The euro crisis

Alasdair Macleod
29 June 2015

Make no mistake; the Greek crisis is a euro crisis that threatens the solvency of the ECB itself, and therefore confidence in the currency.

Before going into why, a few comments on Greece will set the scene.

Last weekend it became clear that Greece is heading for both a default on its government debt and also a failure of its banking system. With the benefit of hindsight it appears that the Greek government was unwilling to pretend that it was solvent and extend its financial support as if it was. The other Eurozone finance ministers and the troika were not prepared to accept this reality. Continue reading The euro crisis

Managing trade deficits

Alasdair Macleod
25 June 2015

Currency devaluation is seen by nearly every macro-economist to be the cure for trade deficits.

Recently they have recommended it to Greece, arguing for the reintroduction of the drachma so that the Greek economy can become “competitive”, and “rebalanced”. This widespread assumption is easily demonstrated to be incorrect.

Empirical evidence confirms the error: in the post-war years Germany and Japan were the strongest exporting nations despite persistent rises in their exchange rates, and the UK consistently the weakest, despite the sought-after benefit of sterling depreciation. Hong Kong dropped currency management entirely in favour of a currency board tied rigidly to the US dollar, and despite having to import everything, managed very well.

Common sense provides an initial explanation: Continue reading Managing trade deficits

Bonds and banks

Alasdair Macleod

18 June 2015

This year has seen some big losses develop in the bond markets, though prices have stabilised in recent days.

US Treasury 10

The chart above is of the yield on the lowest investment risk in ten year maturities. Most other 10-year bonds have seen even sharper rises in yield (i.e. greater price falls). This matters because the banking system is heavily invested in sovereign bonds, not only in the short end of the market where it traditionally invests its liquidity, but also in longer maturities between five and ten years. Furthermore, central banks have become exposed to the same risk through their bond purchases with implications for currency stability, but that is a separate issue. Continue reading Bonds and banks

The fallacies of GDP

Alasdair Macleod
11 June 2015

The common error of confusing growth with progress goes largely unnoticed, though it permeates all macroeconomic analysis. There is no better example of this mistake than the fallacies behind the interpretation of Gross Domestic Product. GDP is the market value of all final goods and services in a given year. As such, it is only an accounting identity reflecting the quantity of money in the economy.

Econometricians constructing GDP have devised a sterile statistic that should not be used to set economic policy. It leads to the common error of assuming any increase in GDP is desirable. Statistics like GDP tell a story of an economy based on historical prices but devoid of any qualitative value; and progress, the improvement in the human condition, is what really matters.

Transactions reflecting both wealth creation and also economically destructive state spending are included in GDP without differentiation. Far from the government component of GDP being singled out from the total, it is often welcomed as contributing to economic growth. Macroeconomists, with an eye on the statistical impact of cuts in government spending, discourage governments from making them. The lack of distinction between wealth-creation and wealth-destruction is fundamental to their belief that state intervention is beneficial.

More light can be shed on this issue with an example. Imagine an economy with a fixed quantity of money and credit; further assume foreign trade is in balance, and that the population is stable. Products will succeed, stagnate or fail. People will get pay rises, pay cuts or be encouraged by reality to move from the least successful businesses into more successful businesses. The businesses of yesteryear fade and those of tomorrow evolve. Winners will redeploy resources released from the failures. Annual GDP, the sum total of all production paid for by everyone’s earnings and profits, will therefore be unaltered from the previous year: it is a zero sum, assuming that as a whole people’s money preferences relative to goods do not change. Without the injection of extra money, people are always forced to choose between items: they cannot add to the purchasing power of their income through extra credit created out of thin air, creating demand that otherwise would not exist.

Progress is, therefore, marked by improved products and lower prices, because as the volume and quality of production increases the total money value of them must remain the same. This is true for both final products and for investment in the higher orders of production. But importantly, GDP growth is nil.

Now we must consider what happens in the case of unsound money; that is to say money and credit that can be expanded by the will of the state and the banks it licences. Over a period of time, this new money is absorbed into the economy, reflected in new transactions that otherwise would not have occurred. The value of transactions attributable to the expansion of money and credit is likely to be a multiple of the new money introduced, as it passes from the original beneficiaries to later receivers.

If we assume this is a single expansion of the quantity of money these new transactions will only be a temporary feature. The prices of goods bought with the new money rise to compensate with a time lag. Having initially expanded, real GDP would then contract as the temporal lag between stimulus and price effect is fully unwound. With all transactions fully accounted for real GDP ends up unchanged, always assuming there has been no change in consumer preferences between money and goods.

The dubious benefit of stimulating demand by increasing the quantity of money and credit has been only temporary. Changes in GDP described above reflect not economic progress, but the absorption of the extra quantity of money and credit deployed. If the matter stopped there, the damage to a properly functioning economy would be limited, but monetary inflation also triggers a transfer of wealth from the majority of people to a small rich minority. This happens because price increases spread from where the new money is first deployed (typically through the banks and financial markets), leaving the majority of people to face higher prices with no offsetting monetary benefit. There is, therefore, a secondary impact: the apparent benefit of increasing the quantity of money is followed by a fall in demand for goods and services because of the wealth-transfer effect, the opposite of the intended result. The economy as a whole ends up worse off than if no monetary stimulus had occurred. This is why extreme monetary inflation is always accompanied by economic collapse.

In the foregoing example, the effect of a single injection of additional money and credit was considered, but once this policy is embarked upon it is almost always continued at a compounding pace. Macroeconomists note only the initial benefits, and when they fade, as described above, they clamour for more. The result over time is that weak-money policies lead to the continual currency debasement with which we are familiar today, together with the build-up of debt, which is the counterpart of expanding bank credit. As the currency buys less, more is required to achieve the same initial effect.

That changes in money and credit do not equate accurately to changes in GDP in practice is partly due to econometricians selecting which activities to include in GDP. They interpose an artificial distinction between categories of spending with the intention of isolating spending on new goods and services deemed to be consumption. This is an error, because these economists are forced into making a subjective judgement that is bound to be at odds with reality. In practice, a consumer can only be described in the broadest terms.

Consumers may spend money on buying assets such as housing, art or stocks and shares: there is no difference between spending on these and on anything else, because they all have a valid purpose in the mind of the consumer. In addition, there are unrecorded transactions on the black market or not recorded from small businesses, as well as transactions in second-hand goods which are specifically excluded on the grounds that the purpose of GDP is to record new production only. Therefore, much economic activity is excluded from the GDP calculation with the complication that money will flow between the econometrician’s version of GDP to the wider transaction universe, undermining all the macroeconomists’ attempts to link an increase in prices to an increase in the quantities of money and credit.

In conclusion, GDP has nothing to do with economic progress. It is a flawed statistic that imperfectly summarises the money-value of selected transactions over a given period. The fact it is usually positive is a reflection of the temporal difference between monetary inflation and the lagging effect on prices, and has nothing to do with economic progress.

Euro-sclerosis

Alasdair Macleod
28 May 2015

There appears to be little or nothing in the monetarists’ handbook to enable them to assess the risk of a loss of confidence in the purchasing power of a paper currency. Furthermore, since today’s macroeconomists have chosen to deny Say’s Law¹, otherwise known as the laws of the markets, they have little hope of grasping the more subtle aspects of the role of money in price formation. It would appear that this potentially important issue is being ignored at a time when the Eurozone faces growing systemic risks that could ultimately challenge the euro’s validity as money.

The euro is primarily vulnerable because it has not existed for very long and its origin as money was simply decreed. It did not evolve out of marks, francs, lira or anything else; it just replaced the existing currencies of member states overnight by diktat. This contrasts with the dollar or sterling, whose origins were as gold substitutes and which evolved in steps over the last century to become standalone unbacked fiat. The reason this difference is important is summed up in the regression theorem.

The theorem posits that money must have an origin in its value for a non-monetary purpose. That is why gold, which was originally ornamental and is still used as jewellery endures, while all government currencies throughout history have ultimately failed. It therefore follows that in the absence of this use-value, trust in money is fundamental to modern currencies.

The theorem explains why we can automatically assume, for the purposes of transactions, that prices reflect the subjective values of the goods and services that we buy. This is in contrast with money that is not consumed but merely changes hands, and both parties in a transaction ascribe to money an objective value. And this is why the symptoms of monetary inflation are commonly referred to as rising prices instead of a fall in the purchasing power of money.

The European Central Bank (ECB) is plainly assuming the euro is money on a par with any other major currency with a longer history. Despite caution occasionally expressed by sound-money advocates in Germany’s Bundesbank, the ECB is aggressively pursuing monetary policies designed to weaken its currency. For example, it has reduced its deposit rate for Eurozone banks to minus 0.2%. This is wholly unnatural in a world where possession of money is always more valuable than an IOU. Furthermore banks are encouraged to limit their customers’ cash withdrawals, often under the guise of fighting tax evasion or money laundering. But in Greece restrictions on cash withdrawals are clearly designed to protect the banks.

So far, there is nothing identified in this article that actually points to a destabilisation of the euro, other than it’s generally a bad idea to fool around with peoples’ rights to it. But lets assume for a moment that Greece defaults. In that case the Greek banking system would certainly collapse (assuming the ECB suspends its emergency liquidity assistance (ELA) because bad debts already on their balance sheets exceed tangible equity by a substantial margin. If that assistance is withdrawn, some €80bn of ELA will be lost. Furthermore, TARGET2 ²  settlement imbalances at the other Eurozone central banks, which have arisen through capital flight from Greece and which are guaranteed by the ECB, total a further €42bn. This leaves the ECB in the hole for €122bn. Unfortunately, the ECB’s equity capital plus reserves total only €96bn, so a Greek default would expose the euro’s issuing bank to be woefully under-capitalised.

Therefore, if Greece defaults we would at least expect the validity of this relatively new euro to be challenged in the foreign exchange markets. Even if the ECB decided to rescue what it could from a Greek default by rearranging the order of bank creditors in its favour through a bail-in, it would still have to make substantial provisions from its own inadequate capital base. For this reason, rather than risk exposing the ECB as undercapitalised, it seems likely that Greece will be permitted to win its game of chicken against the Eurozone, forcing the other Eurozone states to come up with enough money to pay off maturing debt and cover public sector wages. So will that save the euro?

Perhaps it will, but if so maybe not for long. If the Eurozone’s finance ministers give in to Greece, it will be harder for other profligate nations to impose continuing austerity. Anti-austerity parties, such as Podemas in Spain, are increasingly likely to form tomorrow’s governments, and Spain faces a general election later this year. Prime Minister Renzi and President Hollande in Italy and France respectively are keen to do away with austerity and increase government spending as their route to economic salvation. Unfortunately for both the undercapitalised ECB and its young currency, they are increasingly likely to be caught in the crossfire between the Northern creditors and the profligate borrowers in the South.

Even if Greece is to be saved from default, the ECB will need to strengthen the Greek banks. This is likely to be done in two ways: firstly by forcing them to recapitalise with or without bail-ins, and secondly to restrict money outflows through capital controls and harsh limits on depositor withdrawals if need be. Essentially it is back to the Cyprus solution.

Whichever way Greece is played, Eurozone residents will see themselves having a currency that is becoming increasingly questionable. The bail-in debacle that was Cyprus is still etched in depositors’ minds. Cyprus certainly has not been forgotten in Greece, where ordinary people are now resorting to buying mobile capital goods that can be easily sold, such as German automobiles, with the bank balances that cannot be withdrawn in cash and are otherwise at risk from a Cyprus-style bail-in. Greek depositors have realised that euro balances held in the banks are not reliably money. Folding cash is still money, but that is all, and furthermore the folding stuff is rationed.

The next blow for the euro could come from the exchange rate. If the euro continues to lose purchasing power on the foreign exchanges, it is likely to undermine confidence on the ground. And when that happens it will be increasingly difficult for the ECB to retrieve the situation and maintain the euro’s credibility as money. It just doesn’t seem sensible to take such enormous risks with a currency that has existed for only thirteen years.

 

 

[1] ‘Say’s Law Of Markets’ An economic rule that says that production is the source of demand. According to Say’s Law, when an individual produces a product or service, he or she gets paid for that work, and is then able to use that pay to demand other goods and services.

[2] TARGET2 is an interbank payment system for the real-time processing of cross-border transfers throughout the European Union. TARGET2 replaced TARGET (Trans-European Automated Real-time Gross Settlement Express Transfer System) in November 2007.