Canadian Cincinnatus

Europe is experiencing the crisis that Milton Friedman predicted 12 years ago

Some lowlights from a doom-and-gloom BBC report on economic conditions in the eurozone:

“The yield on Spanish 10-year bonds, which are taken as a strong indicator of the interest rate the government would have to pay to borrow money, rose above 7%, while Italian bond yields rose to 6.1%.

Yields above 7% are considered to be unsustainable in the long term.”

“But, as BBC Europe correspondent Chris Morris says, by sending its borrowing costs higher, the markets are sending a message to the eurozone that plans to help Spain are not convincing.”

In the year 2000, at a Bank of Canada conference, the great economist Milton Friedman had this to say about the then-forming currency:

“I think the euro is in its honeymoon phase. I hope it succeeds, but I have very low expectations for it. I think that differences are going to accumulate among the various countries and that non-synchronous shocks are going to affect them. Right now, Ireland is a very different state; it needs a very different monetary policy from that of Spain or Italy. On purely theoretical grounds, it’s hard to believe that it’s going to be a stable system for a long time. …

If we look back at recent history, they’ve tried in the past to have rigid exchange rates, and each time it has broken down. … So the verdict isn’t in on the euro. It’s only a year old. Give it time to develop its troubles.”

Over a decade later, the “troubles” are at hand.

 

 

P.S. Notice how Friedman zeros in on Ireland, Spain and Italy.

 

Finally, a mainstream economist who agrees with me that Greece must leave the Eurozone

In Friday’s edition of Slate, an article by economist Nouriel Roubini appeared with the title, Greece Must Go: The nation is likely to leave the eurozone sooner or later. Sooner is better. Thank you. I had been saying the same thing from at least July of last year, when I stated:

The important thing for the EU is not to save Greece – it is all but lost – but to teach the other PIIGS (Portugal, Ireland, Italy and Spain) a lesson. The EU can do without Greece. 

Some sample quotes from Roubini’s Slate column:

Greece is stuck in a vicious cycle of insolvency, lost competitiveness, external deficits, and ever-deepening depression.

A return to a national currency and a sharp depreciation would quickly restore competitiveness and growth.

Economics teaches us that the worst way for a government to interfere with its economy is to set prices. With the Euro, the EU is manipulating the most important price of all – the price of money. The price of the Euro is appropriate for Germany; it is too high for the siesta culture of the Mediterranean. At some point, the resulting imbalance has to balance. That point is now.

Of course, the process would be traumatic, and not just for Greece. The most significant problem would be capital losses for core eurozone financial institutions. Overnight, the foreign euro liabilities of Greece’s government, banks, and companies would surge. Yet these problems can be overcome. Argentina did so in 2001, when it “peso-fied” its dollar debts.

Some argue that Greece’s real GDP would be much lower in an exit scenario than it would be during the hard slog of deflation. But that is logically flawed: Even with deflation, real purchasing power would fall, and the real value of debts would rise (debt deflation), as the real depreciation occurs. More importantly, the exit path would restore growth right away, via nominal and real depreciation, avoiding a decade-long depression. And trade losses imposed on the eurozone by the drachma depreciation would be modest, given that Greece accounts for only 2 percent of eurozone GDP.

Bankruptcy is an essential part of the healing process in a free market system. Bad debts can’t be allowed to fester. By preventing bankruptcy, all you do is to prolong the recession. This is why Japan’s ‘lost decade’ is entering its third decade. The TARP bailout has played a similar role in the Great Recession. By preventing bad banks from going under, the federal government has ensured that the US economy has flat-lined for over 3 years.

Those who claim that contagion from a Greek exit would drag others into the crisis are also in denial. Other peripheral countries already have Greek-style problems of debt sustainability and eroded competitiveness.

As the Rev Jeremiah Wright is fond of saying, “the chickens are coming home to roost.”

The experience of Iceland and many emerging markets over the past 20 years shows that nominal depreciation and orderly restructuring and reduction of foreign debts can restore debt sustainability, competitiveness, and growth. As in these cases, the collateral damage to Greece of a euro exit will be significant, but it can be contained.

Another example is the US recession of 1920. President Warren Harding’s policy was to do nothing. The result was an intense but short recession. Why was that depression short-lived? Because the bad debts were allowed to clear.

But hey, who needs free market solutions when we have access to Keynesian pump priming? Sure worked well to keep the Great Depression going for a decade. 

 

European austerity is the wrong answer to Europe’s problems

As a small government conservative, I might be expected to champion government austerity wherever I find it. However, this is not the case. For instance, I am greatly opposed to the European-style austerity programs that are being foisted upon Greece and Spain.

But isn’t government austerity good, the fiscal equivalent of cod liver oil? Depends on what you mean by austerity. In Europe, austerity doesn’t just mean cutbacks in government spending. It also means tax increases, particularly on the wealthy. Do you still like austerity - European-style?

The reason such a program cannot work is that the biggest factor determining the state of a government’s budget is economic growth. The reason is twofold: the government’s principal source of revenue is income tax, which declines in a recession; and its biggest expenditure is welfare spending, which skyrockets in a downturn. For this reason, an economic slowdown negatively impacts government revenues and outlays at the same time. In contrast, economic growth positively impacts both items at the same time. Therefore, an economic plan that does not stimulate growth will not work well.

Unfortunately, thanks to steep tax hikes for job creators, European austerity plans are not neutral with regard to economic growth. These plans are job killers - and growth killers. Therefore, while the spending cuts will help the government bottom line, the tax increases will throw more people out of work and cut government revenues even more – negating the positive effects of the cuts. With pain increasing both on the job market and the welfare office, the country finds itself in a death spiral, with government cuts chasing lost government revenues.

This can be seen in the US federal budget since the 2008 meltdown. As I mentioned a year ago. 

Much of the current deficit is caused by a combination of a loss of income tax revenue corresponding with an increase in social spending due to the Great Recession. Medicare, AFDC, Section 8 vouchers, food stamps, unemployment insurance: all of these programs have grown by 50% or more in the past 3 years.

As much as we conservatives like to think, Obama’s big spending initiatives have not been the biggest factor propelling the trillion dollar US deficits. It is social spending, caused by the recession. Grow the economy and these budget-busting items will shrivel all on their own – as revenue rises!

This is why I am also opposed to the IMF. They push the European brand of austerity to any troubled country that will listen to them. Fortunately, countries that turn down their strings-attached loans invariably do better.

Indeed. If you look at history, there are basically only two ways that governments have ever dealt with a crippling debt load. The first is to default. The second is to modestly reduce government spending, keeping discretionary expenditures constant in absolute terms for a number of years, while growing the economy so that tax revenues increase as social spending declines. These are the only two realistic choices. European-style austerity is not an option, at least not one that has ever worked in the past.

 

One cheer for France: France elects an anti-EU President

Say Cincinnatus, aren’t you one of those free market extremists?

Yes.

So why are you cheering (admittedly half-heartedly) about the defeat of France’s conservative president and the election, in his place, of an avowed socialist, who calls himself, “an enemy of finance”?

Good question. The answer is that I think the biggest pressing problem facing Europe today is the Euro. And the socialist central planners who set up the EU and the eurozone were so diabolically clever in setting it up that they got free market conservatives to champion central planning. They did this by joining free trade policy (which conservatives like) at the hip with central planning (which they want). As a result, France’s conservative president, Nicholas Sarkozy propped up the dying corpse of central planning throughout his reign with stop-gap measures like austerity and government bailouts.

This is why I am half-heartedly glad that he is gone. With Hollande, these programs will be that much less likely to be carried out. This has a number of good consequences that I am not sure Hollande does not intend. Without constant bailouts and austerity imposed by countries like Germany on countries like Greece, the EU will destabilize to the point where the PIIGS will depart the eurozone. When this is seen to not cause the end of the world, the entire EU edifice in Brussels will crumble.

But won’t Hollande’s prosperity-through-socialism prove to be economically disastrous for France? Oh, undoubtedly. But there is problem number 1 and problem number 2. In Europe today, problem number 1 is the price distortions caused by the centrally determined cost of money (i.e. the Euro) and Problem number 2 is everything else, whether the welfare state or unassimilatable Muslim immigrants. Problem number 1 needs to be dealt with today. Problem number 2 can wait until next week.

For instance, all of Greece’s current troubles are caused by the fact that it has to labour under a currency that is way too high for them. If it weren’t for the Euro, the Drachma would fall, the easy foreign credit would dry up (forcing Greeks to save), and Greek exports would become competitive again (putting Greeks back to work). As long as the Euro is in Greece, these things won’t happen and Greece will continue to bleed (and to get more indebted with each subsequent bailout package).

But wouldn’t a free-market-based disengagement from the European Union be better for France than more socialism, with its many negative side effects? Absolutely. But tell me, which candidate in the French Presidential elections is a reincarnation of Ronald Reagan? Such a politician currently does not exist in the French political landscape, so we have to settle for the lesser of two evils.

Machiavelli taught that if a political disease is too far-gone, the best solution is to let it run its course. The problem with Sarkozy is not that, in objective terms, he is a worse man than Hollande. He is not. He is a much better man. It’s just that he is good enough to keep the EU plodding along but not accomplished enough to tackle its contradictions head on. Machiavelli also taught that half-measures dig the grave deeper. By any measure, the Sarkozy legacy has been a series of half-measures.

 

The Telegraph: “Eurozone’s ‘big bazooka’ bail-out fund us left in tatters by S&P downgrade”

According to this article: “Plans for a €1 trillion "big bazooka" to stem the debt crisis were crushed on Monday night as Standard & Poor's stripped the European Financial Stability Fund (EFSF) of its AAA credit rating.”

Why was this completely and utterly predictable? Except of course by the highly credentialed, EU bureaucrats.

Don’t say I didn’t tell you so.

The best explanation of the EU follies I have yet read

Every time I hear that EU officials are preparing yet another bailout, bigger than the previous one, to save the Euro, I shake my head. The more good money they throw after bad, the worse the Eurocrats are making the crash when it finally does come. How do I know a crash is coming? Simple. When too much bad debt accumulates, the free market’s natural healing mechanism is bankruptcy. The more bailout money countries like Greece get, the more they waste and the more exposed previously solvent banks become; and the bigger the next bailout needs to be. Clearly, instability in the system is increasing. At some point it has to stop. I think the operating principle of the Eurocrats is fear: fear of the bust. Their answer: to kick the can down the road far enough that Something Happens to fix it.

Richard Fernandez of the Belmont Club, riffing off Nassim Taleb (who has an article in Foreign Affairs on why the US didn’t see the Arab Spring in Cairo coming), offers the best theoretical explanation of why overcentralized bureaucracies cannot foresee (let alone control) Black Swan events:

“The elites won’t see them coming rather than that they can’t. Part of the problem is the consequence of their own damping. By attempting to centrally manage systems according to some predetermined scheme they actually store up volatility rather than dispersing it. By kicking the can down the road they eventually condemn themselves to bumping into a giant pile of cans when they run out of road.”

Taleb here: 

“Complex systems that have artificially suppressed volatility tend to become extremely fragile, while at the same time exhibiting no visible risks. In fact, they tend to be too calm and exhibit minimal variability as silent risks accumulate beneath the surface. Although the stated intention of political leaders and economic policymakers is to stabilize the system by inhibiting fluctuations, the result tends to be the opposite.”

Back to Fernandez:

“Thus every bailout and rescue made in the name of preventing the demise of something deemed “too big to fail” builds up a head of steam until the point is reached when the system can no longer contain the pressure. Then the volatility goes from a seeming zero to an extremely high number. The Black Swan will have arrived. And it always will for as long as fiction is substituted for fact, failure is relentlessly reinforced and false assurances are given all around.”

“Given the fact that politicians and economic managers are elected or promoted for their skill at “controlling events,” they can hardly admit that they cannot. It will take an intellectual revolution to make everyone realize that human control over the real world is really limited. And yet accepting that volatility must be faced rather than hidden is the key to preventing the arrival of even more Black Swans.”

The answer to this problem is decentralization:

“The key difference between a central manager and more localized management is that the local managers do not feel compelled to a create a grand unified theory of events. They do not have an incentive to keep stories consistent with the overall narrative. They have no talking points from which to stray. They only have problems, which they more or less try to solve.

There is a positive correlation between the degree of centralization and the required amount of “smoothing” that the headquarters will demand. Localized response can deal with variation. Huge central planning organizations cannot. And it is in the differences — it is in the outliers — where the significant information lies. When everything has been smoothed out to conform to the 5 Year Central Plan, then Taleb argues, all the real information has been simultaneously purged.”

I think this is about right. The economy is a complex adaptive system. It’s too complicated to control. Indeed, left on its own, it will find its optimal solution. Central control only gets in the way of the uncountable feedback mechanisms built into the marketplace. All the central planners end up doing is to cause the imbalances to unnaturally accumulate even more.

Fernandez then adds this interesting point I hadn’t even thought of:

“One might add that advances in IT itself have contributed to this problem.  With the advent of computer networks, databases and intelligence fusion came not real control but to a large extent, only the illusion of control.  IT did not in fact allow the elites to eliminate Black Swans. What it did was enable them to hatch very large ones.”

Democracy, real democracy - like the referendum that Greece proposed over its bailout (but which was subsequently squelched by the EUrocrats) - is part of the answer to the problem of the technocratic elite: 

“When E. E. Schattschneider said, “Democracy is not to be found in the parties but between the parties,” he was on to something. It is not that either party has the truth, but simply that a debate between any two genuinely opposed sides facilitates the emergence of the truth, even as a byproduct. This is a clue to why freedom works. It prevents the emergence of a single authoritative dogma, which left to itself would ruthlessly exterminate all other points of view, the truth in especial, if it were inconvenient.”

 

Fortune Magazine: “Europe should embrace failure”

Daryl Jones, in Fortune magazine argues that the way out of Europe’s debt crisis is for indebted banks and countries to be allowed to fail: 

“Failure is not a bad thing. Sure, losing or failing doesn't give you the warm fuzzies inside, but failing and adapting ultimately sets you up for greater success.”

“As it relates to Europe sovereign debt, the one solution that has not been seriously considered is failure. Instead, the key solution from almost every Eurocrat and talking head, is to continue to support and promote a broken banking system and failed monetary union. There are other possibilities: let Greece fail, let other sovereigns fail if they can't get their house in order, and let heavily exposed banks fail.

The validation of the failure strategy at least partially comes in comparing the credit default swaps of Italy, Portugal and Ireland from July 1, 2011 to today. Respectively, Italian swaps are up 140%, Portuguese up 38.2%, and Irish down 3.2%. Now to be fair, Ireland hasn't failed, but three of its largest banks, Allied Irish, Irish Life & Permanent, and Bank of Ireland have experienced ‘credit events’ and, as a result, Ireland's credit worthiness has improved, on the margin.”

Add to Ireland my homeland of Estonia. It had a massive real estate bubble that burst in 2008. But because the country is so small and unimportant, it received no bail-out, everything was allowed to fail that couldn’t survive on its own, and as a result, it currently has the highest growth rate in Europe – 8.2% - with the only budget surplus of any EU government. Another example is Iceland. Early on in the crisis you heard a lot about it and its credit bubble. But because it wasn’t plugged into the Euro, nobody bailed Iceland out. As a result, what needed to fail, failed and Iceland is now doing fine.

A counterexample is Japan, which is has been stagnating for almost two decades after its real estate bubble burst. Why is it stagnating? Because nothing has been allowed to go under. Zombie banks lumber on like Frankenstein’s monster, kept alive by the IV drip of Keynesian spending. Oh yeah... Japan has racked up a public debt to GDP ratio of almost 200%.

I think because it is a painful thing, the regenerative powers of bankruptcy are often underestimated. Bankruptcy has an important role to play in the marketplace, particularly in helping an economy recover from a crash. One key ingredient in any economy is capital. How healthy an economy is, is determined at least partially by how well capital is allocated. Crashes often happen because of capital misallocation. Think of all the money sunk into subprime mortgages in the US. The money sitting in these mortgages was unproductive because a large percentage of the people who took out those mortgages had no hope of paying them back. The Eurozone equivalent of the subprime mortgage is the Greek government. Money sitting in Greek bonds is simply wasted because it could be better spent on other things.

How do you get out of this problem? The first rule of getting out of a hole is to stopping digging it deeper. When Germany approved a 350 billion Euro bailout to Greece earlier this summer, that meant 350 billion more Euros are now unavailable for productive investments. What could be accomplished with 350 billion Euros? I bet Steve Jobs would have had some interesting ideas.

One of the advantages of a crash-induced wave of bankruptcies is that it resets the bad debt counters to zero. People with subprime mortgages have no home; people who own Greek debt or Lehman Brothers stock or GM stock get a haricut. But the flip side is that money is only an indicator of wealth. It is not wealth itself. All that has happened is that the monetary value of individuals and corporations has now been better matched with their actual worth. The information content of money has increased because money becomes more correlated with value. Thus investments can be made more intelligently. 

Except when everything that should fail is bailed out. When governments prop up teetering enterprises and failing governments, the transfer of wealth from productive activities to unproductive activities accelerates and the information content of money degrades further. Thrifty and productive Germans get poorer while the lumbering Greek leviathan consumes ever more resources; productive American citizens (and American citizens not yet born) get hobbled by yet more government debt in order to keep wealth-consuming Wall Street zombie banks staggering along. As the productive are increasingly hobbled - so are the unproductive, who are trapped in a spiral of onerous debt repayments. The result is universal stagnation.

In Obama’s America… and in Eutopia… and in Japan. 

 

Forbes magazine – “Give Greece What It Deserves: Communism”

This article in Forbes echoes I have been saying all along about the Greek crisis: don’t keep throwing good money after bad. The important thing for the EU is not to save Greece – it is all but lost – but to teach the other PIIGS (Portugal, Ireland, Italy and Spain) a lesson. The EU can do without Greece. It produces very little. But if the other PIIGS fail, the EU is toast.

“Once in a great while an opportunity comes along to deliver justice to a people, giving them what they truly deserve. Greece’s time has come.

It must be dawning on all but the most obtuse member of the banking elite that they can’t possibly steal enough money from German taxpayers to save the Greek government from default. Put it off, maybe, but collapse is inevitable.”

“Why not go all the way and give the country what many of its people have been violently demanding for almost a century?

Let them have Communism.”

“If you don’t want the real contagion to spread, that is the disease of believing you can perpetually consume more than you produce, leave Greece to the Greeks and let the bankers take their lumps.”

I think too many people forget what a horror communism is (cf Van Jones). Perhaps a real live example in a European nation might serve to remind them.