Summary: As Europe’s governments (and perhaps the US as well) repeat the economic policies of 1929-32, this guest post by Andres Drobny (see bio at the end) warns of the consequences. Government leaders back then did the best they could with the economic theory then available; today’s leaders have no excuse.
Contents
This is written as a dialog, somewhat like those of Plato.
- Smart Guy #1 asks about the coming inflation
- Andres replies: about the Gold Standard, the Euro, and Deflation
- Default and hyperinflation
- Our situation today
- A discussion about the policy response to excess debt
- About the author
- For more information
(1) Smart Guy #1 asks about the coming inflation
While I see some near term deflation, I the inflation I expect long term may come sooner rather than later. US inflation is printing at 3.9% headline, 2.1% core; European Inflation is 3.0% and has been rising; and EM Inflation is about double those. Every central bank in the world is running administered rates at -2% to -3% real (which is almost unprecedented). For the possible result see Michael Murphy’s “Is Default Deflationary?“, Seeking Alpha, 4 December 2011 — Excerpt:
I take a behavioral approach in my book, Survive the Great Inflation: How to Protect You Family, Your Future and Your Fortune from the Worst Fed Regime Ever. I contend that Fed Chairman Ben Bernanke is an expert on deflation and an avowed enemy of deflation, and will do everything in his power to prevent it. His power includes an unlimited checkbook, right up to the day people and governments refuse to accept the U.S. dollar for goods and services. Those who say: “The Fed is out of bullets” take the chance of facing a central bank firing squad any day that, as we learned on November 30, has many bullets left, indeed.
Furthermore, I believe that one of the biggest of those bullets is sovereign defaults because a default extinguishes debt. Deflationary pressures come from debts, interest rate burdens and the austerity required to pay the interest and reduce the debt. As demonstrated repeatedly, most recently by Iceland, default relieves deflationary pressure faster than trying to repay the debt.
(2) Andres replies: about the Gold Standard, the Euro, and Deflation
Towards the end of the roundtable last week one participant suggested that the financial crisis will end only after the US abandons its fiat currency regime and returns to a gold standard. I’ve heard that argument from Ron Paul and commentators on Fox News. Occasionally the idea even gets out to the Lamestream media.
My complaint is not that there is something intrinsically wrong with the concept of a gold standard — or that of fixed, pegged, or floating peg currency systems. All systems have their deficiencies. Of course fiat currency systems and flexible exchange rate regimes have problems. Overshooting is more likely in such regimes, which probably means more bubble and bust cycles. Things seemed more stable under the original Bretton Woods regime than the current Bretton Woods II system {see Wikipedia}. That, I think, was one of the points made by that participant.
But in making his argument, and with what I’ve heard in the media and cyberworld, a crucial point is missed. The government must set the peg to gold accurately, avoiding the mistake the UK made in April 1925. If set too high you get a deflationary bias. Too low a rate can generate an inflationary bias. That’s the risk today. Germany is cheap within the Euro area, so if they save the system, the Bund could be dogs’ meat.
The Euro system didn’t start that way. Germany started expensive in the euro area; Greece and the other peripherals started cheaply. They lost competitiveness over time, presumably because underlying German productivity was higher. Unless Germany accepts higher inflation, the peripherals have to experience deflation — falling wages and prices — to keep up. That’s what the Euro area problems are all about.
This leads to a wider point with a gold standard system. The member countries need to experience reasonably convergent economic performance. Otherwise trouble will eventually emerge. If economic performance across member countries is ‘sufficiently’ divergent, then a gold standard can create real havoc. As we’ve just seen in the Euro area.
That’s also why people around the world complain about the Chinese and Asian currency levels. By fixing them low to the US Dollar (USD), they keep the USD standard alive (though their ever-increasing purchase of Treasury debt as foreign reserves), and thus constrain the adjustment mechanism until a big enough crisis emerges. One-time revaluations (increasing the RMB vs. the USD) aren’t the right answer here. The crawling peg (periodic small increases) is likely to prove better unless Chinese productivity growth softens towards US and global levels (faster wage inflation in China also helps equilibrate things). That issue is for another day.
So, alas, a gold standard is hardly a panacea. Even if you fix the currency at the ‘right’ level, trouble will eventually come if countries diverge in underlying productivity trends. It’s inevitable. Sorry. There’s no silver bullet.
(3) Default and hyperinflation
Now, regarding your specific comments regarding default and hyperinflation: of course default (involuntary deleveraging) is faster than protracted voluntary deleveraging. And, yes, the great hyperinflations were apparently initiated by default, followed by budget deficits that were money financed. Absolutely.
And, default releases the indebted. They no longer must pay back the debt, though they will now be left with little to no funding to spend over their income levels. But at the cost of the creditor taking a hit. And the potential that they will pull credit lines from the next guy. Someone has to pay for the losses.
But it’s simply a fallacy to suggest that the deflationary effects are ‘extinguished’. Sometimes they are only just starting. Like on 15 September 2008. That’s when default starts a domino effect.
You see, it’s not about the initial default or deleveraging, but the policy response to the phenomenon. What’s led in the past to hyperinflation, or protracted depressions for that matter, is the policy response that followed a default. In 2001, Argentina defaulted and then devalued by 300% and got some inflation, and good growth. Iceland is another example. Typically these examples are of small countries.
At the other extreme is the 1930’s, where the policy response was all wrong. They tightened as budget deficits rose and the gold system came under scrutiny. Much of the private sector debt was truly extinguished! Yet it took 10 years of real hardship (the great depression) before things really got tough — and the awful saga of WWII in the 1940s. That boom to bust cycle was hardly fast, nor effective. It was one of the world’s greatest disasters. Quick default didn’t reduce deflationary pressures, nor speed up the adjustment.
(4) Our situation today
So far in our great experiment we are in between these outcomes. A historically large debt bubble has bust and created a historic requirement for deleveraging. Governments have responded with a policy stimulus of historic proportions. This has stretched out the process, leaving us vulnerable over time — but preventing the worst ravages of deflation.
I hope you are right about inflation. Inflation provides the best way out of a debt crisis, especially if we avoid another wrenching process of historic proportions. I hope there’s enough stimulus out there so that inflation becomes the next problem.
But what if there is not enough stimulus? The policy makers don’t seem confident they’ve done enough. If the authorities haven’t provided enough stimulus to stop deflation or policy tightening becomes acceptable around the globe, then things must get a lot worse before the monetary and fiscal spigots get turned on all the way.
So your instincts may well be proven right in the long run. In the end game. But the specific path by which we get to hyperinflation is crucial. It’s an old point. As Keynes warned long ago, you may be right about the long run, but may not be in a position to actually experience it! This was in criticism, before the fact, of the classical laissez faire position of just letting a bust work its way through.
I have been agnostic about whether the policy makers will succeed here. It depends on policy.
Recently policy has been pretty ugly, adding to the risks of another deflationary spiral. The adherence to Europe’s version of the gold standard, at a time of clear divergence in economic trends by member states, is a crucial part of that. So too is the chorus inside the US arguing for tighter money, or fiscal austerity. It’s the 1931-32 mistake. This might well eventually end up in hyperinflation. But probably via an ugly deflationary accident along the way.
(5) A discussion about the policy response to excess debt
Smart Guy #1:
I agree that the deflation/inflation cycle (whether it lasts a millisecond, a quarter, year, or my lifetime) largely depends on government policy. As you suggest, the debate between Austerity and Prolificacy dates back to at least Mellon/Roosevelt — and surely before.
The Inflation Targeting literature (which goes back 3,000 years to the Hippocratic Oath, which states “first do no harm”), suggests that rather than trying to manage the economy via monetary policy, the “best” society can hope for in terms of monetary policy is that the policy makers minimize the uncertainty investors face when making long term capital investments (ie, volatility in the price of outputs generated by their fixed investment) by simply targeting stable current inflation (at about 2%).
“Best” here means the highest productivity, lowest long run unemployment, highest real wages, highest real returns on capital, etc. I assume Bernanke agrees, given his place at the nexus of this literature. He obviously waivers when practicality interposes, as recently when he alluded to “flexible inflation targeting” and [paraphrased] “dual mandate, including addressing high unemployment”.
The ECB (ie, Bundesbank) obviously has focused on price stability. How will they choose when faced with the choice between “no Euro” and a “soft Euro”?
Andres replies:
I don’t believe you are right about the ‘inflation targetting’ literature. It’s the opposite. You are supposed to inflate aggressively if you are targeting inflation and enter a deflation. Bernanke has done precisely what monetarists, including Milton Friedman, have always advocated.
Keynesians argue that this may not be enough and that fiscal stimulus should also be used. It is dangerous to suggest that policy should remain steady in an environment of default risk. Though obviously not as dangerous as the crazy argument for sound money in a high default risk environment — the idea, heard all too often these days, that monetary and fiscal policy should be tightened now.
SG#2 replies:
This is an excellent explanation of how imbalances ultimately need to be reduced by adjustments in currency and relative inflation rates. Adding large debts to this only makes the adjustments that much harder because debt is priced in nominal terms. Allowing for the debts to be reduced over longer time frames by way of inflation is always more palatable than a hard default politically. Part of this is explained by the fact that 99% of the world are debtors and therefore benefit from this approach. Creditors perceive the inflation as a violation of their social contract and thus pine for “real money” like gold or “price discovery” though hard defaults.
I am very skeptical of both these options but they always “appear” attractive ex ante. Further those who argue for this purity are usually able to persuade some of the debtor class to follow this because of its philosophical appeal, or the perception that anything is better than the long slog. This describes the challenge for the political class in the West: avoiding the perception of a quick solution. Bernanke warned that the toughest thing would be to stay the course for a long time. Any path we take will create economic volatility, another issue as well.
Andres replies:
We agree. The political aspect adjustment after a bubble consists of distributing the losses across groups or classes.
But — adding large amounts of public sector debt to keep up demand as private sector deleveraging occurs does help with the adjustment. The biggest creditors — Germany and China and Japan — should do the bulk of the stimulus. That would help resolve imbalances around the globe while limiting the deflationary tendency of a deleveraging process. That is more important than the specific currency regime. I’d rather see another round of China and German fiscal stimulus than changes to currency parities.
(6) About the author
Andres writes the Drobny Global Monitor, acting as the thought leader of the DGA membership circle — helping to keep the discussion intellectually honest, highly focused and profitable.
Before starting Drobny Global Advisors in 1999, Andres Drobny served as Chief Strategist and proprietary trader at Credit Suisse First Boston in London and NY from 1992-1998. While at CSFB, Andres was also on the Global FX Management Committee and a partner in the Leveraged Investment Fund. Prior to CSFB, Drobny was Chief Economist and Head of Research at Bankers Trust London. Before entering the financial markets, Andres was an academic economist at Cambridge and the University of London.
Andres Drobny holds a PhD in Economics from King’s College Cambridge, a Masters from London School of Economics and a Bachelors from Tufts University. When not in front of his Bloomberg, Andres can be found playing soccer or hanging out with friends at his compound in Venice Beach.
Other guest posts by Andres Drobny:
- Economic theory as a guiding light for government action in this crisis, 10 March 2009
- Explaining the government’s response to the financial crisis, 3 December 2009
(7) For more information
Posts about the gold standard:
- Government policy errors as a cause of the Great Depression, 1 November 2008
- Everything written about the economic crisis overlooks its true nature, 24 February 2009
- Fetters of the mind blind us so that we cannot see a solution to this crisis, 1 April 2009
- A top businessman and banker explains our political and economic challenges, 30 April 2011
Posts about deflation:
- Debt – the core problem of this financial crisis, which also explains how we got in this mess, 22 October 2008
- A situation report about the global economy, as the flames break thru the firewalls, 26 January 2009
- Inflation or Deflation? Nobody knows what path will we take., 21 July 2009
- Economic theory as a guiding light for government action in this crisis, 10 March 2009
- Fetters of the mind blind us so that we cannot see a solution to this crisis, 1 April 2009
- A lesson from the Weimar Republic about balancing the budget, 10 February 2010
- All about deflation, the quiet killer of modern economies, 19 July 2010
- Important things to know about QE2 (forewarned is forearmed), 21 October 2010
- Bernanke leads us down the hole to wonderland! (more about QE2), 5 November 2010
- Two regions diverging, tearing the world apart. Birth pangs for a new geopolitical order., 18 November 2010
Is the US going to default on its debt plus all of the liabilities like social security, medicare, pensions etc?
Governments seldom “default” on their liabilities. They do “soft defaults”. Instead they tinker with the terms. Such as change the amounts due, eligability (eg, delay the age, means-test the benefits), and inflation.
Despite the faux hysteria, the financial stability of the US is among the strongest among the developed nations. Aggregate net debt is lower than average. Among the strongest demographics. Attractive to immigrants. Most important, the liability is mostly health care. Unlike the problems of our peers, there are several proven solutions to our high health care costs. We need only adopt one of the better euro solutions. All are superior versions of the US mixed private-public system.
Articles about the US government’s financial condition:
We live in a VERY high risk default world. The USA will print right up to the seeming end….and then some. Federal Deficits are a red herring; ignore them and look at the engine of GDP. What is a 70% component of the USA GDP?
Pray for inflation and then be sad as your asset values plunge slowly but inexorably. Watch the components of Federal Income in juxtaposition to interest rate expenses. (and yours, too) And watch the less-favorable demographically-positioned Countries than the USA—like Japan Inc. Oh and the blowback when the EU sees what Germany has in store and when their Banks finally default!
The “Smart Guys” live in a very different world of 0’s and 1’s. They are not like you and us.
“The USA will print right up to the seeming end”
I love the crazy confidence with which Americans make predictions about economics. They can predict almost nothing about the future, but have delusional confidence when making forecasts about one of the most complex and unpredictable apects of society.
Maybe that guy is secretly Bill Gross, heh. Pimco is reported to have put a massive bet on QE3 happening. But then, I wonder, maybe possibly not? At least as far as funding the government, the USA may not need QE, because all the chaos in the EURO and the ‘rush to safety’ here in the USA. Money is flying out of Southern European banks, and I’m sure some of it is making its way back here to the USA and Treasuries. These days, who needs the Fed?
While foreigners’ flight to safety of US treasuries pushes down US yields, it also pushes the US dollar up. While many US conservatives believe a strong currency is always good, it’s not. As has been explained so many times here and elsewhere, the US dollar is overvalued — one of the factors driving our long-time trade deficit. Capital flows pushng the US dollar up render our products and services less competitive, increasing imports and reducing exports.
That’s especially bad now, when exports are one of the few strong spots in the economy.
Ha…Smart Guy #1 likes Murphy’s view too:
Don’t you find the irony of a comment like yours in light of the crux of your entire Post?
Mr Whirlwind asked some seemingly simple questions. The Smart guys speak like the specialists they are, and as if they were monks in a Cistercain Monastery. The reality is the BAnks own the USA (And soon Europe, too). Some answers may be found here, Mr. Whirlwind:
Good luck
The statement by SG #1 is different in nature than yours.
The statement you quote describes Bernanke’s almost certain response if the US goes into deflation (this has not happened since the early 1930s). Therefore it is not a certain prediction about the future, but a conditional statement.
Aren’t Central banks a poor substitute for management of monetary velocity when deflation affects the larger population? And isn’t inflation merely the by product of The limits of Central Banks ability to create monetary velocity with limited partnerships to the exclusion of the middle class? So isn’t inflation the limit of fractalization of debt?
I am not sure what you are saying, and so cannot reply. Statements such as “when deflation affects the larger population” and “inflation is the limit of the fractalization of debt” have no clear meaning in terms of any economic theory with which I am familar.
Countries routinely survive severe economic crisis, currency devaluation, significant inflation. some un-researched examples: mexico 1994 thailand 1997 russia 1998 USSR 1991 argentina 1999? USA 1970’s
If there is major disorder, then I think “normal life” usually returns within 1-2 years, and the economy is pretty fully recovered in 10 years? I am not exactly sure about these numbers, but I think this is the ballpark. After this time passes, most of the people who were rich before are still rich afterwards, most of the poor are still poor — the order of society isn’t changed much, unless there is also extreme (Lenin / Napoleon etc.) revolution. I don’t see that happening, since Europeans and American’s aren’t hungry enough.
The reason I say this is that sooner or later the powers that be, or the Media, or the collective thinking in America or wherever – we will look at history and realize that it’s time to bite the bullet and let our currency die, let some of our financial system die, and it won’t be the end of the world. Then we’ll stop fighting it and the system will turn over. Farms still there. Houses are still there. Guys in cubicles sitting in front of computers sending pointless memo’s — still there. Oil flowing from the Middle east – I expect it to last longer than our financial/currency system, anyways. And finally, industry and manufacturing: We don’t manufacture squat, so there’s nothing to lose in that department. The only thing we have to do is start from scratch in the way we keep track of counting money and ownership of stuff. A huge nuisance but there’s no reason it should kill a significant number of people.
Gold is a reasonable bet. On the other hand, I don’t expecting a gold-standard currency system, or a new age of financial discipline or any real long term reform- just a big old “reset”.
I don’t understand your logic.
“realize that it’s time to bite the bullet and let our currency die, let some of our financial system die, and it won’t be the end of the world.”
(1) Why do we need to do these things? As I have said so many times, the financial condition of the US is by most metrics among the strongest of the developed nations.
(2) Lots of things are not the “end of the world” yet are VERY painful — involving a generation of suffering, blasted dreams, and lost progress.
Sure gold is not perfect. It worked just only for 5000 years of recorded human history and brought human race from caves to cars, telephones and airplanes. And all that happened without government regulations.
Now Keynes come and says that all that was wrong, all that created liquidity traps and lead us to war.
Never mind that England managed to pay off her debt during 100 Year War while modern regimes keep accumulating their debts even in peaceful time with all that abundance of liquidity.
And again, gold was not perfect, but at least the system was based on intrinsic value, not on politicians-philosophers who control the present Keynesian systems of the world. And then Krugman wonders “why politicians don’t do what is right to do?!”
OK, just this one comment on the mythology of gold. All future comments like this must cite sources. Ones of the “just repeat stuff I’ve read somewhere” will be deleted.
(1) “It worked just only for 5000 years of recorded human history and brought human race from caves to cars, telephones and airplanes.”
Modern financial systems — credit, global flows of trade and capital, etc — date from roughly 1800. To say that we used gold-based monetary systems then and should now is logically like saying that babies use diapers — and so should we.
(2) “while modern regimes keep accumulating their debts”
Debt accumulation occurs under all kinds of regimes. As in the extreme case: Philip II had almost all the gold in the world, but went broke twice. See “The Sustainable Debts of Philip II: A Reconstruction of Spain’s Fiscal Position 1560-1598″, Mauricio Drelichman and Hans-Joachim Voth, 6 November 2007.
(3) “Now Keynes come and says that all that was wrong,”
This is a good example of why only statements with sources will be allowed. Faux economics and faux history rule the land in this time of growing ignorance. Keynes is used as a object of hatred much as “Snowball” was used in Animal Farm and Emanuel Goldstein in 1984.
(4) About gold-based systems
As Drobny says, almost any financial system can be made to work. The Brit’s 19th century gold-based system worked because the Bank of England was allowed to ignore the rules during times of economic crisis.
More broadly, the problem with fixed-currency sytems is that conditions change. Between nations (eg, due to different rates of productivity change and growth). Domestically due to normal economic cycles. If the currency and monetary base are fixed, then other variables must change. Such as employment and income. As we saw on a large scale during the Great Depression — when recovery came to each nation only when it went off the gold standard (see the posts cited in the For More Information section).
We also saw this during the late 19th century. High rates of growth reduced much of rural America to barter — and resulted in frequent depressions that gutted the small farmer and small merchant segments of society. The result concentrated power and wealth in the creditor classes (aka the guilded age), one reason the gold standard finds so many enthusiasts among the creditor classes.
“The Brit’s 19th century gold-based system worked because the Bank of England was allowed to ignore the rules”
and because available gold stocks increased nicely to match economic development thanks to those large deposits in South African colonies.
That’s a powerful point. What would have happened to the great growth of the 19th century without the great gold discoveries (eg, California, Yukon, South Africa)? Economic growth is difficult without an increase in the money supply.
Additional color on the UK gold standard during the 19th century
England during the 19th century had bubbles and busts. The gold standard worked well for them because they allowed the Bank of England to violate the rules during emergencies. For more about this history see these articles by Brad Delong (Prof Economics, Berkeley):
For an excellent introduction to the history of bubbles and busts under a gold standard see “Charles Mackay’s own extraordinary popular delusions and the Railway Mania“, Andrew Odlyzko (U MI), 14 September 2011. He shows how they make sense at the time, until their underlying assumptions prove wrong over the short-term — even if they prove to be correct over the long-term.
Why is a fiat currency regime better than a gold standard?
Because the highest return is always the return-on-coordination. Scaling up ability to explore large-group options requires scalable large-group agility – and also scalable large-group intelligence & coherent alignment to emerging options. Same reasons no species or armies are resource constrained. The bigger constraint is always organizational ability – including tempo.
That means that only state-money denominations are agile enough to keep up with the kinetic demands of uncontrollable public initiative. Commodity-money was thoroughly tested, and was found inadequate. It’s valuation has to be constantly re-scaled, simply because populations & their options scale faster than the magnitude of any commodity store. If that’s the case, just simplify and cut the commodity out of the re-scaling loop that links organizational ability to group outcomes.
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