Speed and Overwhelming Force Meet the Two Deadly Sins

Yesterday I pilloried German economist Wolfgang Franz for what he viewed as the"deadly sin" of central banking: intervening to support illiquid/insolvent governments.

With a credit crunch in the Eurozone looming and ECB President Mario Draghi passing the buck to EZ governments and the EFSF to do the rescuing themselves, I find the words of former IMF chief economist Simon Johnson, writing in 2009 in the Atlantic Monthly, salutary:

In a financial panic, the government must respond with both speed and overwhelming force. The root problem is uncertainty—in our case, uncertainty about whether the major banks have sufficient assets to cover their liabilities. Half measures combined with wishful thinking and a wait-and-see attitude cannot overcome this uncertainty. And the longer the response takes, the longer the uncertainty will stymie the flow of credit, sap consumer confidence, and cripple the economy—ultimately making the problem much harder to solve. Yet the principal characteristics of the government’s response to the financial crisis have been delay, lack of transparency, and an unwillingness to upset the financial sector.

Of course, he's referring to the US Treasury and the Fed in 2008/2009, but it describes the Eurozone and the ECB even better.

Thus we now have two deadly sins of central banking: ongoing monetarizations of government deficits, and failure to decisively prevent a financial panic. Looks like we are going to get two for the price of one.

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 Brüning 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.

Last Man Standing

Now that it is clear that the Eurozone is in a free-fall unraveling (see e.g. Wolfgang Münchau in Der Spiegel), with panic enveloping the sovereign debt of every country except Germany (even such paragons of virtue as the Netherlands and Finland), the solution is clear. If Germany will not agree to the ECB acting as lender of last resort, as somebody must to stop a financial panic, then it should leave the Eurozone and let the remaining countries put their house in order themselves.

This is much simpler without Germany than with it:

1. First, the rump Euro will devalue with respect to the new DM, restoring the rump EZ's competitiveness with respect to Germany (Germany was always the outlier in the unit labor cost ranking);
2. The remaining EZ members can abandon the masochistic and self-defeating austerity approach (not that this absolves them from other important reforms);
3. Germany will be left sitting on devalued Euro sovereign debt and will have to massively bail out its banks;
4. Everyone else will enjoy windfall profits on the appreciating German sovereign debt they own (assuming it is redenominated one-to-one into DM, as it must be for German domestic creditors);
5. The rump EZ can finally empower the ECB to act as lender of last resort and restore their national creditworthiness. (Greece might still be a problem...)

Hats off to Germany for being the last man standing, but it will be a Pyrrhic victory over its European partners that will only bring it grief. A serious attempt to create a workable, mutually advantageous Eurozone would have been preferable, but too much Borniertheit stood in the way. RIP

Post mortem exam question for economists: why was a domino effect hidden within the governance structure of the Eurozone, but not in the Dollar, Pound, RMB and Yen zones?

We Now Welcome the Financial Times Deutschland to Meltdown Economics

Thomas Schmoll in today's Financial Times Deutschland calls it "core meltdown" - the exploding spreads between German Bunds and other Eurozone bonds, now including even previously healthy states like Austria and the Netherlands. Welcome to meltdown economics!

This is something many of us have been predicting for months. If you build a leaky, ramshackle boat (the Euro currency zone) and pilot it against the laws of effective demand, bailing out water with a small bucket once it starts falling apart is not going to help for long. And drilling new holes below the waterline (aka austerity) does not help things either. You need an immediate battening of the hatches (a credible and unlimited commitment of the central bank to scare off attacks) and a plan to increase buoyancy (create effective demand).

The problem with the Euro was that it had secret little time bombs built into it. Once they were activated, they took on a life of their own. There's no point blaming the markets or the speculators. If you build in false incentives and governance structures and no automatic stabilizers, once the ship starts capsizing the process only gains momentum as people rush around on the deck, every man for himself.

It's a lot like nuclear reactors. The uranium fuel is clad in zirconium cans. Once the core exceeds a certain temperature, the zirconium starts reacting with the cooling water and releases hydrogen (something experts for years denied could happen). Any spark will now set off a hydrogen explosion, leading the reactor to self-destruct. Blame the spark, blame the operators (Chernobyl), blame the tsunami (Fukushima)? Or blame the design, which was inherently unstable to a loss of coolant accident such as could be triggered by a single valve jamming (Three Mile Island).

Martin Wolf on Rome's Burning

Martin Wolf in the FT makes an interesting case for Europe (i.e., Germany) saving Italy from self-immolation. Unfortunately, he seems to suggest that this can only be done by Germany coughing up lots of dough. Why this is both economically and politically not a sensible approach is explained in my comment on his article (but his charts are well worth examining - click on the link on the left half way down the text):

What is more important than new governments in Italy and Greece is a new economic approach in Germany. Letting the ECB act as lender of last resort and pursuing German expansion and upward wage revision would be a much more effective and socially just approach than deflation and austerity in the periphery. It would not even cost Germany anything, would compensate in a timely manner for the slacking off of external export demand, and address the competitiveness problem constructively. The notion that Germany should bear the costs of a periphery condemned by its own wage restraint to basket-case status is economically senseless and a political nonstarter. Especially when a mutually profitable solution is available - core expansion - once the blinders of received wisdom are abandoned. If the new Italian and Greek governments' only raison d'etre is to force more deflation on their peoples their prospects are bleak.

German Intransigence Crumbling as EZ Spreads Explode?

Deutsche Bank chief economist Thomas Mayer, in today's Financial Times Deutschland, calls for "unlimited commitment to intervention" from the ECB to stop the collapse of the Eurozone as spreads on Italian, Spanish and French bonds over German Bunds get out of hand (see yesterday's blog "Is France Next?"). This just after Bundesbank President Jens Weidmann reiterated the no-lender-of-last-resort orthodoxy yesterday (blog "All Quiet on the German Front"). Will the walls of German orthodoxy crumble before the Eurozone is toast? If the Deutsche Bank can see the light, there's still hope for the Bundesbank and the German government. But is there time?

Let the EconoMonitor Speak (While I Get Back to Explaining the Industrial Revolution)

You won't find more trenchant analyses of the Euro crisis than these blogs on Roubini's EconoMonitor (from ‘EconoMonitor Highlights,’ 15 Nov. 2011). The complacency and sangfroid of Jens Weidmann yesterday in Frankfurt in the face of an oncoming freight train called market panic/the "Lehman moment" are breathtaking (see Jack Ewing in yesterday's NY Times).

We are now thinking about the unthinkable. Many are saying that we are watching a slow motion train wreck as the risk is rising that the Eurozone will break up. So now what?  Nouriel Roubini, Rebecca Wilder, Randy Wray and William Oman weigh in:

• Why Italy’s Days in the Eurozone May Be Numbered by Nouriel Roubini

• Rising Risk of Eurozone Breakup by Nouriel Roubini

• Eurozone Crisis: Here Are the Options, Now Choose by Nouriel Roubini

• European Policy Makers Don’t Understand But Markets Do by Rebecca Wilder (The Wilder View)

• Is This the End of the Faith-Based European Monetary Union? by L. Randall Wray (Great Leap Forward)

• Europe’s Perfect Storm: When Possibility Meets Actuality by William Oman (RGE Analysts Blog)