungsscenarios originate mostly in the english speaking media. I found Buiter’s piece one of the best I’ve read from him, and Tyler should stick to his US knitting, which is not quite mainstream there either.
Maybe one of the problems in the Euro discourse is that people tend to overlook the differences between the peripheral economies. Greece needs to stop being a country where the rich do not pay taxes (incidentally a strong case for a European tax authority, staffed by people who know how to take what they need) and that has the largest population of Philippina maids in Europe, despite the hardship. A structural problem that cannot be solved by the country’s elite, because that would be suicidal. But Spain, Portugal and Ireland all have much more manageable and incidental problems. For Greece one needs a sort of Treuhand plus a body with Stasi-like powers to collect revenue. Portugal and Ireland can recover on their own, as long as we can manage nominal aggregate demand in the Eurozone to grow by a at least couple of percent (you suggest the ECB should adopt a form of NDGP targeting, interesting). I gusee that the solution for the banking systems in the peripheral countries should be either as Buiter suggets, wiping out the ( now mainly local) shareholders. The follow-up should then be inviting healthy foreign banks to bid for the franchises, leaving in each country a small core of temporarily nationalized banks, to be privatized later. Maybe some of the large Italian and Spanish banks should trim their international networks (I think that having an Italian bank as a parent is not very helpful for the former HypoVereinsbank right now, for instance). Another interim solution could be that the ECB lessens its reliance on ratings for collateral re open market operations. Or that (rather than an EU-wide deposit guarantee scheme, which will take a long time) a fund is created that guarantees to the ECB the value of certain holdings of , eg, Greek debt, i.e. the Greek state debt that will be on the books of the nationalized and recapitalized Greek banks immediately after nationalization. That should at least obviate the need for those banks to invest in top class EUR gvt debt for collateral operations (and let’s keep in minds, those operations are conducted on ECB’s behalf by the local Central Banks.
Thanks anyway for answering, be it indirectly, my question about the desired ECB mandate..
Kantoos, welcome back. Just in time to save the world. The end is near…
For me, the solution is quasi-fiscalism. Monetary policy has to be independent from politics and banking. There is no technical reason, whatsoever, why the money monopolist has to be a bank. We have to seperate monetary policy and banking. To do this, we have to end Deposit Insurance! Instead, give each Eurozone citizen a new safe account at the ECB (via his local bank), use it to supply money by crediting these accounts until NGDP is on trend. Contract the supply (if necessary) by giving the new ECB the right to “tax”, a European VAT, which only gets used to extinquish money. (So it’s not a political tax, there is no spending, no need for democratic control, it’s not fiscal, just quasi-fiscal.) Then, create VAT zones, so you can differenciate the money supply. If -in some Eurozones- core(!) inflation is rising, just raise the VAT.
After this reform, banks and states are on their own. No lending by the new ECB to either banks or states. You could have bank defaults or state defaults without hurting the economy, you can be Austrian without being an Austerian, the money supply always keeps NGDP on trend and they all lived happily ever after.
I think there is some misunderstanding with respect to the role of hyperinflation by Ryan Avent. It did destroy the binding of a certain demographic with the Weimar Republic. The supporting pillars of the Weimar Republic were only SPD and Zentrum, the one a party for workers, the other a party for catholics. Given that catholics were a minority of the population, the kind of natural establishment – protestant non-workers – had no really tight connection with the Weimar Republic. Of course the depression and deflation made workers move from SPD to NSDAP, but in todays Europe, there would still be other political forces in the way of an NSDAP party like takeover.
Like kantoos I find Ryan Avent’s post fascinating. To think RA’s thought to the end, the 1920/30s crisis got resolved by:
(i) a series of unilateral defaults on sovereign debt/ reparations (Nazi Germany) or debt restructuring arrangements.
(ii) ending the currency union – countries succesively left the gold standard in 1932-34, or introduced capital controls (= Nazi Germany).
It did NOT get resolved through temporary, liquidity providing aid packages. These were not only too small and came too late – as RA writes – but also failed to address the underlying fundamental economic imbalances:
(i) excessive debt levels – for which debt restructuring is needed – and
(ii) ar lack of external competitiveness in countries like the U.K. and Weimar Germany – for which devaluation is needed. In Germany this lack of competitiveness owed to the “golden” Weimar years 1924-29 during which a domestic spending boom in the non-tradeables pushed wages to unsustainable levels (as we know since Knut Borchardt – much like what happened in the GIPS in the mid- to late- 2000s), in the UK to rejoining the gold standard at an overavalued exchange rate (much like Germany in the early 2000s).
Instead, faced with what looked like a situation without alternatives, Bruening tried bravely but unsucessfully to do exactly what the Greeces, Irelands and Portugals are trying today: austerity plus internal devaluation through wages, which can only be brought about by mass unemployment. With the known outcome.
If so, the conclusion seems to me that European policy makers need to start thinking the unthinkable, and sooner rather than later:
(i) restructure debts of those countries where debt levels are unsustainable;
(ii) and get used to the thought that some countries may have to leave the euro – specifically, those that competitiveness problems that cannot realistically resolved through internal devaluation (i.e. through wages) without setting the country on fire.
The longer these real solutions are avoided for fear about the short-term consequences, the worse political disintegration of the European project will be.
A narrow banking solution a la Alex F would be ideal, also because it would solve the moral hazard problem. However, politicians (not only democratic ones) would never give up a state-dependent (ie to be bailed out when necessary) financial system that provides soft budget constraints. And that is not a matter for economists, but for voters.
Economists might want to speculate how the financial sector (whose financial firms that enjoy no central bank lender of last resort services and who cannot hold the payments system to ransom (I guess that is what you mean) would function. Initially at least it would be far more expensive (capital ratios of stand alone finance companies in the US used to be at least twice as high as those of banks and gross interest margins were also much higher for a similar return on capital.
And these companies had the competitive advantage that they could opearte nationwide, in contrast to commercial banks (I am referring to the period of roughly 1960 through 1985).
We know very little about the endogeneity characteristics of credit loss experience through the cycle in our current system, but it is plausible that there is a fair bit. In a system fully independent of the state, that would be entirely different. I suspect that the internal feedback mechanisms that make financial systems recover from supply shocks (partially through the expectation of bailouts) have a certain degree of anticyclicality. A free banking system would be exceedingly procyclical, apart from probably being more expensive. The latter can easily be illustrated by reference to the expected loss formula commonly used in bank risk management models (and in Basle II). The two key terms, probability of default and recovery, are both likely to be strongly more sensitive to cyclical variations in economic conditions in case of a free banking system (banks would cut outstandings aggressively when they expect a downturn and the value of all forms of collateral would also be more volatile, and highly covariant with default probabilities (ie when a bank needs to sell collateral, there is no market; the mechanism that drives fire sales). As a result, banks would (rating agencies would force them) have to carry much higher capital ratios and retain higher shares of earnings in good times. And even then there may be some residual systemic risk.
It is not interesting that that is exactly what the bank regulators are trying to achieve (at the level of the individual firm; for systemic risk a mitigating approach is being explored)? What would be better: a regulated banking system with regular need for bailouts and imposing on the taxpayer the cost of regulatory rentseeking, industry moral hazard and likely misallocation of capital), a “synthetic” free banking system where regulators try to limit moral hazard costs but with the externalities of a free banking system as described above (severe procyclicality), or a true free banking system? Only if the idea of macroprudential regulation can be given a practical and not too costly (in terms of externalities especially) expression, the new regulatory approach may be superior.
Also, how would this work in, especially, Germany, the champion of the first type?
As I tried to point out in a comment to an earlier post, the Euro is not a more flexible Gold-standard. And if it’s more flexible, it’s to the worse.
A country facing a capital-flight under a Gold-standard will at least have a stable value of their gold reserves. With the Euro that is not the case. If a capital flight sets in, the country will face not only the problem of money running out of their banking system but on top the value of their assets usable as a collateral to create new money (e.g. government bonds) will fall, reducing the capacity to provide liquidity to their banking system even further. Without some kind of fiscal union the situation in the Euro-Zone is worse than 1930.
And if you look at unemployment in Greece or Spain, you cannot say it is so much better than during the Great Depression. It just didn’t reach the core countries of the Euro yet.
@ Tarantoga
I saw your comment before, sorry for not replying. Time constraint.
I am not sure I understand your argument in full. Single countries don’t create money as they don’t have independent central banks. Your argument is that government bonds loose value, and that hurts the liquidity of domestic banks?
The point I was making was that contrary to the Gold standard, there is a CHOICE of inflation rate, not an exogenously given rate that changes with the gold hoarding behaviour of others. And that is definitely positive, isn’t it?
The biggest advantage of the Gold standard in my view is that it is much easier to exit the Gold standard than the Euro.
The comparison Gold Standard vs. Euro ist difficult, but very interesting. So thanks for your input.
My point is: Under a Gold standard a countries ability to provide liquidity to it’s banking system is constrained by it’s Gold reserves. But at least those reserves have a stable value. So the capital flight is the only problem. Under the Euro regime liquidity in the banking system is created by posting collateral to it’s central bank under the rules set by the ECB. As long as the banks have enough collateral and as long as they are willing to pay the interest rate set by the ECB, they can get liquidity. Now if a capital flight sets in, the value of the assets used as collateral declines. I don’t know at what level the Euro system refinances Greek government bonds now, but it is derived from the market value of those bonds. As the capital flight progresses, the market value of the potential collaterals of the banking system declines, allowing less refinancing where more would be needed to fight the capital flight. So if the market value of Greek government bonds goes down to 50% face value, the effective amount of collateral usable by the banking system to get liquidity halves, making the effects of the capital flight even worse.
@ Tarantoga
Thanks for the clarification.
The liquidity for banks (e.g. ELA in Ireland) is provided regardless of the value of the respective sovereign bonds. But I agree that the banking system cannot be stabilized by a nation state if the sovereign is highly indebted, but that was not your argument, was it? Moreover, the gold under the gold standard was not available for providing bank with liquidity.
If you combine the Euro with a central regulatory authority for banking, that also contains an FDIC-like deposit insurance, that would certainly help. And that is to some extent a fiscal union, but a farily limited one.
As a result the ability of a “save country” to “finance” (imo “sterilize” would be the better term) it’s deficits via capital markets increases greatly (look at German 10 year bond yields) while the “unsave country” has no chances to get access to capital markets because their bonds are so poor as a collateral for refinancing.
“The liquidity for banks (e.g. ELA in Ireland) is provided regardless of the value of the respective sovereign bonds.”
From my knowledge that is only true if you assume the banking system has alternative collaterals for refinancing. As far as I know, the ECB doesn’t refinance Greek bonds above their market value (which would be needed given their current market value to make them as good as other Euro area debt). Of course no one forces Greek banks to hold Greek government bonds as collateral. But if they switch to -say- German government bonds that makes the fiscal situation of Greece only worse. That is what we are seeing right now.
The market yield of government bonds is the result of deposits in the banking system seeking save and liquid investments and a certain amount of bonds available as such investments. More reserves but less bonds leads to lower yields and vice versa. Now in a currency union a national banking system has not only the national bonds available as such investments, but bonds from other members as well. As soon as the national bonds are considered bad (e.g. because they cannot be refinanced as good), the national bank deposits are invested in other countries bonds driving the yields of the national bonds up to unsustainable levels. The balance of bank deposits to available bonds got destroyed. That mechanism is right now running havoc across Europe and it will infect one country after another.
@ T
It seems that you see only the local banks as potential investors for the sovereign bonds. That is a strong assumption, to say the least.
True, but if the local banks are not willing to invest in the national debt, why should anybody else (at least at sustainable yields)? Many people wonder why Greece yields are so high while US short term yields are even nominally negative. The fiscal situation of both is not looking good, it may even be harder for the US to reduce the deficit to 0 because of their size and impact on the world economy. All I want to say is: There are perfectly rational reasons for this, you just have to look at the mechanisms in the financial system.
To make it clearer: Look at the regulative framework. A Bank doesn’t need any capital to buy sovereign bonds at auction and if they want to refinance their liquidity, they can do at ECB interest rates. That is very different for me or any other non-bank investor. So if the sovereign debt is not attractive for a local bank at some interest rate, it’s for nobody.
Tarantoga,
I have been wrestling with the collateral issue too. Especially since typically 50-60% of gvt paper of PIIGS is held by local banks (according to the stress tests (and more than likely the banks that were too small for the test will have some as well). Large non-local holders are BNP and SocGen, RBS, Barclays etc. The vast majority of systemic banks have little exposure.. Here are the stress test results (gross positions so they could include trading book assets but not short positions and CDS hedges.
ttps://spreadsheets.google.com/spreadsheet/pub?hl=de&hl=de&key=0AuEtgCUuVBDUdFlwcHN2eFFqcHhHekJDWm1NN200Wmc&single=true&gid=0&output=html
As the actual procedure is that the local central banks are custodians for the ECB, maybe a screwball idea (what else would work?) would be the following:
Governments involved to lend specially created new treasury stock (say with a 1 year maturity) to the local banks with their existing holdings of local treasury paper (maybe with a little over collateralization) and other forms of ECB eligible collateral, as collateral. The banks could then withdraw the original paper from the ECB and use the new paper for their reserve needs (and transfer the existing paper to a colalteral account with a custodian for the gvt). There would be several advantages from (1) using special purpose paper due to the fact that it could be customized to suit ECB, issuing country and rating agency demands, at a cost to the shareholders of the banks involved, but probably a lower cost than letting the fire sales run their course. And (2) from the nature of the transaction: lending (it would not be a bond swap, or brady-sryle transaction, although that could be added on a country by country basis). New, special purpose paper could also be instrumental in bank recaps (lessons to learn from the Irish example: look at Indonesia late 1990s). Of course this should be transparent to the stability accountants and not create net fresh debt (in nominal terms).
It would also give speculators a far more difficult target, since the most important investors in the market (the local banks) would no longer have to trade which might even lead to a short squeeze. Central banks have a great deal of expertise in hitting market when they are vulnerable from their FX intervention practice, and should have no difficulty in mapping precisely the holdership of EUR treasury paper.
Kantoos,
Prof Sinn refers to “the stock of refinancing credit” in this article
http://www.voxeu.org/index.php?q=node/6821
What does he mean? How serious is that as a constraint?
Kantoos,
Thanks for this – I’m new to your blog, so this is very interesting stuff. I was particularly interested in reading your thoughts on fiscal integration and its (un)desirability. Just earlier today, I posted my own thoughts on the same topic – when you look at the numbers, the scale of “federal” redistributions in the EU are not actually that different from those in the USA, nor is the variation in the business cycle across the two currency zones. Thus, in terms of why the euro is not working, but the dollar is (well, sort of!), we need to look elsewhere:
http://www.ronanlyons.com/2011/08/08/can-the-eurozone-survive-insights-from-the-dollar-zone/