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Friday, November 18, 2011

Austerity is the Problem, Not the Solution

And inflation isn't the immediate danger either.

Angela Merkel and the Bundesbank have demonstrated once again that they just doesn't get it. In a speech yesterday in Berlin, she ruled out letting the ECB act as lender of last resort, proving one may have a PhD in physics and still not understand the rudiments of economics (but then, how many economists know anything anymore about those old Keynesian - and Fisherian - canards effective demand, debt deflation, financial panics and liquidity traps).

Instead, German economists are obsessed with the inflation of 1923 ("That path “belongs to the deadly sins of a central bank,” Wolfgang Franz, chairman of the German Council of Economic Experts, an official panel that advises the government, said in an interview with the Frankfurter Allgemeine newspaper" - excerpt from the same NY Times report). This from an old colleague of mine at the University of Stuttgart, who may know some conventional wisdom about labor markets but evidently hasn't an inkling about bank runs, financial panics, cascades in complex systems, and the lender of last resort. The issue is not whether the ECB proceeds to open-endedly finance the deficits of Greece, Ireland, Italy and Spain (soon to be joined by France, Belgium, Austria...), but whether it declares a creditable commitment (like the Swiss National Bank has made) to prevent a firesale of their sovereign debt and a flight to security (to German Bunds, dollars, gold, Swiss francs). Such a declaration would actually avoid having to buy up these country's debt to any large extent, while purchases in drips and drabs without such a commitment just buy time and waste money. (If the commitment somehow were not credible enough to intimidate markets, then the jig is up and we can all go home. But it has to be seriously tried.)

Why aren't German economists more obsessed by the lessons of 1931 - the BrĂ¼ning austerity "Notverordnungen" ("emergency decrees") that induced mass unemployment, spiraling deflation, the collapse of the Weimar Republic, the discrediting of democracy and market capitalism and the rise of the Nazis, which until then had been a marginal party? The inflation of 1923 was ended, not by austerity, but by a currency reform that wiped the slate clean of the domestic war debts (not reparations) that were unredeemable anyway after the lost war. Inflation was a lousy way of doing the job - destroying the life savings of large parts of the middle classes, but the economy then turned around and growth resumed strongly until the New York stock market crash of 1929. (By the way, buyers of German WWI war debt were allowed to leverage their purchases by using previous purchases as collateral, something the American ambassador James W. Gerard, in his memoir "My Four Years in Germany", predicted would bring them no end of grief in the postwar period. Sounds familiar? Securitization avant le lettre!)

They have learned the wrong lesson - 1923 instead of 1931 - and are not going to admit they're wrong. Instead, they apparently will stick to austerity to the end, with one Eurozone country after another being sucked into the vortice of self-imposed sovereign default. Mind you, these are all countries that would have been perfectly viable economically on their own (maybe Greece is an exception...), if they weren't straight-jacked into the Euro corset. None of them was any more guilty of fiscal mismanagement than Germany (Ireland could have regulated its banking sector more carefully, but then it was providing a service to the rest of the EU's risk-loving banking community, acting as a Trojan Cayman Island). What they weren't guilt of was German "Lohndumping" - constraining their wages to stagnation, so that they systemically lagged productivity for over ten years, just avoiding deflation and accumulating cost advantages in the export sector at the expense of domestic demand (Germany having a good traditional industrial specialization in high-end cars, specialized capital goods and industrial chemicals also helped).

So it looks at the moment like we are condemned to relive the gratuitous policy blunders of 1931 (see my 25 Sept blog), with all the consequences like mass unemployment, bank runs, and the rise of xenophobic and racist extreme right parties. All useless sacrifices to the gods of 1923 because, inexplicably, we are unable to learn the lessons of 1931. Even though austerity naively looks like the answer to a debt crisis (belt tightening), in fact, by inducing a collapse of domestic demand and a fall in nominal wages, it actually increases the effective debt burden and induces investors to flee. If we haven't learned this lesson by now from Greece, Italy, and Spain, apparently we never will.

Why don't the lovers of naive economic morality tales and sartorial metaphors reason instead as follows? To pay off our debts, we have to roll up our sleeves, increase employment and work harder (at frozen wages), not fire workers, depress activity, and thereby lower productivity (note to business cycle wonks: productivity is procyclical). Choose your morality tale, choose your historical catastrophe wisely.

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