Austrian economists like Peter Schiff and Jim Grant propose non-intervention combined with a return to the Gold Standard as a solution for the economic crisis. This is basically the recipe that has been let loose on the eurozone periphery, and the result is an unmitigated disaster, but it warrants a larger treatment.
After going through exactly how the eurozone works and why it's so deflationary, it's difficult to understand why the love for the gold standard remains in Austrian quarters. In our view, the evidence is pretty conclusive. We have already discussed the Gold Standard in our first article about Austrian economics, but the fact is, the euro operates very similar as that it forces deflationary policies upon deficit countries when they need exactly the opposite.
It is interesting to see what Peter Schiff, as a prominent current Austrian economist argued in 2010, in reaction to the first Greek bail-out:
The net effect has been to demonstrate that the ECB will monetize the debts of any member-state that has borrowed too much. As this understanding sinks in around the globe, the euro just sinks.
Well, the euro hasn't sunk, in fact, quite the contrary has happened. Schiff would argue that this is because monetization of debt is faster in other major currency areas, but we shouldn't discount the deflationary forces in the eurozone behind this either.
What the ECB has actually done (a couple of years after this), is more fundamental. It promised that if bond yields would rise out of control in the periphery it would, in exchange for the country in question signing up to policy prescriptions, intervene in its bond market as much as necessary.
As we had argued for some time before that promise was made, this mere promise has been enough to calm the bond markets of these peripheral euro countries and the ECB hasn't actually had to use this facility. We're curious whether Schiff is aware of work by Belgium economist Paul de Grauwe on this, as it's central to the understanding on how the euro works.
In essence, de Grauwe argues (and demonstrates here) that countries that don't issue their own currency (like eurozone members) can fall victim to self-fulfilling panic attacks in the bond market that push them into bankruptcy. Compare the situation in which people get scared and sell bonds of a country (say the U.K.) that issues its own currency versus that which doesn't (say Spain).
Money leaving the UK is exchanged for other currencies (leading to an economy stimulating depreciation), but the buyers of these pounds will re-invest it in the country's assets, so it doesn't really leave the country. In extremis, the central bank can buy debt if there are few buyers, the country can't really go bankrupt.
However, money leaving Spain can, without having to be exchanged into another currency, be invested outside Spain, and before the ECB promised otherwise there a buyer of last resort, like the Bank of England. You'll appreciate how a trickle of selling in Spanish bond markets can easily trigger a self-fulfilling vicious circle under these circumstances, and it was under pressure of these kinds of events that the ECB was forced to change track.
You might also note that since the ECB has emerged as a buyer of last resort, eurozone bond markets have calmed a great deal and spreads have narrowed considerably, further panning out de Grauwe's work.
Despite numerous bail-outs, the euro has, contrary to Schiff's expectations, not weakened but strengthened instead, and the mere promise of ECB "debt monetization," as Schiff likes to call it, has improved, not worsened the situation, at least in the bond markets.
However, the eurocrisis is far from over ...
What's much more worrying is that the eurocrisis isn't over, but for reasons that have little to do with what Schiff sees as the weakness, and everything to do with something he favors. Let us explain.
To simplify matter somewhat, the South 'enjoyed' capital inflows in the boom years after the creation of the euro but before the financial crisis.
This led to their price levels rising much faster than the core eurozone countries, so they accumulated a loss in competitiveness over the years, which resulted in large current account deficits (see graph above in which GIPS stands for Greece, Italy, Portugal, Spain).
As a result, their prices are now up to 30% misaligned, and since they can't devalue their currency, these countries forced to go through the arduous process known as "internal devaluation." The latter describes the process by which their prices rise by up to 30% less than those in the core countries, to recoup the lost competitiveness and get their trade balance back to sustainable levels.
Countries don't come any more "core" than Germany, trying to recoup a 30% price level misalignment versus Germany, which has the best anti-inflation track record in the world (bar Japan's deflation record, but that's a distinct mixed blessing), well, good luck to that.
The essence is that prices have to actually fall (or those in Germany and other core countries should rise much faster, but there is little chance of that).
That is, the periphery actually needs deflation to recoup the lost competitiveness versus the core countries. Basically they have to create a massive economic crisis, which increases unemployment so much as to actually lead to falling wages, which will feed into falling prices.
In order to grasp how difficult that is, even in Greece, where output has been falling for 6 years in a row (the economy has shrunk more than a quarter) and unemployment shot up to nearly 30%, prices are not falling yet (although they're very close on doing so).
Being member of the euro makes it actually quite easy to create that recession, as the peripheral countries can't do anything to stimulate their economy, they're in a deflationary straitjacket:
- They can't devalue their currency
- They can't lower interest rates or embark on other monetary stimulus
- Instead of fiscal stimulus, they have to embark on austerity
In short, this is just what the Austrian economist like Schiff would order. Let recession cleanse themselves, government and central banks should not try to do anything against this natural cleansing process.
How did that work out?
Not so good. You might also want to remember that we already argued in the previous article that the euro works just as the gold standard did in the 1930s, and that Schiff is an ardent supporter of the gold standard and wants it introduced in the US ASAP.
Do we need any more proof that the Austrian policy prescription, a combination of a fixed exchange rate regime and lack of stabilizing macro policies is a recipe for disaster under the present circumstances? What we need is exactly the opposite, flexible rates and active macro policies.
But it gets worse. In our first article we've quoted how Schiff isn't afraid, in fact, actually welcomes deflation. Now, look at the figure below:
You see that public and private debt together, whilst falling a little, stand at over 345% of GDP. What do you think falling prices will to the real value of that debt, and what would the consequences for the sustainability for these debt levels be?
Austrians often point to Japan as the great Keynesian disaster, but in fact, it could just as well be called an Austrian disaster, as Japan let deflation set in, albeit a particularly mild form of it. All that Japanese stimulus was clearly insufficient, otherwise this would never have happened. That's one reason how Japan ended up with a public debt/GDP ratio of over 200%, the highest in the world.
The eurozone, where the Austrian cocktail of no (monetary or fiscal) policy stimulus with a fixed exchange rate system that, just as the Gold Standard in the 1930s, forces deflationary policies on member countries rules, there is something else happening, which is even more nefarious than what has happened in Japan.
Because wages and prices have more downward resistance in the eurozone, deflation is actually very hard to engender. We've already discussed that this makes adjustment for competitiveness losses terribly difficult, in essence a massive economic crisis is created to discipline wage and price setters.
But here, the nefarious effect on debt dynamics is not via falling prices, as in Japan, but through the "denominator effect." That is, nominal GDP is falling, not through falling prices, but because of falling production. The result is the same as in Japan, but worse.
Falling nominal GDP automatically increases the public debt/GDP ratio. But this denominator effect is reinforced because public deficits rise as well, as falling production increases unemployment, reduces the tax base and increases social spending. These countries have to run ever harder to stand still.
The Austrian recipe of laissez-faire on macro-economic policies, combined with Austrian love of fixed currency systems, is one of disaster. The fact that in the 1930s, countries who abandoned the Gold Standard the fastest were also the fastest to recover isn't an accident.
These countries could devalue, recoup their lost competitiveness, and liberate themselves from the deflationary straitjacket that is a fixed currency system. We cannot fathom why anyone would recommend such a system, much less as a proposal to solve the present economic crisis.
If you have doubts about that take a look in the modern day recreation of this deadly combination of a deflationary straitjacket and a fixed currency, they have to go through the arduous process of "internal devaluation" to recoup competitiveness, but in the process either falling prices or falling GDP (or both) explodes their already very problematic debt-dynamics.