When you’ve got friends like this – Part 8

I noted a proposal overnight from so-called progressive American economist Dean Baker on Al Jazeera (November 28, 2011) – Time for the Fed to take over in Europe – which suggests that the US Federal Reserve Banks should insulate the US economy from the bumbling leadership crisis and “step in if the European Central Bank fails to deal with the debt crisis”. The proposal is that the US central bank should fund EMU nation deficits. This is another one of cases when friendly fire shoots the progressive movement in the foot. You can read the previous editions When you’ve got friends like this to see what the problem is. The simple point that far from protecting the US economy this proposal would likely cause a collapse in the currency and an inflationary surge that would divert attention of the US government away from creating employment, undermine the real standard of living of workers, and provide new ammunition for those who want to implement damaging austerity. For all that, the US government would only put the EMU nations into a holding pattern anyway.

I agree with the substantive claims that Dean Baker makes:

1. “The European Central Bank (ECB) has been working hard to convince the world that it is not competent to act as a central bank”.

2. “One of the main responsibilities of a central bank is to act as the lender of last resort in a crisis” – although I would note that the concept of lender of last resort has never been applied in the way that Dean Baker uses the term.

As I noted in this blog – Wir wollen Brot!, when economists talk about the central bank playing the role of “lender of last resort” they are referring to the capacity of the central bank to lend to its member (private) banks – that is, provide reserves in return for collateral at some discount (penalty) rate.

That is quite a different concept to the proposal (which I support) of the ECB purchasing government debt (that is, funding budget deficits). This proposal is really to convert the ECB into a “fiscal authority” to fill the gap left by the poor initial design choices made when the currency union was established.

Central banks usually do not play that role although I consider they should. It is clear that the Euro area as a whole does have the monetary resources available to fund all government spending at the member country-level. After all, the ECB issues the currency under monopoly conditions.

If we consider the Eurozone to be a single economy, then the ECB becomes the default fiscal authority in the absence of that capacity being created. The problem then is that as an unelected and unaccountable (to voters) institution, it is unsatisfactory for this role to be devolved to the ECB.

I consider the proposal that the ECB bails out member governments is a short-term palliative initiative to stop the crisis and get growth going again. Ultimately, I consider, as I have been saying for many years, the Eurozone is a failed construct and should be abandoned.

As it stands, the ECB is the only show in town to save the Eurozone from a very drawn out and damaging recession.The member states in the EMU cannot spend without taxation revenue or debt-issuance. The only institution in the EMU that can spend without recourse to prior funding is the ECB. That is the consequence of the flawed design of the monetary system that the neo-liberal conservatives in Europe forced upon the member states at the inception of the union.

In relation to the current reluctance of the ECB to take a major role, Dean Baker says:

It is arguing instead that it would sooner see the eurozone collapse than risk inflation exceeding its 2.0 per cent target.

In fact the ECB is not saying that and is already actively making secondary bond market purchases of bonds from governments which the bond markets will not lend to at reasonable rates at present.

In this recent blog – The ECB is a major reason the Euro crisis is deepening – I provided the most recent data applicable to the ECBs so-called Securities Market Programme (SMP) which was established on May 14, 2010.

You can read more recent information about the programme HERE. The ECB provides the weekly Data (click on the Ad-hoc communications Tab) about the SMP purchases.

As of November 25, 2011 the ECB has bought 203.5 million euros worth of bonds under the programme. The purchases are accelerating each week.

The following graph updates my previous graph and shows the history of the SMP since May 2010 (up to the most weekly statement from ECB – November 25, 2011). The bars shows the weekly purchases (or redemptions) while the blue line shows the cumulative asset holdings associated with the program (now at 203.5 billion Euros).

Clearly they accelerated at times when the private bond markets were withdrawing from tenders (as evidenced by the widening spreads of member state bonds against the bund). The SMP is unambiguously a fiscal bailout package which amounts to the central bank ensuring that governments can continue to function (albeit under the strain of austerity) rather than collapse into insolvency.

I think the correct interpretation of the ECB’s actions at present is that in return for providing the SMP which is keeping the currency union afloat in the short-term, they are enforcing austerity on governments which is really fast-tracking the demise of the union in the medium-term. A series of economies (the member states), which are heavily interlinked in terms of trade, cannot grow by cutting public spending when private spending is weak.

Private spending is weak because there is rising unemployment and no incentive to invest in new productive capacity. The public spending cuts are exacerbating that weakness.

The ECBs role in this stupidity is outlined in some detail in this blog – The ECB is a major reason the Euro crisis is deepening.

Dean Baker then wrote:

It would be bad enough if the ECB’s incompetence just put Europe’s economy at risk. After all, there are tens of millions of people who stand to see their lives ruined because the bureaucrats at the ECB don’t understand introductory economics. But the consequences of a euro meltdown go well beyond the eurozone.

I agree largely with this comment although in what follows we might also be asking who actually understands “introductory economics”.

The fact is that the Australian government’s ridiculous announcement today (November 29, 2011) in its = Mid-year Economic and Fiscal Outlook 2011-12 – to further cut public spending in a slowing economy because the latter is pushing the budget deficit up and they are”determined” to deliver a surplus next year – to hell or high water – has been directly influenced by the Euro crisis.

The substantial loss of tax revenue to the Australian government has arisen because sharemarkets are down on the back of the Euro uncertainty.

It doesn’t justify the response of the Australian government who should stimulate when confronted with an economy that is slowing but it proves Dean Baker’s point that the Eurozone crisis is extending well beyond its borders.

The introductory point that he considers that the ECB fails to understand is that they will not create inflation if they fund all the deficits in Euro and allows them to grow in the short- to medium-term to underpin growth.

There is no inflation risk in the Eurozone at present – rather the opposite is the threat. There are massive reserves of idle productive capacity which can be brought into use as nominal demand rises.

The ECB has inherited the Bundesbank obsession about “printing money” causing hyperinflation.

I have some sympathy for the ECB though in one respect. They were not created to provide validation to the spending and taxation decisions that different governments have made. They are not accountable or responsible for those decisions. I am sure that is not their concern but it should be the only concern.

Monetary systems that are consistent with democracy should always located the fiscal responsibility and the currency issuing sovereignty in the one unit.

Dean Baker is concerned that the Eurozone crisis will damage the US recovery and push into int a second-dip recession because of the “loss of the European export market, and the likely surge in the dollar”.

Unlike all the member states in the EMU, the US government has the ultimate capacity to deal with a slowdown arising from the export sector. It can simply stimulate domestic spending either directly through its own spending or via the private sector by tax cuts, increased transfers and other means.

There should be no knock-on effect to the US economy. If that is happening (and it certainly is in the Australian context) then it becomes the fault of the sovereign government of that nation and has nothing much to do with the ECB.

Dean Baker thinks that the Eurozone crisis has the potential to push US unemployment “into a 14-15 per cent range” which he says “would be a really serious disaster”.

Again, the US government would be the cause of that not anything that happened in Europe. I also was curious about the descriptor – I count 9 per cent – the current rate of unemployment in the US as being a really serious disaster. A rise to 14-15 would be a catastrophe.

But we shouldn’t get stuck on style differences.

What we should get stuck on though is Dean Baker’s proposal to counter all of this Eurozone malarkey. He says:

Fortunately, the Fed has the tools needed to prevent this sort of meltdown. It can simply take the steps that the ECB has failed to do. First, and most importantly, it has to guarantee the sovereign debt of eurozone countries. The Fed simply has to commit to keep the interest rate yields on debt from rising above levels where it risks creating a self-perpetuating spiral of higher debt leading to higher interest rates, which in turn raises the deficit and debt.

This doesn’t mean giving the eurozone countries a blank check. The Fed can adjust the interest rate at which it guarantees debt, depending on the extent to which countries reform their fiscal systems. For example, if Greece and Italy crack down on tax evasion, this can be a basis for allowing a lower interest rate. If they allow their wealthy to freely evade taxes, then this can be a basis for raising rates. The difference between a 2.0 per cent interest rate and 7.0 per cent interest would be a powerful incentive to eliminate corruption and waste.

I won’t comment much on the idea the US would start telling foreign countries what an appropriate fiscal position is or is not. For f*&k’s sake, the US is languishing with 9 per cent unemployment because it refuses to conduct appropriate fiscal policy.

I obviously do not support foreign nations telling other nations how to conduct their fiscal policy just as I do not support a cabal in Brussels or Frankfurt telling Greece or France how to conduct their policy.

Further, I know it is twee for so-called progressives to keep telling us that the solution to the crisis for governments to “make the rich pay” but the reality is that might sound nice and be a useful policy on equity grounds but it is not the solution to the crisis.

The crisis is being extended because there is not enough aggregate demand to drive growth and income. Taking some purchasing power off the rich will probably worsen that situation although it would not be as damaging as taking cash off the lower income groups.

These distributional matters (whether the rich pay or not) should be separated from the main game – which isn’t to say I don’t support higher tax rates for the rich and lower tax rates for the poor.

But the overall tax take should only be designed to ensure the public/private spending mix is suitable for full employment without inflation.

So what a government “takes” off the rich has to be added back anyway which I suspect is not what Dean Baker is thinking when he says that countries need to “reform their fiscal systems”.

Further, the “difference between a 2.0 per cent interest rate and 7.0 per cent interest” that Dean Baker thinks “would be a powerful incentive to eliminate corruption and waste” is smaller than some of the spreads now and hasn’t had that effect as far as we can tell.

What we can say is that “differences” of that magnitude are driving the Eurozone to insolvency. So there is really no US bargaining tool available in terms of this “difference”. Do as we say or go broke is what the idea suggests! Not a very sound basis for policy reform.

However, the substantive objection I have to Dean Baker’s proposal – which amounts to the US Federal Reserve selling US dollars in the foreign exchange market and buying Euros so that they could buy Eurozone government debt – is that it would almost certainly lead to a collapse in the US dollar collapse which would then have a range of consequences – some good (increased trade competitiveness) others bad (increased inflation).

Overall, I assess these consequences as being undesirable at this point and totally unnecessary.

Why would that be the case?

The size of the current deficits in Europe for those nations that are under attack from the private bond markets are substantial.

The most recent Eurostat Euro area budget data (published October 21, 2011) reports a government deficit (in millions of Euro) for 2010 of 572,526 or 6.2 per cent of GDP.

The following graph shows the budget deficits (bars) in millions of Euro and as a percent of GDP (red line – right axis) for the EU16 nations (before Estonia joined on 1/1/2011) in 2010.

If we only consider the so-called PIIGS then their 2010 deficits were 259,990 million euro or 45 per cent of the total outcome noted above.

Note that the ECB has already purchased 203.5 million euros worth of government bonds in the secondary markets and most of those purchases were before Italy came under attack.

To be clear deficits are flows not stocks so these flows have to be funded (in the EMU situation) every year. The numbers will be larger by the end of 2010 but the 2010 figures are sufficient to give you some idea of how large the US Federal Reserve spending (currency exchange) program would have to be.

As of today, the 1 Euro = 1.3294 U.S. dollars. So just purchasing the PIIGS debt to fund their 2010 deficits would have required the US Federal Reserve sell around 347,024 million USD which is about 5.8 per cent of the US GDP over the last four quarters.

That is a huge injection of US dollars into the world foreign exchange markets.

The volume of spending that would be required are even larger than the estimates provided here. That is, because to really solve the Euro crisis the deficits in (probably) all the EMU nations have to rise substantially.

What do you think would happen to the US dollar currency value? The answer is that it would drop very significantly. The word collapse might be more appropriate than drop.

Mainstream economists regularly use the example of the Weimar hyperinflation to express their assessment of the likely impacts on the ECB funding the Eurozone deficits.

Their assessments are erroneous. A rising “money supply” isn’t inflationary. Spending creates inflation.

However, in relation to the proposal that the US Federal Reserve might fund all the Eurozone deficits the experience of the Weimar years is not that inapplicable.

This book – R.L. Bidwell (1970) Currency Conversion Tables: A Hundred Years of Change, London: Rex Collings) – contained the following table which shows what happened to the German mark (against the US dollar and the British pound) during the 1920s.

The Treaty of Versailles was responsible for an acceleration in the depreciation of the Mark although one needs to be a little careful here because the Treaty (through the Reparations Commission set up by the Council of Four) demanded payment of the reparations in gold marks rather than the paper mark plus a cut of Germany’s exports (26 per cent).

The London Ultimatum changed things significantly and essentially ensured that the German currency would collapse and hyperinflation would emerge. On May 5, 1921, the British Prime Minister David Lloyd George demanded that the Germans pay in gold or foreign currencies.

While it is debatable what actually happened (whether the hyperinflation was a deliberate German ploy to undermine the reparations or was caused by the reparations) it is clear that to meet the demands of the London Ultimatum, the German government started selling marks for US dollars at a preposterously increasingly rate.

It was at this point that the currency started to dive which only exacerbated the problem because it increased the amount of markets required to meet the Reparations Commission demands.

By 1922, the currency was in freefall, productive capacity was shrinking fast, and hyperinflation emerged.

The proposal that the US Federal Reserve bail out EMU nations would cause a plunge in the US value. It is not akin to the Central Bank currency swap arrangements that the US Federal Reserve has engaged in since 2007.

At this point in the crisis, there is nothing to be gained by a massive US dollar depreciation and the inflationary impulses such a large depreciation would probably impart.

Who said budget outcomes were under government control?

This headline appeared on the front page of the ABC news portal this afternoon (November 29, 2011) in relation to the story – Swan swings the axe as revenue falls – which reported the Federal Treasurer’s decision to cut government spending (and increase taxes) at a time the Australian economy is slowing.

The Government has been pursuing an austerity program aiming to get the budget into surplus next year. It is a demonstration of ideological obsession with surpluses rather than any sound appraisal of where the budget should be. They have been doing that at a time when private spending is incapable of supporting growth and so aggregate demand is declining.

With the Euro crisis hitting tax revenue, it was obvious that the deficit would rise no matter how hard they attacked spending to get to surplus.

When we will characters learn that you reduce deficits via growth and that requires supporting aggregate demand rather than undermining it?

The only question that seems relevant in relation to the Treasurer’s photo is when did he start modelling his ties on the ECB statue?

Digression

I was reading the material associated with the latest OECD economic outlook and noticed this graphic on the OECD Home Page which they say are their key issues. Each carried a little caption which didn’t seem to copy over (-: so I added my own which I think captured the message they were trying to portray to the world.

It would be hard to come up with anything different.

Conclusion

Progressives should stick to the main game – nifty solutions like the US Federal Reserve bailing out Euro nations – are not only poorly crafted but they divert attention away from the problem – which is a poorly designed monetary system that cannot withstand large negative aggregate demand shocks.

Further, the Eurozone cannot support rising deficits at present unless the ECB intervenes. Progressives should be demanding higher deficits to spur growth. The Europeans can support that themselves while they work out how to dismantle the bodgy monetary system they created.

The former should be their first focus which will give them time to work out the second in a co-operative manner.

That is enough for today!