From a November 9th note to our clients:
U.S. stock markets were down fairly hard yesterday, between 3 and 5%, due to growing fears around Europe. The punditry seem to be laying most of the blame on Italian Prime Minister Silvio Berlusconi, but while he has certainly not helped things, this is nonsense.
The problem in Europe is that almost no one has a grasp of gross-versus-net financial assets. In a financial economy (i.e., one with credit), under any type of monetary system, some sector of the economy has to supply new, unencumbered units of money (or interest-bearing government debt) on a perpetual basis (i.e., a financial economy requires some sector to run ongoing deficits of something that will allow it to keep stable account of its ongoing production of other things, including financial assets). Under the gold standard, it was gold mines running "deficits" of gold in order to add to the money stock. Under modern monetary standards (pdf), it’s sovereign governments, either through a fiscal authority perpetually spending more than it takes in with taxes, or a central bank expanding its net liabilities (which typical central bank asset sales and purchases, even the permanent ones, don’t do), or some combination of the two.
In 1973, the U.S. and most of the world moved off of a gold standard and onto our modern fiat system of inconvertible paper money. However, mainstream macroeconomic textbooks never fully accounted for that move. In the wake of the Great Depression and World War II, and with the tailwind of the Baby Boomers in the last three decades of the twentieth century, there was so much room for private sector credit growth that governments could run relatively small deficits and the global economy still grew at a healthy pace. So the old assumption (which is correct when money is something external like gold) that there was a difference between a government borrowing money via bond issuance and a government printing money was never properly re-examined (economist Abba Lerner was a notable exception, as was Wynne Godley more recently). Economists also mis-measure inflation and ignore factors like population age structure (for example, the Baby Boomers entering their household formation years in the 1970s were a huge factor in the so-called inflation of that era).
As a result, 90% or more of the economics profession believes (1) that it’s more prudent (indeed, virtuous, as some view it as a morality play) for governments to tax and borrow in order to finance their expenditures, and (2) that any time a central bank purchases a financial asset with newly created money, it is “printing money” and expanding the money supply, which will inevitably cause inflation or hyperinflation. But these beliefs are just plain wrong, and they're destroying the European Monetary Union (EMU or eurozone) today and threatening the U.K., Japan, and now the U.S.
Greece’s government debt was problematic, but by itself it was not going to bring down the global financial system or world economy. But the most recent rescue package from the European Union (EU) was so badly designed that it has caused buyers of Italian government debt to go on strike (legitimately, at least until Italian debt is selling at 50 cents to the euro or less). And now interest rates demanded of Italy are too high for it to ever successfully service given its much lower expected rate of domestic economic growth.
The result is that the world’s fourth largest issuer of government debt now stands on the precipice of a debt default crisis, which is a very big deal. When you take the size of Italy’s outstanding debt, global systemic financial leverage, and prevailing economic and political stupidity into account, the potential outcomes look really bad — as bad as or worse than the 2008 financial crisis. According to one anonymous Federal Reserve official, when they carried out eurozone-related stress testing of U.S. banks, it all looked OK until they simulated Italy going under. The official, summing up their findings, said, “if Italy goes, God help us all.”
There are several key points:
- If Italy were still monetarily sovereign (i.e., had its own central bank like the U.S., U.K., Japan, Canada, et al), it could manage this crisis rather easily. But its government ceded sovereignty to the EMU and European Central Bank (ECB) when it decided to join the eurozone.
- The ECB has all the necessary firepower (as it and it alone can create an unlimited supply of new euros) but (1) EMU rules essentially put it in a straitjacket and (2) many of its members live in mortal fear (erroneously — see the macro textbook point above) of reliving the hyperinflation of 1920s Weimar Germany.
- The EU’s European Financial Stability Fund (EFSF) could potentially step into the breach and backstop (start buying) Italy’s debt, but it doesn’t have anywhere near the authorized capital required to do so. And what capital it has is collected from EMU taxpayers and outside investors and lenders, because the EMU as a whole doesn’t demonstrate any understanding of soft currency economics (the euros required can come from only one place — the ECB).
Worst of all, while sovereign nations and the EMU have all of the tools at their disposal to prevent this from happening, they aren’t likely to act until the damage to the financial system has brought the real global economy (i.e., the things that people outside of the financial industry casino do for a living) to its knees. And at current un- and underemployment levels in many parts of the world, that’s not just one more grotesque display of agency malfeasance by my industry and the political class — it’s unnecessary, unjust, and just plain immoral. I only wish that the 99’ers (99 weeks or more unemployed and the 99 percenters) as a whole had a firmer grasp of the problem (continued education disinvestment will ensure that this wish becomes a pipe dream).
It’s fair to ask whether a more activist ECB would cause inflation. There’s a risk of inflation in all monetary systems, but especially with soft currencies like today’s that can operationally be created out of thin air. But it's first important to realize that inflation is the only constraint on the world’s ability to resolve the European debt crisis. (And as the Great Depression and other episodes show, resolving a debt crisis is likely to just lessen deflation rather than cause inflation). As noted above, inflation is an abused and widely misunderstood term (how many times have we been promised hyperinflation and exploding interest rates in the U.S. and Japan, and yet we only see it in countries like Greece and Italy that don’t have the ability to “print” money?). It’s also a chronically mis-measured and over-estimated variable according to current academic research, viz (emphasis added): “[In] the United States, we found that most of the movements in conventional measures of inflation ... are due to relative-price changes. Only around 15-20% of the movements in these measures of inflation correspond to pure inflation …”
In a better world, governments would be focused first and foremost on putting people back to work and ring-fencing the global financial system from the real economy, and we would be able to legitimately concern ourselves with potential (and actual) inflation. Instead, we’re forced to endure chronic un- and underemployment, economic growth and investment well below potential, a series of policy errors worldwide that would be comical if not for the human suffering they cause, and policymakers throwing up their hands and saying that there’s little more that governments can do. Even the staunchest government debt Cassandras should be able to see which of these is the greater insult to future generations.
That's the end of today's rant. For less politically charged reading, you might enjoy our look at October’s astounding stock market performance.
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