Tuesday, June 26, 2012

Be Careful What Lesson You Learn

Many of us are watching transfixed with horror at the ongoing mess in Europe.  It's the low-grade horror of a large slow-motion disaster movie.  I want to talk about the reasons for the disaster, and how it could be (or could have been) different.

One of the major reasons for the disaster is the design of the European Central Bank (ECB.)  The ECB is and is not like our Federal Reserve.  An important difference is that the ECB cannot buy government debt.  This means that in times of economic crisis, the ECB cannot step in and act as a "lender of last resort", one of the historical roles of a central bank.

Why this limitation?  Because the Germans, as a condition for creating the Euro, required that the sole role of the ECB was price stability.  This is because the Germans have a visceral fear of hyperinflation.  You can understand their reasoning.  Hyperinflation in Germany in the 1920s led to an unstable political environment.  That environment helped the rise of Hitler and the Nazis.  Not wanting a repeat - let's make sure we never have hyperinflation.

But what if the Germans learned the wrong lesson?  In 1919, after the Peace of Versailles, John Maynard Keynes wrote a book called The Economic Consequences of the Peace.  Three important facts about the post-war (WW I) world are:
  1. The world went back on to fixed exchange rates (the gold standard.)
  2. The fixed exchange rates were  at the wrong level, causing persistent outflows from Germany
  3. Huge wartime reparations were imposed on Germany, which it was in no position to repay.
So with this setting:  what was Germany to do?  The government financed itself by simply printing money, leading to the hyperinflation and the rest.  But was the hyperinflation the source "cause" of the subsequent problems, or just an intermediate symptom?  Instead of blaming hyperinflation, the lesson should be the underlying forces that led to the hyperinflation.

Consider the parallels with today.
  1. The Euro-zone countries are locked into a fixed exchange rate, similar to the gold standard.
  2. Some countries in the Euro-zone are not currently competitive, using the exchange rate under which they entered the Euro.  Instead of printing money, as in the 1920s, the Euro-zone countries or their banks ran up high levels of debt, which everyone else pretended (for a long time) were repayable.
  3. Huge repayment plans are being imposed on some countries, which they will not be able to repay for decades, if ever.
So what is going to happen?  The austerity programs being imposed on the debtor countries are politically unsustainable.  Radical parties of the right and the left are on the rise.  The Germans think the solution is even more austerity and putting them in charge.

Without a different mindset, this won't end well.  The lesson to be drawn from the 1920s is not "avoid hyperinflation at all costs."  Instead, the lessons should be
  • Avoid impossible fixed exchange rates between differing economies, and
  • Don't impose impossible debt payment plans.
If you don't learn these two lessons, then as Keynes noted, there will be consequences.