Tuesday, February 24, 2015


The latest update from Greece:  The European Commission (EC) and European Central Bank (ECB) have approved Greece's plan for a four-month extension.  Now all that has to be one is for member parliaments to approve it.  Uh, good luck with that one.  So, if by some miracle they all agree, we have a reprieve until the end of June for Greece to either submit a new plan to continue in the euro, or to plan for the Grexit.  

The usual suspects are warning Southern Europe not to give up on austerity now just as it is finally beginning to pay off.  And, of course, they are warning of disaster if Greece leaves the euro.  But here is the thing.  I can imagine that their counterparts in 1932 or 1933, around the Roosevelt election saluting Hoover for his brilliant economic stewardship and warning Roosevelt not to abandon Hoover's policies just as they were starting to pay off.  After all, they would point out, despite immense pressure, Hoover did manage to maintain the dollar peg to gold.  And around the summer of 1932, the US economy really did bottom how and really was starting to show the beginnings of a feeble recovery.  And Roosevelt's election really did set off a panic in the finance system.  I outsource this history (which I had never learned before) to Scott Sumner.

From 1929 to 1932, the world economy in general and the U.S. economy in particular were experiencing massive deflationary pressure.  And deflationary pressure, for a wide variety of reasons, is bad.  For one thing, prices, and especially wages tend to be "sticky" and to resist falling.  When they experience downward pressure, instead of simply falling, they introduce widespread distortions into the economy.  Unemployment, for one.  But even in the absence of wage/price stickiness, deflation would cause problems.  For one thing, when nominal incomes fall, even if prices fall at the same rate, debts become more burdensome relative to incomes.  (This is a huge problem with sovereign debt in Southern Europe today).  For another, deflation means that nominal makes real interest rates higher than nominal interest rates, so borrowing necessarily becomes arduous.  This discourages investment.  And besides, under deflationary conditions, holding cash pays real interest, which discourages borrowing and (again) reduces investment.  In extreme cases, severe deflation can lead to currency collapsing altogether and ceasing to circulate, so that country has to resort to barter. (That is what happened to Russia in the 1990's).

What caused the deflationary pressure in the 1930's, or what causes it in general is controversial.  But one clear source of deflationary pressure is an over value currency.  And in the 1930's there was a huge obstacle to countries relieving the pressure of an over value currency -- the gold standard.  David Frum describes what that meant for the US:
Between 1929 and 1932, the U.S. money supply collapsed, as banks failed and bank deposits and commercial credit vanished. . . . . Why didn't the Federal Reserve act to prevent the contraction? Again: the gold standard.
In a modern recession, the Fed will buy Treasury securities in the open market. After the purchase and sale, the Federal Reserve has more securities -- and the former owners of the securities have new cash.
Those new cash owners then spend or lend their cash, spurring economic activity. But in 1930, the new cash owners didn't spend or lend. They swapped their cash for gold. The "open market" operations that were supposed to accelerate economic activity instead accelerated the country's gold drain.
So the Fed ceased -- and instead passively allowed the economy to collapse in order to save the nation's currency.
That is, in effect, what Southern Europe has been asked to do since 2008.  Governments that have gone along have been praised by all the VSP's for their wise stewardship.  No doubt the VSP's of the 1930's praised such wise stewardship by Hoover as well.  So why did the US go along with it?  In large part, because the slightest suggestion of any change of heart set of financial panic.  The financial system certainly panicked over the election of Roosevelt.  Sumner describes how stocks dropped every time Roosevelt seemed to gain in the polls and the financial press dreaded that possibility.  Hoover boasted that he had saved the dollar from going off gold.  Once Roosevelt won, a five-month interregnum ensued.  (Presidents were inaugurated in March in those days).  General financial panic gripped the country over fears that he would devalue the dollar.  Sumner:
[U]nder a gold standard if there is uncertainty about whether a devaluation will occur then gold hoarding increases, which is deflationary. This happened on four occasions during the Great Depression, and on each occasion asset prices and industrial production declined sharply.
FDR basically had three choices. The traditional route would have been to lie and say that he would adhere to the platform, maintaining the gold standard while working toward an international agreement to give silver a monetary role. The markets knew that other countries weren’t going to adopt silver. Then when he took office he could have said; “Because I wasn’t able to get agreement, we have to go it alone with a currency devaluation.”

Or he could have told the truth and said he was going to devalue the dollar. That would have forced Hoover’s hand, and a devaluation would have occurred almost immediately. . . . .
Instead he was continually evasive.
Once Roosevelt did devalue against gold, improvement was immediate.  Sumner's conclusion, "The irony is that while a hard gold standard is far far worse than fiat money. A gold standard where there is uncertainty about the future dollar peg is much worse than even a hard gold standard."

The graph below is often taken as proof that the gold standard was responsible for the Great Depression.  I am not so sure.

Really it proves nothing except that (1) every country eventually left the gold standard and (2) every country eventually recovered.  Of all the countries shown ONLY the US experiences a real turning point upon leaving the gold standard.

Now, industrial production appears to be more vulnerable to an over valued currency than total GDP.  If the graph on the left is to be believed, the correlation between recovery in industrial production and leaving the gold standard is much clearer.

The parallels to present-day Southern Europe are obvious.  The euro serves in the place of gold.  If leaving the gold standard was so beneficial in the 1930's, why doesn't all of Southern Europe rush to leave the euro.  Well, there are at least two reasons.  First, in the 1930's, although currency was backed by gold, at least paper currency physically existed.  The drachma, the lira, the peseta and so forth  no longer physically exist and will have to be made anew.  No one quite knows how to do it.  Second, the position of the US in the 1930's was unusual.  For one thing, we were a creditor country.  Most countries that devalue are debtors.  Second, the US economy was large enough relative to anyone else's that the external effects of the devaluation were minor.  In most countries, the external effects of a major devaluation are immense and traumatic.  Import prices surge, leading real incomes to plummet.  External debts surge, leading to widespread bankruptcy.  But exports become cheap and grow.  Domestic industry ceases to be undercut by artificially underpriced imports and can recover.  Economies may stage a quick recovery.  But the short term impact is painful in the extreme.  Consider some "successful" devaluations:

Russia:  When Russia devalued in 1998 its currency had collapse to the extend that much of the economy was operating on barter.  In the aftermath:
Russian inflation in 1998 reached 84 percent and welfare costs grew considerably. Many banks, including Inkombank, Oneximbank and Tokobank, were closed down as a result of the crisis. . . . Prices for almost all Russian food items had gone up by almost 100%, while imports had quadrupled in price.
Many citizens were stocking up for bad times and throughout the country shop shelves were being emptied, leaving a shortage of even the most basic items, such as vegetable oil, sugar or washing powder. The crisis reduced demand for food and lowered food consumption, because substantial depreciation of the ruble significantly raised domestic prices for food stuffs. 
Yet recovery was rapid:
Russia bounced back from the August 1998 financial crash with surprising speed. Much of the reason for the recovery is that world oil prices rapidly rose during 1999–2000. . . Another reason is that domestic industries, such as food processing, had benefited from the devaluation, which caused a steep increase in the prices of imported goods.
Also, since Russia's economy was operating to such a large extent on barter and other non-monetary instruments of exchange, the financial collapse had far less of an impact on many producers than it would had the economy been dependent on a banking system. Finally, the economy has been helped by an infusion of cash; as enterprises were able to pay off arrears in back wages and taxes, it in turn allowed consumer demand for the goods and services of Russian industry to rise.

Argentina:  Argentina had pegged its currency to the dollar.  When the dollar began to soar in the late 1990's, the Argentine economy came under pressure.  The IMF expected the Argentines to allow it to collapse in order to preserve the dollar peg.  When this proved unsustainable, Argentina defaulted and devalued. The immediate effects were again traumatic:
Many private companies were affected by the crisis: Aerolíneas Argentinas, for example, was one of the most affected Argentine companies, having to stop all international flights for various days in 2002. The airline came close to bankruptcy, but survived.
Most barter networks, viable as devices to ameliorate the shortage of cash during the recession, collapsed as large numbers of people turned to them, desperate to save as many pesos as they could for exchange for hard currency as a palliative for uncertainty.
Several thousand newly homeless and jobless Argentines found work as cartoneros, or cardboard collectors. The 2003 estimation of 30,000 to 40,000 people scavenged the streets for cardboard to eke out a living by selling it to recycling plants. This method accounts for only one of many ways of coping in a country that at the time suffered from an unemployment rate soaring at nearly 25%
Agriculture was also affected: Argentine products were rejected in some international markets, for fear they might arrive damaged from the poor conditions they grew in.
 Yet recovery was again rapid as exports surged and domestic industry was no longer undercut.*

These, then, are the choices faced by Southern Europe in general and Greece in particular.  Leaving the euro means the certainty of immediate trauma, followed by the possibility of rapid recovery. Staying (at least on current terms) means more of the same grind.  Continued uncertainty means -- well, see the link on the Hoover-Roosevelt interregnum for what continued uncertainty means.  Let's see what four months (or less) bring us.

*Incidentally, these events took place under a left-wing government.  Another development was that as many businesses failed, the work force took them over.  This measure was an act of desperation, not a deliberate policy, and had no official encouragement.  But the government in power was ideologically inclined to passively tolerate such actions instead of move to crush them.  Another thing for Syriza to consider.

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