When the 1930s start looking like the good old days...

Nicholas Crafts suggests that when it comes to European currency-zone problems and debt burdens, the 1930s looks better than today in some ways. (The Eurozone: If only it were the 1930s VOX 12/13/2013)

Like many discussions of available ways that the euro crisis could be resolved in a constructive way that further European unity and strengthen the institutions of the European Union, it winds up being things that Germany under the leadership of Chancellor Angela "Frau Fritz" Merkel are highly unlikely to permit.

The implications of this discussion are quite uncomfortable. They are that, under the present agreements to resolve the crisis, several Eurozone economies face a long period of fiscal consolidation and low growth. For these countries, different rules of the game with regard to financial integration and, in particular, a different sort (1950s-style) of central bank would ease the pain. An ECB designed to make life easier for the debtors would have a higher inflation target, hold down interest rates for longer, and help in eliminating some of the debt overhang. Obviously, this is not a central bank for normal times – nor is it a design that Germany could contemplate – but in a depressed economy with a debt problem it might be more appropriate. The implicit fault-line within the Eurozone is evident. [my emphasis]

The gold standard in the 1930s became a similar economic straightjacket to what the eurozone has become today to Cyprus, Greece, Ireland, Italy, Portugal and Spain:

It is well-known that staying on the gold standard in the 1930s increased the severity and duration of the economic downturn (Bernanke 1995). It is commonplace to note that leaving gold allowed a return to independent monetary policy, was conducive to the end of price deflation, permitted policies that could change inflationary expectations, and facilitated necessary adjustments of real wages. It is less widely remarked that exit from the gold standard could make the achievement of fiscal sustainability and the reduction of public-debt-to-GDP ratios much less painful. The experience of the UK illustrates the point.

For the UK, leaving the gold standard made the fiscal arithmetic of dealing with the large overhang of public debt from WWI much less daunting.

This problem with the gold standard is a basic macroeconomic lesson from the 1930s. But the Very Serious People in Europe and the US seem effectively unaware of them.

And the expected results look grim. As Crafts explains in language whose restraint doesn't hide the seriousness of the point he's making:

The rules of the Eurozone prescribe a gross government debt ratio of 60%, and the debt-convergence rules adopted in the light of the crisis indicate that 1/20th of the excess over this level shall be removed each year. The OECD (2013) calculates that to stay within this rule for every year from 2014 to 2023, Greece will have to maintain a primary budget surplus of about 9% of GDP, Italy and Portugal about 6% of GDP, and Ireland and Spain about 3.5% of GDP. Table 3 shows that in the past, equivalently large reductions in debt ratios have to a large extent depended on favourable interest rate/growth rate differentials. It is difficult to see this being repeated in a slow growth environment where monetary policy is run by the ECB.

If fiscal orthodoxy is the route back to Maastricht, this will entail a long period of high public-debt-to-GDP ratios. The implications of this are unlikely to be favourable for growth, and could have a significant negative impact. Although the claim of a 90% threshold beyond which growth declines sharply is probably not robust [i.e., not based on reality - Bruce] the evidence does suggest that growth is likely to be adversely affected by high debt ratios (Egert 2013), and continuing fiscal consolidation will undermine growth in the absence of offsetting policy stimulus. The experience of the interwar period suggests that prolonged stagnation entails risks of incubating political extremism (de Bromhead et al. 2013) and anti-market sentiment. Given that maintaining the budget surpluses required in order to eliminate the debt overhang is quite possibly beyond what is politically feasible, the risk of further defaults is non-trivial (Buiter and Rahbari 2013). [my emphasis]

Crafts' list of useful measures is sad, not because they aren't sensible but because Frau Fritz is so unlikely to let them happen:

As the interwar experience underlines, a key starting point is for the ECB to ensure there is no price deflation in the Eurozone.

Unlike the death-to-banking-union banking union agreement that Frau Fritz just got approved, which is likely to increase the deflationary pressures the eurozone is already experiencing.

Then, the alternatives to fiscal consolidation as a means of reducing public debt ratios are well known, namely, financial repression, debt forgiveness, or debt restructuring/default.

All heresy to Frau Fritz and her "ordoliberal" economic outlook.

Financial repression works on the interest rate/growth rate differential by way of the government being able to borrow at ‘below-market’ rates. Current EU rules severely limit the scope for this.

And Merkel likes it that way.

History suggests that a combination of financial regulations designed for the purpose, the re-introduction of capital controls, and a central bank willing to subvert monetary policy in the interests of debt management might be required.

Capital controls would be screaming heresy to Merkel's ordoliberalism as well, though this year's Cyprus arrangement included limited capital controls. But as a general rule, capital controls contradict the entire concept of a currency zone. Adopting widescale capital controls would be an admission that the euro was in a critical state, which it is. It would also be something German finance would seriously frown on, given the huge benefit they currently receive from capital flight to Germany and Germany's huge, now more-or-less protectionist levels of trade surpluses.

Debt forgiveness would be very expensive for the creditors – forgiving a quarter of the debts of Greece, Ireland, Portugal, Italy, and Spain would cost about €1,200 billion – and, in the absence of watertight fiscal rules to prevent a repeat, risks a serious moral hazard problem.

It would also hammer German banks and force the German government to deal with the weaknesses of its banks. It would be impossible to make it look like they were not hitting up the German taxpayer big-time to do so. Avoiding just that was the immediate reason that Frau Fritz embarked on her disastrous insistence starting with the Greek bailout that countries over-burdened with debt take on additional debt rather than get debt reduction: so that German banks wouldn't be hurt by losses on Greek and other eurozone debt.

The "moral hazard" that a debt haircut might create for countries currently carrying debts they will never be able to fully pay off is dwarfed at the moment by the pro-cyclical effects of austerity policies during a depression.

Paris and Wyplosz (2013) suggest that forgiveness could, however, play a part if the ECB were to buy up government debt in exchange for perpetual interest-free loans – in effect monetising part of the debt.

Also heresy for Merkel's ordoliberalism, which would see that as "moral hazard," as well.

Tags: angela merkel, austerity economics, eu, euro, european union, greece