Tuesday, July 3, 2012

The eurozone's problems are monetary, not fiscal

Readers will recall that I recently published the blog, “The ECB can easily save the eurozone”. I elaborate on that theme in today’s posting.

Economic depression is always and everywhere a monetary phenomenon. That is the monetarist postion, which is shared all the way from Friedman on the the right to Krugman on the left, from Bernanke at the Fed to Eichengreen, Temin, Sumner and many others in academia. Monetarism has prevailed because it explains economic phenomena (such as depressions) better than any other theory.

So let us agree to the axiom: depressions are monetary phenomena. They are caused by inept central bankers who fail to maintain adequate growth in nominal GDP.

Depressions are not caused by droughts, floods, George Bush, over-indebtedness, war, budget deficits, stock market crashes, housing bubbles, banking crises, Barack Obama, overproduction, underconsumption, laziness, tax evasion, automation, cheap imports, high oil prices, poor-quality education, ATMs, over-regulation or “income inequality”.

Depressions are caused by inadequate money growth. Europe’s problems today are monetary in nature, not fiscal or financial.

Can we also agree that depressions are to be avoided? There is a school that argues that depressions can be prophylactic, and we will shortly hear from them. But let’s agree that an “eat your spinach” monetary policy that prescribes depression as a prohylaxis is probably a bad idea.

European monetary policy today has wickedly prescribed depression as the solution to the eurozone’s woes.

Most contemporary economists believe that a central object of policy should be the avoidance of massive economic contractions. There are three reasons for this: (1) depressions cause human misery, not a policy desideratum; (2) depressions cause fiscal crises; and (3) depressions can have destructive social and political consequences.

At present, the eurozone’s policy prescription for sinful Southern Europe is a depression that will force the South to (1) undergo internal devaluation in order to restore competitiveness; (2) break structural rigidities such as sticky wages and entrenched labor unions and professions; and (3) downsize the welfare state to a more affordable size. This is the classic gold standard deflationary policy which caused the Great Depression.

Depression and deflation, it is said, will increase competitiveness, balance budgets, and force the South to become more like the North and thus a better fit for continental monetary union. The problem is the sinful patient, not the poisonous prescription. The eurozone (or at least the northern part of it) truly believes that an imposed southern depression is appropriate public policy, and that there is no better alternative.

European monetary union was a political decision foisted on Europe by the French and against the opposition of the economics profession. Europe would emerge, Paris said,  as a world financial powerhouse (La Place Financiere). The transatlantic enemy and its almighty dollar would be cast down, and the euro would rightfully become the world’s reserve currency. Etcetera.

Thirteen years later, EMU has proven to be a fiasco, a world-historical mistake, a gigantic blunder on an unimaginable scale. But no one inside the eurozone’s cone of silence can say this. Too much has been invested in “Europe” in general and EMU in particular to admit error now.

This state of affairs is analogous to 1916, when it had become obvious to objective observers that a mechanized war of attrition was a disaster, but no one could admit it because so many had already died. And so the European powers persisted in the same blood-soaked strategy for two more years of death and destruction.

Right now, Europe faces a choice as critical as that in 1916. Will she admit error and turn back, or will she blunder forward into economic disaster?

As I have argued before, Europe faces three choices:
1. Fiscal union, with joint-and-several eurobonds and Berlin-imposed austerity;
2. An ECB monetary solution combining inflation and debt monetization; or
3. Deep depression followed by breakup, default, redenomination and inflation.

At present, Europe is on a very rocky and circuitous path towards fiscal union. Each time that Merkel gives ground, it is in the direction of fiscal union, not inflation.

Assuming that fiscal union were even possible, it would be an unmitigated  disaster. Fiscal union means that the South would become a colony of the North, with continuing deflation, fiscal austerity, and loss of sovereignty. Germany will bleed herself white as she pumps her tax revenues southward, while the South will seethe in hatred and resentment at German-imposed austerity and misery. Economic growth will stagnate, Japan-style.

Fiscal union is a debt solution to a monetary problem. It will pile debt upon debt, both in the South and in the North. The eurozone debt mountain will grow ever bigger, and wealth will dissipate.

I will reiterate that depressions are monetary phenomena, and the cure for depressions is sufficient money creation to produce a desired rate of nominal growth. The only way that this can be achieved in the eurozone is if the ECB’s mandate is changed to include financial stability and economic growth, with fiscal monetization explicitly permitted. This is the only way that budgets can be balanced, excessive austerity can be avoided, massive indebtedness can be averted, and prosperity can replace depression.

But this will require an entirely new definition of the EMU, the euro and the ECB. Instead of seeking to Germanize the Mediterranean, the EU must seek to Mediterraneanize the euro. (In philosophical terms, move the ECB from Frankfurt to Rome.)

From the perspective of ECB governance, this is almost conceivable, since the South and its allies can probably outvote the North on the governing council. But because the ECB charter does not permit inflation or monetization, there are limits to how far the Southern caucus can go without violating the ECB’s charter (which is a treaty).

If one reads the comments of the Bundesbank and its allies, their position is that Germany signed up for a common market and a common currency, but not for fiscal union or fiscal monetization, which is true. They point to the letter of the law, as does the Constitutional Court. As long as the Germans persist in this policy, the eurozone’s problems will only become more acute. And if Germany continues to give ground on the road to fiscal union, the fiasco will only be compounded and ramified northward.

We do not know how Germany will respond when the eurozone finds itself in extremis, nor do they. But at present, all signs point to disaster.

1 comment:

Benjamin C said...

Dear Mr. Mahoney,

commentators from the US often believe that fiscal union is possible. However, the countries are extremely fragmented. There is no such thing as a European public, so that a policy formation is not possible.

I agree much more with the Minsky point of view expressed in your other articles, namely that debt cycles lead to financial instability. I also believe that the Euro crises is much worse than most people believe. If one looks at the size of the balance sheets of the central banks in each country one see more and more a fragmentation of the money market. Very few people realize that Germanys Bundesbank is now full of receivables against other central banks. If this trend continues for another 6-12 months, these receivables will approach perhaps a trillion € or 30% of GDP. Added to that the commitment through the bailout mechanism the stability of Germany is very much in question.