<![CDATA[博客-财经网-名家博客-迈克尔•佩蒂斯 最近更新20篇文章]]> <![CDATA[博客-财经网]]> <![CDATA[Syriza and the French indemnity of 1871-73]]> European nationalists have successfully convinced us, against all logic, that the European crisis is a conflict among nations, and not among economic sectors. Today’s Financial Times has an articlediscussing the travails of Greece’s new Finance Minister, Yanis Varoufakis as he takes on Germany:

In a small but telling sign of the frosty relations between Berlin and the new Greek government, the German finance ministry last week criticised Mr Varoufakis for failing to follow through with a customary courtesy call following his appointment. Mr Schäuble, meanwhile, has warned Greece not to attempt to “blackmail” Berlin with demands for debt relief.

This is absurd. The European debt crisis is not a conflict among nations. All economic systems— and certainly an entity as large and diverse as Europe— generate volatility whose balance sheet impacts are mediated through different political and economic institutions, among which usually are domestic monetary policy and the currency regime. With the creation of the euro as the common currency among a group of European countries, monetary policy and the currency regime could no longer play their traditional roles in absorbing economic volatility. As a result, for much of the euro’s first decade, a series of deep imbalances developed among various sectors of the European economy. Because Europe’s existing economic and political institutions had largely evolved around the national sovereignty of individual countries, and also because the inflation and monetary histories of individual countries varied tremendously before the creation of the euro, it was probably almost inevitable that these imbalances would manifest themselves in the form of trade and capital flow imbalances between countries.(1)

We have a great deal of experience in modern history with the kinds of imbalances from which Europe suffered and continues to suffer, and from the historical precedents three things are clear. First, the imbalances that led eventually to the current crisis had their roots in hidden transfers between different economic sectors within Europe, and not between countries. It is only because of deep institutional differences among the member countries that these imbalances manifested themselves largely in the form of trade imbalances between the different countries in Europe. These hidden transfers artificially forced up the savings rates in some countries and, for reasons that I havediscussed elsewhere, it is a matter of necessity, well understood in economics (although too often forgotten by economists), that artificially high savings rates in one part of an economic system must result in higher productive or non-productive investment (in advanced countries usually the latter) or artificially low savings in another part of that system.

Second, deep distortions in savings and investment historically have almost always led to an unsustainable increase in debt, and Europe was no exception. For many years European debt has risen faster than European debt-servicing capacity, but the gap between the two has not been recognized and written down, and instead manifests itself in the form of excessively high and rising debt burdens whose costs have eventually to be assigned.

Third, and most worryingly, it has always been easy for extremists and nationalists to exploit the grievances of the various economic groups to distort the meaning of the crisis. One way is to transform it into a class conflict and another way is to transform it into a conflict among member states. Resolving a debt crisis involves nothing more than assigning the losses. In the current crisis these costs have to be assigned to different economic sectors within Europe, but to the extent that the assignation of costs can be characterized as exercises in national cost allocation, it is easy to turn an economic conflict into a national conflict.

Most currency and sovereign debt crises in modern history ultimately represent a conflict over how the costs are to be assigned among two different groups. On the one hand are creditors, owners of real estate and other assets, and the businesses who benefit from the existing currency distortions. One the other hand are workers who pay in the form of low wages and unemployment and, eventually, middle class household savers and taxpayers who pay in the form of a gradual erosion of their income or of the value of their savings. Historically during currency and sovereign debt crises political parties have come to represent one or the other of these groups, and whether they are of the left or the right, they are able to capture the allegiance of these groups.

Except for Greece, in Europe the main political parties on both sides of the political spectrum have until now chosen to maintain the value of the currency and protect the interests of the creditors. It has been the extremist parties, either on the right or the left, who have attacked the currency union and the interests of the creditors. In many cases these parties are extreme nationalists and oppose the existence of the European Union. If they succeed in taking control of the debate, the European experiment will almost certainly collapse, and it will take decades, if ever, for a European union to revive.

But while distortions in the savings rate are at the root of the European crisis, many if not most analysts have failed to understand why. Until now, an awful lot of Europeans have understood the crisis primarily in terms of differences in national character, economic virtue, and as a moral struggle between prudence and irresponsibility. This interpretation is intuitively appealing but it is almost wholly incorrect, and because the cost of saving Europe is debt forgiveness, and Europe must decide if this is a cost worth paying (I think it is), to the extent that the European crisis is seen as a struggle between the prudent countries and the irresponsible countries, it is extremely unlikely that Europeans will be willing to pay the cost. As my regular readers know, I generally refer to the two different groups of creditor and debtor countries as “Germany” and “Spain”, the former for obvious reasons and the latter because I was born and grew up there, and it is the country I know best. I will continue to do so in this blog entry.

It is a horrible irony that while the view that the European crisis is a conflict between prudent Germany and irresponsible Spain could easily tear apart the European experiment, it terribly muddles Europe’s actual experience and may create a false impression of irresponsibility. To see why, it is useful to start with a little history. Nearly 150 years ago Spain’s “Glorious Revolution” of 1868 saw the deposition of Isabella II and the collapse of the first Spanish Republic. More importantly for our purposes it also unleashed within continental Europe a conflict over the succession to the Spanish throne which ultimately, through a series of circuitous events, resulted in France’s declaration of war on Prussia in July 1870. This was widely seen in France as a chance partially to even the score over Prussia’s victory during the Napoleonic wars, but in the end France’s revanchist fantasies were frustrated. By early 1871, the French army  was roundly defeated by Prussia, which during that time had unified the various German states as the German Empire under the Prussian king.

There were at least two important results of France’s military defeat. Of minor importance for the purpose of my blog entry, but interesting nonetheless for those obsessed with modernism and with France’s late 19th Century cultural history, like me, the Franco-Prussian War will always be remembered for its role in the subsequent creation and collapse of the Paris Commune. This event left its mark on the thinking of many cherished artists and intellectuals, from Manet and Rimbaud to Proudhon and Haussman.

But the other, to me, very interesting and far more relevant consequence was the French indemnity. As part of the privilege of conquest and as a condition for ending the occupation of much of northern France, Berlin demanded war reparation payments originally proposed at 1 billion gold francs but which eventually grew to an astonishing 5 billion, at least in part because of an explicit decision by Berlin to impose a high enough burden permanently to cripple any possible French economic recovery.

To give a sense of the sheer size of this payment, usually referred to in the literature as the French indemnity, this was equal to nearly 23% of France’s 1870 GDP.(2) Germany’s economy at the time,according to Angus Maddison, was only a little larger than that of France, so Germany was the beneficiary of a transfer over three years equal to around 20% of its annual GDP. This is an extraordinarily large transfer. I believe the French indemnity was the largest reparations payment in history — German reparations after WWI were in principle larger but I don’t think Germany actually paid an amount close to this size, and certainly not relative to its GDP.

Transfer beneficiary

Astonishingly enough France was able to raise the money very quickly, mostly in the form of two domestic bond issues in 1871 and 1872, which were heavily over-subscribed. One of the most complete studies of the French indemnity, I think, is a booklet by Arthur Monroe published in 1919.(3)  According to Monroe, the first issue of 2 billion in perpetual rentes was issued in June 1871, a mere 48 days after the treaty was signed, and was heavily oversubscribed. The second issue was even more successful:

Thirteen months after announcing the first loan the government opened subscriptions for a second, this time for three billions, again in 5 per cent rentes, but issued at 842. The response to this was astounding, for more than twelve times the amount desired was subscribed, more than half of the offers coming from foreign countries.

Monroe goes on to note that “it is no small compliment to the credit of France at this time to note that about one-third of the foreign subscriptions were from Germany,” so when we think about the net transfer to Germany, it was less than 5 billion francs. Although Monroe says that more than half the subscriptions came from outside France, and one-third of those were German, with twelve times oversubscription there is no way for me to estimate how much was actually allocated to German purchasers so I have no estimate for the amount by which the 5 billion should be adjusted.

The payments were made in the form of bills of exchange and to a lesser extent gold, silver, and bank notes, and Berlin received the full payment in 1873, two years before schedule. It was during this time that Germany went fully onto the gold standard, and obviously enough the massive indemnity made this not only possible but even easy. It also guaranteed currency credibility almost from the start, and it may jolt modern readers to know that at the time monetary credibility was not assumed to be part of the German DNA, so the additional credibility was welcome.

What does all of this have to do with Syriza? A few weeks ago I was discussing with a group of my Peking University students Charles Kindleberger’s idea of a “displacement”, and I proposed, as does Kindleberger, that the 1871-73 French indemnity is an especially useful example of a displacement from which we can learn a great deal about how financial crises can be  generated.(4)  It then occurred to me that the French reparations and their impact on Europe could also tell us a great deal about the euro crisis and, more specifically, why by distorting the savings rate wage policies in Germany in the first half of the last decade would have led almost inexorably to the balance of payments distortions that may eventually wreck the euro.

It is a nice accident that the French indemnity accelerated Germany’s adoption of the gold standard, because massive transfer payments from Germany to peripheral Europe were probably necessary for many of these countries to adopt the euro, in some  ways their own version of the gold standard. Before jumping into why I think the French indemnity is relevant to the Greek crisis, I want to make three quick points:

1.  I went into more detail on how France raised the money than might at first seem necessary for the purpose of this blog entry because it actually illustrates a potentially useful point. In the first third of my 2001 book,(5) I discussed extensively the historical role of global liquidity on the evolution of national balance sheets and sovereign debt crises. One important point is to distinguish between financial crises that occur within a globalization cycle and those that end a globalization cycle. Whereas the latter are often devastating and mark the end for many years of economic growth, the former — like the 1994 Tequila crisis or the 1997 Asian crisis, or even the 1866 Overend Gurney crisis — may seem overwhelming at first, but markets always recover far more quickly than most participants expect. When markets are very liquid, and in their leveraging-up stage, they can absorb large debt obligations easily, and because they can even turn these obligations into “money”, they almost seem to be self-financing.

The 1858-73 period was one such “globalization period”, with  typical “globalization” characteristics: explosive growth in high-tech communications and transportation (mainly railways), soaring domestic stock and real estate markets, booming international trade, and a surge in outflows of capital from the UK, France, the Netherlands and other parts of Europe to the United States, Latin America, the Far East, the Ottoman Empire, and other financial “frontiers”. I would argue that this is why, despite Berlin’s expectation that the indemnity would cripple the French economy, it was surprisingly easy for France to raise the money and for its economy to continue functioning. Germany, similarly, struggled over many aspects of the WWI reparations, but after 1921-22, when global markets began their decade-long globalization boom, driven by extraordinarily high US savings (and characterized by the familiar globalization sequence: electrification of American industry, the spread of telephones, automobiles, radios, cinema, and other communications and transportation technologies, booming international trade and capital flows, the Florida real estate mania, stock market booms, and, of course, the rise to fame of one Charles Ponzi), Germany found it relatively easy to raise the money that famously became part of the reparations recycling process — until, of course, the 1930-31 global banking crisis, after which Germany was forced into default. This may be relevant as we think about any possible future European sovereign bond restructuring. Any attempts to assess their impacts based on historical precedents must distinguish between periods of ample liquidity and the radically different periods of capital scarcity. Once the liquidity contraction begins, every debt restructuring will be brutally painful, unlike now when they are absorbed almost without a thought.

2.  I explain in my book that the French indemnity actually increased global liquidity by expanding the global supply of highly liquid “money-like” assets. Of course Germany’s money supply increased by the amount of the transfer (not the full amount, because part of the subscriptions actually came from Germany), but this was not offset by an equal reduction in France’s money supply. The creation of a huge, highly liquid, and highly credible instrument, the two French bond issues, involved the creation of “money” in the Mundellian sense. While the transfer of money from France to Germany might have seemed systemically neutral, in fact it resulted in a systemic increase in global “money”.

3.  From an “asset-side” analysis, as I discuss in my January 21 blog entry, the transfer of capital over three years from France to Germany equal to more than 20% of either country’s annual GDP would have had very predictable impacts — they should have been very negative for France, as Berlin expected, and very positive for German. In fact the actual results were very different. This is because there are monetary and economic conditions under which liability structure matters much more, and conditions under which it matters much less. Economists and the policymakers they advise are too quick to ignore these differences, perhaps because there is not as well-formulated an understanding of balance sheets in economics theory as in finance theory, so that when someone like Yanis Varoufakis proposes that there are ways in which partial debt forgiveness increases overall economic value, instead of merely creating moral hazard, worried economists often recoil in horror, while finance or bankruptcy specialists (and an awful lot of hedge fund managers) shrug their shoulders at such an obvious statement.

It is mainly the third of the above three points that is relevant for the current discussion about European sovereign obligations. One might at first think that France’s indemnity, at nearly 23% of GDP over three years, might have been devastating to the economy. It certainly left France with a heavy debt burden, but its immediate economic impact was not nearly as bad as might have been expected. Wikipedia’s assessment is pretty close to the consensus among historians:

It was generally assumed at the time that the indemnity would cripple France for thirty or fifty years. However the Third Republic that emerged after the war embarked on an ambitious programme of reforms, introduced banks, built schools (reducing illiteracy), improved roads, spreading railways into rural areas, encouraged industry and promoted French national identity rather than regional identities. France also reformed the army, adopting conscription.

Far more interesting to me is the impact of the indemnity on Germany. From 1871 to 1873 huge amounts of capital flowed from France to Germany. The inflow of course drove the obverse current account deficits for Germany, and Germany’s manufacturing sector struggled somewhat as an increasing share of rising domestic demand was supplied by French, British and American manufacturers. But there was a lot more to it than mild unpleasantness for the tradable goods sector. The overall impact in Germany was very negative. In fact economists have long argued that the German economy was badly affected by the indemnity payment both because of its impact on the terms of trade, which  undermined German’s manufacturing industry, and its role in setting off the speculative stock market bubble of 1871-73, which among other things unleashed an unproductive investment boom and a surge in debt.

Do capital inflows cause speculative frenzies?

As Germany began to absorb the inflows, its current account surplus of course reversed into deficits, which by definition means that there was a large and growing excess of investment over savings. Part of this was caused by rising German consumption, but much of it was caused by surging investment. Unlike in peripheral Europe 135 years later, the capital inflows were not mediated through commercial banks into the pockets of households, businesses, and local governments but rather ended up wholly in the hands of Berlin. Germany in the 1870s had an opportunity denied to peripheral Europe in the 2000s, in other words, to control the use of the massive transfer. I will get back to this point a little later.

As money poured into Germany the German economy boomed, along with German consumption, investment (a growing share of which went into projects at home and abroad that turned out in retrospect to be overly optimistic), and into the Berlin and Viennese stock markets. By early 1873 more experienced German, Austrian and British bankers were quietly warning each other of a speculative mania, and they were right. The stock market frenzy culminated in the 1873 global stock market crisis, which began in Vienna in May, shortly after the beginning of the 1873 World Fair, and rapidly spread throughout a world brimming with liquidity (a large part of the first French indemnity payments went directly to London to pay outstanding German obligations). By September the crisis reached the United States with the collapse of Jay Cooke and Company, one of the leading US private banks, and for the first time in history the New York Stock Exchange was forced to close, for ten days. The subsequent global “Long Depression”, which lasted until 1896, was felt especially severely in Germany, one of whose first reactions was the collapse of the railway empire of Bethel Henry Strousberg, a  major industrialist at the time whose prehistory included a stint in jail for absconding from a previous job as financial agent with other people’s money (petty criminals who become industrial magnates seem to be another characteristic of globalization periods).

Within a few years of the beginning of the crisis attitudes towards the French indemnity had shifted dramatically, with economists and politicians throughout Germany and the world blaming it for the country’s economic collapse. In fact so badly was Germany affected by the indemnity inflows that it was widely believed at the time, especially in France, that Berlin was seriously contemplating their full return. The great beneficiary of French “largesse” turned out not to have benefitted any more than Spain had benefitted from German largesse 135 years later.

This is interesting. The German economy responded to French capital inflows in almost the same way that several peripheral European economies responded to  large German capital inflows 135 years later. It might seem an unfair comparison at first because the 1871-73 transfer to Germany was huge, but it turns out that the magnitude of the French transfer into Germany was broadly similar, in fact probably smaller, to the inflows into peripheral Europe. By the way I should point out that I use Spain to represent peripheral Europe not just, as I stated earlier, because I was born and grew up there, and so know it well, but also because Spanish government polices were in many ways among the most “responsible” in Europe, and so cannot really be blamed for the aftereffects. Spain’s debt and its fiscal accounts were far stronger than the European average and stronger than those of Germany in most respects.

It is hard to imagine that the amount of inflows into Germany from 1871 to 1873 could have been comparable to the inflows Spain experienced, but if anything they were actually smaller. Here is why I think they were. From 2000-04 Spain ran stable current account deficits of roughly 3-4% of GDP, more or less double the average of the previous decade. Germany, after a decade of current account deficits of roughly 1% of GDP, began the century with slightly larger deficits, but this balanced to zero by 2002, after which Germany ran steady surpluses of 2% for the next two years.

Everything changed around 2005. Germany’s surplus jumped sharply to nearly 5% of GDP and averaged 6% for the next four years. The opposite happened to Spain. From 2005 until 2009 Spain’s current account deficit roughly doubled again from its 3-4% average during the previous five years. The numbers are not directly comparable, of course, but during those four years Spain effectively ran a cumulative current account deficit above its previous 3-4% average of roughly 21-22% of GDP. Seen over a longer time frame, during the decade it ran a cumulative current account deficit above its earlier average of roughly 31-32% of GDP.

These are huge numbers, and substantially exceed the French indemnity in relative terms. Of course the current account deficit is the obverse of the capital account surplus, so this means that Spain absorbed capital inflows above its “normal” absorption rate equal to an astonishing 21-22% of GDP from 2005 to 2009, and of 31-32% of GDP from 2000 to 2009. However you look at it, in other words, Spain absorbed an amount of net capital inflow equal to or substantially larger than Germany’s absorption of French reparations during 1871-73. It is not just Spain. In the 2005-09 period a number of peripheral European countries experienced net inflows of similar magnitude, according to an IMF study, including Portugal, Greece and several smaller east European countries.

By the way in principle it isn’t obvious which way causality ran between capital account inflows and current account deficits (the two must always balance to zero). In 1871-73 it is obvious that German capital inflows drove current account deficits. In 2005-09 European countries might similarly have run large current account deficits because of the capital inflows imposed upon them, but it is also possible that they had to import capital by eagerly borrowing German money in order to finance their large current account deficits. To put it differently, German money might have been “pushed” into these countries, as the “blame Germany” crew has it, or it might have been “pulled” in, by the need to finance their spending orgies, as the “blame anyone but Germany” crew insist. For those who prefer to think in more precise terms, Germany either created or accommodated the collapse in Spanish savings relative to Spanish investment. For those — including, distressingly enough, most economists — who believe a country’s savings rate must be driven only, or mainly, by domestic household preferences, please refer to “Why a savings glut does not increase savings“.

The structure of the balance of payments itself does not tell us conclusively which caused which, German outflows or Spanish inflows, and no one doubts that there was a strong element of self-reinforcement that was an almost automatic consequence of the payments process, as I have discussed in the January 21 entry on this blog. If it were the latter case, however, it would be an astonishing coincidence that so many countries decided to embark on consumption sprees at exactly the same time. It would be even more remarkable, had they done so, that they could have all sucked money out of a reluctant Germany while driving interest rates down. It is very hard to believe, in other words, that the enormous shift in the internal European balance of payments was driven by anything other than a domestic shift in the German economy that suddenly saw total savings soar relative to total investment. I have discussed many times before what happened in Germany that resulted in the savings distortion that convinces me that the flows originated in Germany, as it has many others.

What is interesting is how similar the consequence of the inflows were even though Berlin was able to control the disbursement of the inflows in a way of which Madrid could only dream. And yet from 1871 to 1873 the German economy experienced one of the most dramatic stock market and real estate booms in German history, and although the flow of funds into government coffers rather than through banks to businesses and households ensured that the subsequent rise in German consumption was not nearly as extreme as it was in Spain, Germany did engage in a frenzy of investment at home and abroad in which a substantial share of the inflows was effectively wasted in foolish investment. Of course unlike Spain today, there never was any question about Germany’s obligation to repay the transfer. It had come, after all, in the form of reparations demanded by a victorious army, and not in the form of loans. In fact it took the massive US lending to Germany in the 1920s for German investment misallocation to lead to wholesale default on external debt.

Syriza’s challenge

It is useful to remember this history when we confront the consequences of Greece’s recent elections. Syriza’s victory in Greece has reignited the name-calling and moralizing that has characterized much of the discussion on peripheral Europe’s unsustainable debt burden. I think it is pretty clear, and obvious to almost everyone, that Greece simply cannot repay its external obligations, and one way or another it is going to receive substantial debt forgiveness. There isn’t even much pretence at this point. This morning financial advisor Mish Shedlock, sent me (as a joke? as a sign of despair?) German newspaper Zeit‘s interview with Yanis Varoufakis entitled “I’m the Finance Minister of a Bankrupt Country”.

Even if the question of who is to “blame”, Greece or Germany, were an important one, the answer would not change the debt dynamics. It would take the equivalent of Ceausescu’s brutal austerity policies in Romania, which were imposed during the 1980s in order for the country fully to repay its external debt, to resolve the Greek debt burden without a write-down. Given that Ceausescu’s policies led directly to the 1989 revolution, which culminated in both Ceausescu and his wife being executed by firing squad, the reluctance in Athens to imitate Romania in the 1980s is probably not surprising.

But to say Greece simply cannot repay isn’t the end of the story. As Europe moves towards a more rational debt policy with Greece, I would say that there are three important things to remember:

1.  There is an enormous economic cost, not to mention social and perhaps political, to any delay. I worry about the terrifyingly low level of sophistication among policymakers and the economists who advise them when it comes to understanding balance sheet dynamics and debt restructuring. Greece’s debt overhang imposes rising financial distress costs and increasingly deep distortions in the institutional structure of the economy over time, and the longer it takes to resolve, the greater the cost.

I think most analysts understand that costs will rise during the restructuring process. I am not sure they understand, however, that delays will impose even heavier costs during the many years of subsequent adjustment. There is a lot of bad blood and recrimination among the various parties. I suspect that some of those who oppose Syriza are probably revolted by the thought that a rapid resolution of the Greek crisis would rebound to Syriza’s credit, but they must understand that dragging out the restructuring process will impose far greater long-term costs on the Greek people than they think.

My friend Hans Humes, from Greylock Capital, has been involved in more sovereign debt restructurings than I can remember, and he once told me with weary disgust that while it is usually pretty easy to guess what the ultimate deal will look like within the first few days of negotiation, it still takes months or even years of squabbling and bitter arguing before getting there. We cannot forget however that each month of delay will be far more costly to Greece and her people than we might at first assume.

2.  From what I read, much of the focus of the restructuring will be aimed at determining an acceptable and manageable debt-servicing cashflow for Greece. There is a mistaken belief that this is the only “real” variable that matters, and the rest is cosmetics. I don’t agree. Greece’s nominal debt structure will not just affect the debt-servicing cashflows but will also determine future behavior of economic agents.

There are at least two important functions of an economic entity’s liability structure. One is to determine the way operating profits or economic growth is distributed among the various stakeholders, or, put differently, to determine economic incentive structures. The other is to determine the way external shocks are absorbed. This is why the restructuring process is so important and can determine subsequent economic growth. The face value and structure of outstanding debt matters, and for more than cosmetic reasons. They determine to a significant extent how producers, workers, policymakers, savers and creditors, alter their behavior in ways that either revive growth sharply or slowly bleed away value. Incentives must be correctly aligned, in other words, so that it is in the best interest of stakeholders collectively to maximize value (this rather obvious point is almost never implemented because economists have difficulty in conceptualizing and modelling reflexive behavior in dynamic systems). Rather than let economists work out the arithmetic of the restructuring based on linear estimates of highly uncertain future cashfllows, whose values are themselves affected by the way debt payments are indexed to these cashflows, Greece and her creditors may want to unleash a couple of options experts onto the repayment formulas and allow them to calculate how volatility affects the value of these payments and what impact this might have on incentives and economic behavior.

3.  In fact the overall restructuring must be designed so that the interests of Greece, the producers who create Greek GDP, and the creditors are correctly aligned. To date sovereign debt restructurings have almost never included the instruments that reflect the instruments in corporate debt restructurings that accomplish this alignment of interests, largely because these instruments have not been “invented”. Among other things the negotiating committee might want to dust off the GDP warrants that were included in Argentina’s last debt restructuring.

If the restructuring is well designed, within a year of the restructuring I think we could easily see Greek growth surprise us with its vigor. I was delighted to see that Greece’s new Finance minister agrees. An article in Monday’s Financial Times starts with the claim that “Greece’s radical new government revealed proposals on Monday for ending the confrontation with its creditors by swapping outstanding debt for new growth-linked bonds, running a permanent budget surplus and targeting wealthy tax-evaders.” Today’s Financial Times has an article by Martin Wolf that mentions the benefits of “a growth linked bond”. In The Volatility Machine I spend chapters explaining how to create liability structures that minimize external shocks, align the interests of creditors and citizens, and improve the quality of payments for creditors, and I show why these make a restructuring much more successful for all parties concerned. This is just basic finance theory. Yanis Varoufakis should really take the lead in designing an entirely new form of sovereign debt restructuring, not just for Greece but for the many countries, in Europe and elsewhere, that will soon follow it into default.

Enough people seem to hate or fear Syriza that there will be little attempt to approach Greece’s problems with enough imagination to give either party what it needs, but in fact with the right cooperation, imagination, and intuitive understanding of how balance sheet structures change overall value creation, a Greek debt restructuring could leave both sides far better off than either side might imagine. Of course if done right this matters far more than for just its impact on the Greek economy. While everyone probably agrees that Greece simply cannot proceed without debt forgiveness, less widely agreed, but no less obvious in my opinion, is that there are a number of other European countries that also need debt forgiveness if they are to grow. Because I was born and grew up in Spain, and my French mother founded and ran a successful business there which my family and I still own, I am confident that I know the country well enough to say that even with some impressive reforms having been implemented under Mariano Rajoy, Spain is nonetheless one of these countries. I suspect that many other countries including Portugal, Italy, and maybe even France are too.

I also know, however, that Spanish debt prospects are an extremely sensitive and emotional topic, and I will be roundly condemned for saying this. Today’s Financial Times has a very worrying article explaining why Madrid wants to be seen among the hardliners in opposing a rational treatment for Greece: “when it comes to helping Greece, there will be no such thing as southern solidarity or peripheral patronage.” This is the reverse of what it should be doing. In an article for Politica Exterior in January 2012, I actually proposed, albeit without much hope, that Spain take the lead and organize the debtor countries to negotiate a sustainable agreement, but in its fear of Podemos, the Spanish equivalent of Syriza, and its determination to be one of the “virtuous” countries, it strikes me that Madrid is probably moving in the wrong direction economically. Ultimately, by tying itself even more tightly to the interests of the creditors, Rajoy and his associates are only making the electoral prospects for Podemos all the brighter.

As it is, and for reasons that may have to do with recent history, Francisco Franco, and the psychological scars he left among those of my generation, any discussion in Spain is likely to be subsumed under non-economic considerations, especially angry denunciations of moral virtue and moral turpitude. These non-economic considerations are not irrelevant. In fact some of them are very important and even admirable. But they must be understood within a more neutral context.

As far as I can tell there are at least four important reasons that opponents of debt forgiveness, not just in Germany but also in Spain, have proposed as to why demands for debt forgiveness would be a long-term disaster for Spain:

1.  Spain’s economic future depends on its remaining a member of Europe in good standing. To demand debt forgiveness (let alone a renegotiation of the currency union) would cause a financial crisis and relegate Spain to backward country status.

2.  If Spain fails to honor its debt commitments it will be considered forever an unreliable prospect and will be frozen out of future investment and trade.

3.  More importantly, it would be morally wrong. The German people provided Spain with real, hard-earned resources which Spaniards misused. It is not fair or honorable that Spain punish the German people for its generosity.

4.  Spain had a real choice, and it chose to spend money wantonly on consumer frivolities and worthless invest projects. It got itself into this mess only because of the very poor economic policies a corrupt Madrid implemented. Had Spaniards acted more like Germans and refrained from excessive consumption — the result of a flawed national character trait — it would not have suffered from speculative stock and real estate market bubbles, wasted investment and, above all, an unsustainable consumption boom and a collapse in savings. It is unfortunate that ordinary Spaniards must suffer for the venality of tis leaders, but ultimately they are responsible.

These four arguments, which are the same arguments made about other highly indebted European countries, have been made not just by the greedy Germans of caricature, but also, more importantly, by indignant locals. They genuinely believe that their country behaved stupidly and must pay the price, and it is hard not to respect their sincerity.

Blaming nations

The last of the four points is I think the most powerful of the arguments and among the most confused, and it is the one I hope I have at least partly addressed with my discussion of the French indemnity, and that I will discuss more below, but I should briefly address the first three, and of course while I refer to Spain, in fact much of what follows is as true of Greece and other heavily indebted European borrowers as it  is of Spain:

1.  There is no question that a renegotiation of Spanish debt or of its status within the currency union would be accompanied by economic hardship and perhaps even a crisis. But compared to what? The Spanish economy is already in disastrous shape and there is compelling historical evidence that countries suffering under excessive debt burdens can never grow their way out of their debt no matter how radical and forceful the reforms.

This means that by refusing to negotiate debt forgiveness, not only must Spain be prepared to live with unbearably high unemployment and slow growth for many years, which would undermine the social, political and financial institutions that are the real determinants of whether a country is economically advanced or economically backwards, but in the end after many years of suffering Spain would be forced into debt forgiveness anyway, only now with an economy in far worse shape. Historical precedents also suggest that while the real reforms Madrid has implemented seem to have failed, in fact it is the debt constraint that has prevented their impacts on productivity from showing up as economic growth. I suspect that many of these reforms have actually been very positive for Spain’s long-term productivity. In that sense I think Mariano Rajoy and his government have put in an impressive performance. Unless Madrid waits too long, they may very well even unleash tremendous growth once debt is written down, but until the debt is resolved, they will not seem to have worked. Throughout modern history even “good” reforms have failed to generate growth in nearly every previous case of overly indebted countries, unless of course those reforms sharply reduce outstanding debt.

Some economists argue the facts on the ground already contradict my pessimism. Last week Madrid announced excitedly that GDP grew by 1.7% last year, its fastest pace in seven years. TheFinancial Times pointed out that Spain was well-positioned in 2015 to continue to take advantage of lower energy costs, a weaker euro, and a cut in personal and corporate taxes, to which I would add lower metal prices, massive QE, and stronger than expected consumption. But even if these tailwinds are permanent, and they clearly are not, nominal GDP growth is still much lower than the growth in the debt burden. This is as good as it gets, in other words, and it is not good enough. As the debt burden continues to climb, and as social and political frustrations mount, Spain will slide inexorably backwards into the backward-country status it wants so badly to avoid. 

2.  There is overwhelming evidence — the US during the 19th Century most obviously — that trade and investment flow to countries with good future prospects, and not to countries with good track records. The main investment Spain is likely to see over the next few years is foreign purchases of existing apartments along the country’s beautiful beaches. Once its growth prospects improve, however, with among other things a manageable debt burden, foreign businesses and investors will fall over each other to regain the Spanish market regardless of its debt repayment history. This is one of those things about which the historical track record is quite unambiguous.

3.  It was not the German people who lent money to the Spanish people. The policies implemented by Berlin that resulted in the huge swing in Germany’s current account from deficit in the 1990s to surplus in the 2000s were imposed at a cost to German workers, and have been at least partly responsible for Germany’s extremely low productivity growth — most of Germany’s growth before the crisis can be explained by the change in its current account — rather than by rising productivity.

Moreover because German capital flows to Spain ensured that Spanish inflation exceeded German inflation, lending rates that may have been “reasonable” in Germany were extremely low in Spain, perhaps even negative in real terms. With German, Spanish, and other banks offering nearly unlimited amounts of extremely cheap credit to all takers in Spain, the fact that some of these borrowers were terribly irresponsible was not a Spanish “choice.” I am hesitant to introduce what may seem like class warfare, but if you separate those who benefitted the most from European policies before the crisis from those who befitted the least, and are now expected to pay the bulk of the adjustment costs, rather than posit a conflict between Germans and Spaniards, it might be far more accurate to posit a conflict between the business and financial elite on one side (along with EU officials) and workers and middle class savers on the other.  This is a  conflict among economic groups, in other words, and not a national conflict, although it is increasingly hard to prevent it from becoming a national conflict.

But didn’t Spain have a choice? After all it seems that Spain could have refused to accept the cheap credit, and so would not have suffered from speculative market excesses, poor investment, and the collapse in the savings rate. This might be true, of course, if there were such a decision-maker as “Spain”. There wasn’t. As long as a country has a large number of individuals, households, and business entities, it does not require uniform irresponsibility, or even majority irresponsibility, for the economy to misuse unlimited credit at excessively low interest rates. Every country under those conditions has done the same. What is more, even if the decision about the disbursement of the inflows could have been concentrated in the hands of a single, responsible entity, the experience of Germany after 1871 suggests that it is nearly impossible to prevent a massive capital inflow form destabilizing domestic markets. Germany, after all, was much better placed than Spain later was for two important reasons. First, unlike Spain today, Germany was not saddled with an enormous debt obligation which it had to repay. Second, in 1871-73 the transfers went straight to Berlin, which was able fully to control the disbursements. In 2005-09, on the other hand, the transfers to Spain left behind an enormous debt burden and were discrete and widely dispersed in ways that were almost certainly biased in favor of the most optimistic or foolish lenders and the most optimistic or foolish borrowers.

And this is a point that’s often missed in the popular debate. Over and over we hear — often, ironically, from those most committed to the idea of a Europe that transcends national boundaries — that Spain must bear responsibility for its actions and must repay what it owes to Germany. But there is no “Spain” and there is no “Germany” in this story. At the turn of the century Berlin, with the agreement of businesses and labor unions, put into place agreements to restrain wage growth relative to GDP growth. By holding back consumption, those policies forced up German savings rate. Because Germany was unable to invest these savings domestically, and in fact even lowered its investment rate, German banks exported the excess of savings over investment abroad to countries like Spain.

Why didn’t Germans, rather than Spaniards, take advantage of the excess savings to fund a consumption boom? The standard response is to point to German prudence and Spanish irresponsibility, but it must be remembered that as German and Spanish interest rates converged (driven in large part by German capital flows into Spain), because they adopted a common currency at a time when Spanish inflation had been higher than German, the real interest rate in Spain was lower than that of Germany. As German money poured into Spain — with Spain importing capital equal to 10% of GDP at its peak — the massive capital inflows and declining interest rates ignited asset price bubbles, and even more inflation, setting off in Spain what Charles Kindleberger called a “displacement”. This locked Spain into a classic self-reinforcing cycle of rising asset prices and declining interest rates.

What is more, under normal (i.e. pre-euro) conditions the Spanish peseta would have dropped and Spanish interest rates risen, but the conditions of the euro prevented both adjustment mechanisms, and to make things worse this gave Berlin’s policies far more traction than anyone expected, locking Germany into an over-reliance on capital exports to Spain, the obverse of Germany’s current account surplus. German workers gave up wage growth in order to eke out employment growth, which itself depended on an ever rising surplus. Throughout it all there was little productivity growth as German companies reduced their investment share in the economy.

Meanwhile German banks, flush with the higher savings that low wage growth, rising surpluses and growing corporate profits all but guaranteed, continued eagerly to export into Spain the savings they simply could not invest at home. So why didn’t ”Spain” step in and put an end to this process by refusing to borrow German money? Because, again, there was no “Spain”. There were millions of households and business entities all of whom were offered unlimited amounts of lending at very low or even negative interest rates, and under the conditions of euro membership Madrid could not intervene. If German and Spanish banks blanketed the country with lending proposals, Madrid could do nothing to stop it (at least not without raising domestic unemployment and igniting the  ire of Brussels and Berlin). As long as there were some greedy, overly optimistic or foolish borrowers (and in a country of 45-50 million people how could there not be?), German and Spanish banks fell over themselves to make loans. The money had to be absorbed by Spain and there was no mechanism to ensure the quality of its absorption.

Above all this is not a story about nations. Before the crisis German workers were forced to pay to inflate the Spanish bubble by accepting very low wage growth, even as the European economy boomed. After the crisis Spanish workers were forced to absorb the cost of deflating the bubble in the form of soaring unemployment. But the story doesn’t end there. Before the crisis, German and Spanish lenders eagerly sought out Spanish borrowers and offered them unlimited amounts of extremely cheap loans — somewhere in the fine print I suppose the lenders suggested that it would be better if these loans were used to fund only highly productive investments.

But many of them didn’t, and because they didn’t, German and Spanish banks — mainly the German banks who originally exported excess German savings — must take very large losses as these foolish investments, funded by foolish loans, fail to generate the necessary returns. It is no great secret that banking systems resolve losses with the cooperation of their governments by passing them on to middle class savers, either directly, in the form of failed deposits or higher taxes, or indirectly, in the form of financial repression. Both German and Spanish banks must be recapitalized in order that they can eventually recognize the inevitable losses, and this means either many years of artificially boosted profits on the back of middle class savers, or the direct transfer of losses onto the government balance sheets, with German and Spanish household taxpayers covering the debt repayments.

Who is fighting whom?

I am not rejecting the claim that “Spain” acted irresponsibly, in other words, only to place the blame on “German” irresponsibility. But it is absolutely wrong for Volker Kauder, the parliamentary caucus leader of German Chancellor Angela Merkel’s Christian Democrats, to say, according to an article in last week’sBloomberg, that “Germany bears no responsibility for what happened in Greece. The new prime minister must recognize that.” There was indeed plenty of irresponsible behavior on both sides, during which time wealth was transferred from workers of both countries to create the boom and to absorb the subsequent bust, and wealth will be transferred again from middle class households of both countries to clean up the resulting debt debacle.

Put differently, there is no national virtue or national vice here, and there is no reason for the European crisis to devolve into right-wing, nationalist extremism. The financial crisis in Europe, like all financial crises, is ultimately a struggle about how the costs of the adjustment will be allocated, either to workers and middle class savers or to bankers, owners of real and financial assets, and the business elite. Because the major parties have refused to acknowledge the nature of this allocation process, and have turned it into a fight between a creditor Germany, on the one hand, and indebted peripheral European countries on the other, I was able to make in 2010-11 one of the easiest predictions I have ever made in my career — whichever extremist parties, whether of the right or of the left, who first went on the offensive against Germany, the bankers and the currency bureaucrats, I predicted, would surge in electoral popularity and would eventually reformulate the debate.

That is why the question of debt forgiveness must be reformulated by the centrist parties first. Fundamental to the argument that Spain (or Greece, or anyone else) has a moral obligation to repay in full its debt to Germany are two assumptions. The first assumption is that “Spain” borrowed the money from “Germany”, and that there is a collective obligation on the part of Spain to repay the German collective. The second assumption is that Spain had a choice in what it could do with the German money that poured into the country, and so it must be held responsible for its having mis-used hard-earned german funds.

The first assumption is, I think, easily dismissed. Germany exported capital because by repressing wage growth, Berlin ensured the high profits and low consumption that forced up its national savings rates. Instead of employing these savings to invest in raising the productivity of German workers (in fact domestic investment actually declined) it offered them either to fund German consumption at high real interest rates (and there were few takers), or through German and Spanish banks this capital was offered to other European households for consumption or to other European businesses for investment. The offers were taken up in different ways by different countries. In countries where the offered interest rates were very low or negative, the loans were more widely taken up than in countries where real interest rates were much higher. To ascribe this difference to cultural preferences rather than to market dynamics doesn’t make much sense.

What started slowly quickly accelerated, again for reasons of market dynamics. As the huge inflow into Spain set off stock market and real estate booms, some Spanish households, feeling wealthier, borrowed to increase their consumption, and many Spanish households and businesses borrowed to buy real estate. In the subsequent frenzy, credit standards collapsed as Spanish and German banks fought to gain market share, and as optimism soared, consumption grew to unsustainable levels, until eventually Spain was so overextended that it collapsed. The same story can be told elsewhere. In fact this is what happened in Germany after the French indemnity.

As for the second assumption, that Spain had a choice, this too should be quickly dismissed. Clearly Spanish households and businesses in the aggregate behaved, in retrospect, with astonishing abandon. But could they have done otherwise — did they have a choice? Almost certainly not. Germany did not when it received the French indemnity, and I don’t think there are many, if any, cases of countries that were able to absorb productively such massive inflows. In every case I can think of, massive capital inflows were accompanied by speculative bubbles and financial crises. Even the US in 19th century — urgently needing foreign capital to finance a massive amount of productive investment that could not be financed out of domestic savings, making it the best candidate possible to receive massive foreign inflows — was not able to absorb surges in inflows without seeing the creation of bubbles, investment scandals, and financial crises. Is it reasonable to insist that Spain’s failure to choose a path that no other country in history seems ever to have chosen indicates greater irresponsibility on the part of the borrowers than of the lenders? As long as there is a widely diverse range of views among Spanish individuals and businesses about prospects for the future, as long as there is a mix of optimists and pessimists, or as long as there are varying levels of financial sophistication, I think it would have been historically unprecedented if at least some Spanish entities did not respond foolishly to aggressive offers of extremely cheap credit, especially once this cheap credit had set off a real estate boom.

In summary, I think there are several points that those of us who want “Europe” to survive should be making.

1.  The euro crisis is a crisis of Europe, not of European countries. It is not a conflict between Germany and Spain (and I use these two countries to represent every European country on one side or the other of the boom) about who should be deemed irresponsible, and so should absorb the enormous costs of nearly a decade of mismanagement. There was plenty of irresponsible behavior in every country, and it is absurd to think that if German and Spanish banks were pouring nearly unlimited amounts of money into countries at extremely low or even negative real interest rates, especially once these initial inflows had set off stock market and real estate booms, that there was any chance that these countries would not respond in the way every country in history, including Germany in the 1870s and in the 1920s, had responded under similar conditions.

2.  The “losers” in this system have been German and Spanish workers, until now, and German and Spanish middle class savers and taxpayers in the future as European banks are directly or indirectly bailed out. The winners have been banks, owners of assets, and business owners, mainly in Germany, whose profits were much higher during the last decade than they could possibly have been otherwise

3.  In fact, the current European crisis is boringly similar to nearly every currency and sovereign debt crisis in modern history, in that it pits the interests of workers and small producers against the interests of bankers. The former want higher wages and rapid economic growth. The latter want to protect the value of the currency and the sanctity of debt.

4.  I am not smart enough to say with any confidence that one side or the other is right. There have been cases in history in which the bankers were probably right, and cases in which the workers were probably right. I can say, however, that the historical precedents suggest two very obvious things. First, as long as Spain suffers from its current debt burden, it does not matter how intelligently and forcefully it implements economic reforms. It will not be able to grow out of its debt burden and must choose between two paths. One path involves many, many more years of economic hell, as ordinary households are slowly forced to absorb the costs of debt — sometimes explicitly but usually implicitly in the form of financial repression, unemployment, and debt monetization.  The other path is a swift resolution of the debt as it is restructured and partially forgiven in a disruptive but short process, after which growth will return and almost certainly with vigor

5.  Second, it is the responsibility of the leading centrist parties to recognize the options explicitly. If they do not, extremist parties either of the right or the left will take control of the debate, and convert what is a conflict between different economic sectors into a nationalist conflict or a class conflict. If the former win, it will spell the end of the grand European experiment.

——————-

I leave my readers with three questions that I hope we can discuss in the comments section:

1. If a huge amount of capital, equal say to 10-30% of a country’s annual GDP, is forcibly distributed to an enormous group of entities within that country in a short time period, and if the only way in which to distribute this capital is through a wide variety of banks, with biases such that the more optimistic and irresponsible the bank, the more it profits, and the more optimistic and irresponsible the borrower, the more it receives, is it meaningful to refer to either side as behaving “irresponsibly”, and if so, which side? Does this sound like a loaded question? If it is, can it be rephrased in a less loaded way?

2. There have been many cases of large capital recycling in history — just in the last 100 years I can think of the recycling of the US trade surplus to Germany and other countries in the 1920s, the petrodollar recycling to Latin America in the 1970s, and the recycling to the US of the Japanese trade surplus in the 1980s and the Chinese trade surplus in the 2000s. These were all accompanied in the recipient country by stock, bond and real estate bubbles and by overconsumption and wasted investment. Have there been cases of large capital recycling that did not end in tears for the recipients? If so, how were they different?

3. What about the other side of the recycling? In most cases the recycling country also experienced bubbles and rising debt. Have there been cases that did not also end in tears and if so, how were they different?

Notes:

(1) The imbalances themselves occurred in forms that are widely understood and for which we have many historical precedents. I discussed these in my book, The Great Rebalancing: Trade, Conflict, and the Perilous Road Ahead for the World Economy (Princeton University Press, 2013). I am far from the only one to have done so. Martin Wolf’s excellent The Shifts and the Shocks: What We’ve Learned—and Have Still to Learn—from the Financial Crisis (Penguin Press, 2014) presents a schematic account of the causes of the crisis, and in The Leaderless Economy: Why the World Economic System Fell Apart and How to Fix It (Princeton University Press, 2013) Peter Temin and David Vine set out with great clarity the framework within which Europe’s internal imbalances had inexorably to lead to the current outcome.

(2) Michael B. Devereux and Gregor W. Smith, “Transfer Problem Dynamics: Macroeconomics of the Franco-Prussian War Indemnity”, August, 2005, Queen’s University, Department of Economics Working Papers 1025

(3) Arthur E. Monroe, The French Indemnity of 1871 and its Effect (The MIT Press, 1919)

(4) Charles Kindleberger, A Financial History of Western Europe, (Routledge 2006)


(5) Michael Pettis, The Volatility Machine: Emerging Economics and the Threat of Financial Collapse (Oxford University Press, 2001)

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<![CDATA[Can monetary policy turn Argentina into Japan?]]> Monetary policy is as much about politics as it is economics. It affects the ways in which wealth is created, allocated, and retained and it determines the balance of power between providers of capital and users of capital. In January one of my readers kindly passed on to me a link to an interesting reportpublished two years ago by Bain and Company called “A World awash in Money: Capital trends through 2020”. According to the authors:

Our analysis leads us to conclude that for the balance of the decade, markets will generally continue to grapple with an environment of capital superabundance. Even with moderating financial growth in developed markets, the fundamental forces that inflated the global balance sheet since the 1980s—financial innovation, high-speed computing and reliance on leverage—are still in place.

There certainly has been a great deal of liquidity in the two years since the report was published, and I agree with the authors that this is likely to continue over the next several years, and maybe well into the next decade. I disagree with their assessment of the source of this liquidity — what Charles Kindleberger would have probably called the “displacement” (see Note below). I think policies that implicitly or explicitly constrained growth in median household income relative to GDP are more to blame than the changes in the financial system they cite because these plosives tended to force up the savings rate. The financial system changes are much more likely to be consequences rather than causes of abundant liquidity, although there is plenty of historical evidence to suggest that the two come together, and that they are mutually reinforcing.

I am especially interested in the authors’ claim that “the investment supply–demand imbalance will shift power decisively from owners of capital to owners of good ideas”, especially owners of “good ideas” in technology. This has happened before. Technology “revolutions” tend to take place when a huge amount of risk-seeking capital flows into very risky and often capital-intensive high-tech investments, generating large network benefits and creating tremendous rewards for successful technology ventures. Particularly for those technology projects that benefit from growing networks — railroads, telephones, video, the internet — there is a strong element of pro-cyclicality, in that early successes spur greater visibility and faster adoption, which of course creates further success. I addressed this process in a 2009 article for Foreign Policy, in which I described six waves of “globalization” in the past 200 years as having certain characteristics in common:

What today we call economic globalization — a combination of rapid technological progress, large-scale capital flows, and burgeoning international trade — has happened many times before in the last 200 years. During each of these periods (including our own), engineers and entrepreneurs became folk heroes and made vast fortunes while transforming the world around them. They exploited scientific advances, applied a succession of innovations to older discoveries, and spread the commercial application of these technologies throughout the developed world. Communications and transportation were usually among the most affected areas, with each technological surge causing the globe to “shrink” further.

But in spite of the enthusiasm for science that accompanied each wave of globalization, as a historical rule it was primarily commerce and finance that drove globalization, not science or technology, and certainly not politics or culture. It is no accident that each of the major periods of technological progress coincided with an era of financial market expansion and vast growth in international commerce. Specifically, a sudden expansion of financial liquidity in the world’s leading banking centers — whether an increase in British gold reserves in the 1820s or the massive transformation in the 1980s of illiquid mortgage loans into very liquid mortgage securities, or some other structural change in the financial markets — has been the catalyst behind every period of globalization.

Are we in such a period? We certainly were before the 2007-08 crisis, but every globalization period has been followed by a contraction which, too, has certain characteristics in common.

Because globalization is mainly a monetary phenomenon, and since monetary conditions eventually must contract, then the process of globalization can stop and even reverse itself. Historically, such reversals have proved extraordinarily disruptive. In each of the globalization periods before the 1990s, monetary contractions usually occurred when bankers and financial authorities began to pull back from market excesses. If liquidity contracts — in the context of a perilously overextended financial system — the likelihood of bank defaults and stock market instability is high.

This disruption has already occurred to some extent. After 2007-08, global GDP growth dropped sharply, the growth in global trade dropped even more sharply, we have seen soaring unemployment, and I expect that we will soon see a wave of sovereign defaults.

But this time may be different in one important way. The 2007-08 crisis may well be the first global crisis that has occurred in a period of credible fiat currency.

“Everyone can create money,” Hyman Minsky often reminded us. “The problem is to get it accepted.” Having money accepted widely is what it means to be credible, and in past crises, if money was credible it was constrained by the amount and quality of its  gold or silver backing, whereas if it was unconstrained, that is fiat money money, it was not terribly credible. Were we still living in that world, we would already have seen a wave of sovereign defaults and the forced, rapid recognition and writing down of bad debts. We would have probably also seen a collapse in several national banking systems and an even more brutal economic contraction than what we have already experienced.

No more collapsing money?

“Panics do not destroy capital,” John Mill proposed in his 1868 paper to the Manchester Statistical Society. “They merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works.”  Our ability to postpone the recognition of the full extent of these unproductive works depends in part on our ability to expand the supply of credible money. If we are constrained in our ability to expand the money supply, one impact of the crisis is a contraction in money (velocity collapses) that forces lenders to write down debt. If money can expand without constraints, however, debt does not have to be written down nearly as quickly.

With the main central banks of the world having banded together to issue unprecedented amounts of credible currency, in other words, we may have changed the dynamics of great global rebalancing crises. We may no longer have to forcibly write down “hopelessly unproductive works”, during which process the seemingly endless capital of the globalization phase is wiped out, and we enter into a phase in which capital is scarcer and must be allocated much more carefully and productively.

Instead, the historically unprecedented fact of our unlimited ability to issue a credible fiat currency allows us to postpone a quick and painful resolution of the debt burdens we have built up. It is too early to say whether this is a good thing or a bad thing. On the one hand, it may be that postponing a rapid resolution protects us from the most damaging consequences of a crisis, when slower growth and a rising debt burden reinforce each other, while giving us time to rebalance less painfully — the Great depression in the US showed us how damaging the process can be. On the other hand the failure to write down the debt quickly and forcefully may lock the world into decades of excess debt and “Japanification”. We may have traded, in other words, short, brutal adjustments for long periods of economic stagnation.

Only the passage of time will tell us whether or not this is indeed the trade-off we have made or want to make. Argentina used to be the archetype of financial crisis, when a collapse in the supply of money caused massive debt write-downs. “This time” may indeed be different in the sense that there is a very real possibility, as the authors of the Bain study propose, of many years of “superabundant” capital, instead of the scarce capital that has historically characterized the post-crisis period.

Excess capital tends to be associated with periods of tremendous technological advances, and because these are experienced primarily by the technologically most advanced countries, the next decade might bring some benefit to the world’s most advanced economies — which will be all the more noticeable in the context of the low commodity prices that presage the end of “convergence”. The idea that advanced countries may outperform developing countries may seem shocking. For the past few decades the world has gotten used to the idea that economic convergence between rich countries and poor is inexorable.

But it isn’t. Over long periods of time, convergence has been the exception, not the rule. In periods during which commodity prices are high, or the advanced economies have created artificially high demand that developing countries can exploit (during war, for example), we are usually swept by waves of optimism and a firm belief in economic convergence. But once these conditions end, the high hopes quickly abate. I have written elsewhere, for example, of Albert Hirschman’s optimism during the 1950s and 1960s that led him and many others, especially those influenced by Marxist ideas of economic growth, to believe that development was primarily a technical problem. Once we had resolved the problem, as we seemed to be doing in the heady days of the 1950s and early 1960s, we could expect fairly rapid economic convergence.

By the late 1970s, of course, development economists were despairing over the seeming intractability of backwardness. Their models of linear development (most famously W.W. Roster’s “five stages” of economic development) were gradually replaced by more complex analyses of economies as “systems”, in which complex institutional constraints could distort or prevent convergence. The now (unfairly) discredited dependence theorists, for example, argued that under certain conditions convergence was not even theoretically possible.

Hirschman too became far more pessimistic about long term convergence, and began worrying about the nature of these constraints, even pointing out how misguided optimism itself could lead to highly pro-cyclical policies that reverse the convergence process, in part by encouraging the kinds of inverted balance sheets that I discussed in my blog entry of two weeks ago. The outpouring of almost comically muddled explanations of and forecasts for the Chinese growth miracle has been an especially egregious example of the way well-intentioned economic analysis has led to, or at least encouraged, worse outcomes. China’s cheerleaders have for many years encouraged policies that we are finally recognizing as foolish.

The idea of emerging markets having decoupled from the advanced economies has died, and I suspect the idea of convergence will soon become another victim of the crisis. If the world does indeed face another decade or two of “superabundant capital” in spite of economic stagnation and slow growth, the historical precedents suggest a number of other consequences.

The brave new world of weak demand and frenzied speculation

Last week I had drinks with one of my former Peking University students and we discussed some of the ways the global economy might react to a world adjusting from a global crisis with weak demand and excess liquidity. In no particular order and very informally these are some of the consequences we thought were likely or worth considering:

  • During periods of excess capital, investors are willing to take on far more risk than they normally would. High tech is one such risky investment, and has historically done very well during periods in which investors were liquid and hungry for yield. This suggests that developed countries will benefit relatively because of their dominance of high tech, and the US will benefit the most.

But we have to make some important distinctions. The willingness to take excess risk is not necessarily a good thing socially. If it leads investors to pour money into non-productive investments, excess real estate and manufacturing capacity, or into investments that with negative externalities, excess risk-taking simply destroys wealth. The economy is better off, in other words, only if policymakers can create incentives that channel capital into entrepreneurial activity or into activity with significant positive externalities (i.e. whose social value is exceeds the value that investors can capture).

In several countries before the crisis, including the US, China and parts of Europe, a lot of overly-aggressive financing went into projects with negative externalities — empty housing, useless infrastructure, excess capacity — and it is important that this kind of risk-taken isn’t encouraged. Policymakers should consider the conditions under which excess risk-taking is channeled by the private sector into socially productive investments, for example into high tech, small businesses, and high value added ventures. With their highly diversified financial systems and incentive structures that reward innovation and entrepreneurialism, the US, the UK and perhaps a handful of “Anglo-Saxon” and Scandinavian economies, in their different ways, are especially good at this. Much of Europe and Japan are not. The latter should take steps to increase the amount by which they will benefit from many more years of high risk appetite among investors.

  • Normally, developing countries only benefit indirectly from periods of abundant capital and excess risk taking because abundant capital tends to lead increased investment in developing countries and higher commodity prices. This, however, is perhaps the first time that excess liquidity has overlapped with a period of crisis and contraction, so it is hard to know what to expect except that the days of historically high hard commodity prices are well behind us (food may be a different matter). I suspect that developing countries are going to lag economically over the next few years largely because of high debt levels.

Why? Because one of the ways the market will probably distinguish between different types of risk is by steering away from highly indebted entities. Excess debt is clearly worrying, and while there will always be investors who are willing to lend, in the aggregate they will probably discriminate in favor of equity-type risks unless policymakers create incentives in the opposite direction.

  • Developing countries almost never benefit from the high tech boom that typically accompanies periods of excess liquidity because they tend to have limited technology capabilities. Policymakers should consider nonetheless how to take advantage of what capabilities they do posses.

India for example has a vibrant innovation-based sector, but it suffers from low credibility and from regulatory and red-tape constraints that will make it hard for Indian innovation to benefit from global investors’ high risk appetites. New Delhi — and perhaps local state capitals — should focus on addressing these problems. If Indian technology companies are given the regulatory flexibility and if investors find it easy to put money into (and take it out of) Indian technology ventures, we might see India capture some of the benefits of what may be a second or third wave of information technology. 

Brazil is another large developing economy with pockets of tremendous innovation but which overall also suffers from low credibility and distorted incentive structures — and way too much debt. I am neither smart nor knowledgeable enough to propose specific policies, but policymakers in Brazil, like in India and in other very large developing economies — and they must be large in order that their relatively small technology sectors can achieve critical mass — must develop an explicit understanding of the institutional constraints and distorted incentive structures that prevent the development of their technology sectors, and take forceful steps to reverse them.

  • China is weak in high -tech innovation largely because of institutional constraints, including education, regulatory constraints, distorted incentive structures,and a hostile environment for innovative thinking (defying attempts to separate “good” innovative thinking from “bad”).  Overly-enthusiastic American venture capitalists, Chinese policymakers, and Chinese “entrepreneurs”, many of whom have almost become Silicon Valley caricatures will disagree, but in my experience most China, and certainly those involved in technology, are very skeptical about Chinese innovation capabilities. For example, when I taught at Tsinghua University, China’s answer to MIT, my students regularly joked that the only way to turn Tsinghua graduates into high tech innovators was to send them to California.

The main reason for its weak track record in innovation, I would argue, is that in China, like in many countries, there are institutional distortions that directly constrain innovation, as I explain in myblog entry on “social capital”. There are also indirect distortions, most obviously extraordinarily low interest rates and the importance of guangxi, that made accessing credit or developing good relationships with government officials infinitely more profitable, and requiring far less effort, for managers than encouraging innovation.

It is politically too difficult to resolve many of these institutional constraints nationally. In fact we are probably not even moving in the right direction — for example Beijing has recently sharply reduced internet access within China for domestic political reasons, and it is a pretty safe bet that this and other attempts to secure social stability will come at the expense of a culture of innovation.

But if Beijing is reluctant to relax constraints at the national level, it might nonetheless be willing to do so in specific local jurisdictions. If there were pockets within the country operating under different legal, regulatory, tax and cultural systems, and much more tolerant of the political and social characteristics of highly innovative societies, China might see the creation of zones of innovation that would benefit from the favorable global environment. I am skeptical about the impact of the Shanghai free-trade zone on trade or investment, for example, but it could become a more credible center of Chinese innovation under a very different legal and regulatory system  — much as Shanghai was, by the way, in the 1920s and 1930s. China has benefitted in the past from special economic zones, with different laws and regulations, dedicated to manufacturing. It might benefit in the future if it turns these into special “innovation” zones, also with very different laws and regulations —  and above all a far greater appetite for the “bad” things that are always part of highly innovative cultures, including a wide open internet and tolerance for any kind of discussion.

  • Excess liquidity and risk appetite makes it easy to lock in cheap, long-term funding for investment projects. Countries that have weak infrastructure, or whose infrastructure is in serious need of improvement, have today an historical opportunity to build or replenish the value of their infrastructure with very cheap capital. This is truly the time for governments to identify their optimal infrastructure needs and to lock in the financing. The most obvious places for productive infrastructure spending, it seems to me, are the United States, India and Africa.

The constraint in the US seems to be a politically gridlocked Congress unable to distinguish between expenditures that increase the US debt burden and expenditures that reduce it. Borrowing $100 for military expansion, higher government salaries, or an expansion in welfare benefits will increase the US debt burden, for example, but borrowing $100 in order to build or improve infrastructure in a way that increases US productivity by $120 actually reduces the US debt burden.

This mindset at the federal, state and local levels prevents highly accommodative money from flowing easily into infrastructure projects, and it means that the US will probably miss an historic opportunity to upgrade its infrastructure cheaply in ways that will boost growth for decades to come. The US must come up with institutional alternatives that will allow it to overcome these constraints, for example there has been some talk of a national development bank whose sole purpose was to raise money for infrastructure investment. That is a great idea if Congress can pull it off.

  • The constraint in both India and Africa is low credibility. Aside from concerns about the siphoning off of a significant share of the money that was earmarked for investment, especially in several African countries, foreign funding of infrastructure would come mainly in the form of debt financing, and this would almost certainly have to be denominated in dollars, euros or some other hard currency, which, given the size of the required funding, might raise questions about repayment prospects.

In the case of India it may be that under Prime Minister Narendra Modi the issue of credibility will be resolved, although my Indian friends tell me that we are far from resolving the issues of bureaucratic entanglement that hamstring attempts to put into place the kind of infrastructure that India needs. One way or the other India has a very rare opportunity, if it is able to put together a credible plan, to build out substantial infrastructure on very accommodating financing terms, and given its urgent need for infrastructure, the resulting increases in productivity would actually cause India’s debt burden to fall substantially.

For African countries the problem is far more complex. Not all African countries are the same, of course, but many if not most African economies are likely to be directly or indirectly very sensitive to commodity prices. Some African countries has been able to get funding from China beyond what has been available in the market, but as commodity prices decline, as many of the funded projects turn out to be less productive than planned, and especially as earlier loans to African and Latin American countries begin to come due, my suspicion is that China will face the same problems new lenders to African have historically faced. The path of regaining credibility for individual countries is likely to be slow and arduous.

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Note:


From Charles Kindleberger’s “Anatomy of a Typical Crisis”: “We start with the model of the late Hyman Minsky…According to Minsky, events leading up to a crisis start with a “displacement,” some exogenous, outside shock to the macroeconomic system. The nature of this displacement varies from one speculative boom to another. It may be the outbreak or end of a war, a bumper harvest or crop failure, the widespread adoption of an invention with pervasive effects—canals, railroads, the automobile—some political event or surprising financial success, or debt conversion that precipitously lowers interest rates. An unanticipated change of monetary policy might constitute such a displacement and some economists who think markets have it right and governments wrong blame “policy-switching” for some financial instability.

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<![CDATA[Inverted balance sheets and doubling the financial bet]]> On Tuesday the National Bureau of Statistics released China’s 2014 GDP growth numbers and reported growth consistent with what the government has been widely promoting as the “new normal”.

According to the preliminary estimation, the gross domestic product (GDP) of China was 63,646.3 billion yuan in 2014, an increase of 7.4 percent at comparable prices. Specifically, the year-on-year growth of the first quarter was 7.4 percent, the second quarter 7.5 percent, the third quarter 7.3 percent, and the fourth quarter 7.3 percent.

As nearly every news article has pointed out, GDP growth of 7.4% slightly exceeded consensus expectations of around 7.3%, setting off a flutter in the Shanghai Stock Exchange that reversed nearly a quarter of Monday’s disastrous drop of almost 8%. But although it exceeded expectations 2014 still turned in the lowest reported GDP growth since 1990, presenting only the second time since growth targeting began in 1985 that the reported number came in below the official target (the first time was in 1989). We will undoubtedly be swamped in the coming days with analyses of the implications, but I read the data as telling us more about the state of politics than about the economic health of the country.

Over the medium term I have little doubt that growth will continue to slow, and that at best we have only completed about one third of the journey from peak GDP growth to the trough. As long as it has debt capacity Beijing, or indeed any other government, can pretty much get as much growth as it wants, in China’s case simply by making banks fund local government infrastructure spending.

Most economic analyses of the Chinese economy tend to base their forecasts on the sequence and pace of economic reforms aimed at rebalancing the economy, and on the impact these reforms are likely to have on productivity growth. It may seem contrarian, then, that I forecast Chinese near term growth largely in terms of balance sheet constraints. I am not implying that the reforms do not matter to the Chinese economy. The extent to which the reforms Beijing proposes to implement reduce legal and institutional distortions in business efficiency, eliminate implicit subsidies for non-productive behaviour, reorient incentives in the capital allocation process, undermine the ability of powerful groups to extract rent, and otherwise liberalise the economy, will unquestionably affect China’s long-term growth prospects.

But I expect that any significant impact of these reforms on short-term growth will largely be the consequence of two things. The first is how reforms will affect the amount, structure, and growth of credit. The second is how successfully Beijing can create sustainable sources of demand that do not force up the debt burden — the most obvious being to increase the household income share of GDP and to increase the share of credit allocated to small and medium enterprises relative to SOEs.

To put it a little abstractly, and using a corporate finance model to understand macroeconomics, I would say that most economists believe that China’s growth in the near term is a function of changes in the way the asset side of the economy is managed. If Beijing can implement reforms that are aimed at making workers and businesses utilize assets more productively, then productivity will rise and, with it, GDP.

This sounds reasonable, even almost true by definition, but in fact it is an incomplete explanation of what drives growth. In corporate finance theory we understand that although growth can often or even usually be explained as a direct consequence of how productively assets are managed, it is not always the case that policies or exogenous variables that normally change the productivity of operations will have the expected impact on productivity growth. When debt levels are low or when the liability structure of an economic entity is stable, then it is indeed the case that growth is largely an asset-side affair. In that case for GDP growth to improve (or for operating earnings to rise), managers should focus on policies aimed at improving productivity.

But when debt levels are high enough to affect credibility, or when liabilities are structured in ways that distort incentives or magnify exogenous shocks, growth can be as much a consequence of changes in the liability side of an economy as it is on changes in the asset side. At the extreme, for example when a company or a country has a debt burden that might be considered “crisis-level”, almost all growth, or lack of growth, is a consequence of changes in the liability structure. For a country facing a debt crisis, for example, policymakers may work ferociously on implementing productivity-enhancing reforms aimed at helping the country “grow” its way out of the debt crisis, but none of these reforms will succeed.

When liabilities constrain assets

That both orthodox economic theory and government policy-making ignore the way liability structure can overwhelm the impact of asset-side management is surprising given how strong the historical confirmation. There is a long history of countries either facing debt crises or struggling with dangerous debt burdens — including many countries today both in the developed world and the developing world — in which policymakers have promised to implement dramatic policies that will improve productivity and return the economy to “normalcy”. But just as today growth stubbornly stagnates or decelerates in Europe, Japan, China, and a number of over-indebted countries, it is hard to find a single case in modern history in which a country struggling with debt has been able to reform and grow its way out of its debt burden until there has been explicit or implicit debt forgiveness. It is no accident that growth in Japan, China and Europe keep disappointing analysts, and on Tuesday the IMF yet again cut its global growth forecast by 0.3% — to 3.5% and 3.7% in 2015 and 2016. It will almost certainly continue to cut it over the next few years.

In the book I plan to write this year I hope to explore the conditions under which the structure of liabilities matter to growth, and to show how sometimes it is even the only factor that determines growth rates. It is not just as a constraint that a country’s liability structure affects growth, however. There are times when it can actually reinforce growth. There are in fact many ways in which a country’s balance sheet can significantly affect growth rates, both during growth acceleration and growth deceleration, and China demonstrates just such a case.

In fact as far as I can tell, in every case in modern history of very rapid, investment-driven growth, at least part of the growth was caused by self-reinforcing credit structures embedded in the balance sheet. One way is by encouraging additional investment to expand manufacturing and infrastructure capacity. Rapid growth raises expectations about future growth, making it easy to fund projects that expand capacity even further, and these projects themselves result in faster growth, which then justifies even higher growth expectations. Another way is by improving credit perceptions. When loans are backed by assets, rapid growth increases the value of these assets, so that the riskiness of the existing loan portfolio seems to decline, allowing the lender to increase his risky loans and the borrower to increase his purchase of assets, which of course puts further upward pressure on asset values.

There is nothing surprising about either process — we all understand how it works. But what we sometimes forget is that when this happens economic activity can easily exceed the increase in real economic value-creation, and more importantly, the same balance sheet structure can cause growth to decelerate far faster than we had expected during the subsequent adjustment period. The balance sheet causes growth to be higher than it would have otherwise been during the growth phase and slower when growth begins to  decelerate. It is not just coincidence that nearly every case in modern history of a growth miracle has been followed by a brutally and unexpectedly difficult adjustment. The same balance sheet that turned healthy growth into astonishing growth turned a slowdown into a collapse.

My 2001 book, The Volatility Machine, was about the history and structure of financial crises in developing countries, and in the book I discuss some of these balance sheet structures that exacerbate both accelerating and decelerating growth. In this essay I want to discuss concrete examples of such structures and show how they impact growth. In the book I distinguish between “inverted” and “hedged” balance sheets, and it is worth explaining the distinction. A hedged balance sheet is simply one that is structured to minimise the overall volatility of the economic entity, whether it is a business or a country.

When the balance sheet is fully hedged, the only thing that changes its overall value is a real increase in productivity. Any exogenous shock that affects the value of liabilities and assets, or that affects income and expenditure, will have opposite effects on the various assts and liabilities, and together these will add to zero. Of course the closer an economic entity is to having a perfectly hedged balance sheet, the lower the cost of capital, the lower the rate at which expected earnings or growth is discounted over time, the easier it is for businesses to maximise operating earnings without worrying about unexpected shocks, and the longer the time horizon available for both policymakers and businesses in planning.

An inverted balance sheet is the opposite of a “hedged” balance sheet, and involves liabilities whose values are inversely correlated with asset values. These embed a kind of pro-cyclical mechanism that reinforces external shocks by automatically causing values or behavior to change in ways that exacerbate the impact of the shock. When asset values rise, in other words, the value of liabilities falls (or, to put it differently, the cost of the liabilities rise), and vice versa.

Balance sheet inversion

A business or country with an inverted balance sheet benefits doubly in good times as its assets, or its earnings, rise in value and its liabilities, or its financial expenses, fall. The process is often self-reinforcing, especially when the inverted entity is a country, in which case the economy can be described as being in a virtuous circle. When Brazil began to reform its economy and instituted a new currency regime in 1994, for example, one of its greatest vulnerabilities was its extremely high fiscal deficit, more than 100% of which was explained by debt servicing costs. Most Brazilian government debt was of less than six months maturity, and nearly all of it matured within one year (short-term debt is extremely inverted). As Brazilian reforms associated with the 1994 currency regime increased overall confidence, short-term interest rates declined, and within months the fiscal deficit followed suit. This caused confidence to rise sharply, and interest rates to fall further. In Brazil interest rates fell steadily from well over 50% in the early 1994-95 to around 20% by the summer of 1998.

Of course in bad times the opposite happens – the value of assets fall while the value of liabilities rise, and the virtuous circle quickly becomes a vicious circle. Financial distress costs are not linear, and so it is not surprising that conditions usually deteriorate much more quickly than they improve. When the Russian crisis in 1998 shook confidence in emerging markets, Brazilian interest rates suddenly began rising, which caused the fiscal deficit to shoot up and so undermined confidence further, locking the country into an extremely vicious circle that took interest rates back to over 40% within two or three months. In January of the following year Brazil was forced into a currency crisis.

Inverted balance sheets, in other words, automatically exacerbate both good times and bad. Among other things this often leads to confusion about the sources of growth and value creation and the quality of management. When an economy is doing well the short-term gains for the economy that are simply a consequence of balance sheet inversion are often treated in the same way as ordinary productivity gains caused by better management when we try to judge the effectiveness of the underlying economic policies. In reality, however, they are just forms of speculative profits.

This may seem a surprising statement, but in the Brazilian case described above, for example, while part of the decline in the fiscal deficit before the summer of 1998 can be explained by better policies, at least part of the decline came about simply because of the very short debt maturities. If the Brazilian government had funded itself with longer-term debt — which would have been much more appropriate and far less risky — the fiscal deficit would not have declined nearly as quickly as it did. Part of the improvement in the fiscal deficit, in other words, was simply the consequence of what was effectively a speculative bet on declining rates, and did not reflect better fiscal policies. One unfortunate consequence, however, was that analysts and policymakers overvalued the quality and impact of government policies.

Of course when conditions turn, inverted balance sheets also provide short-term losses, although, perhaps not surprisingly, managers or policymakers almost always recognise the component of “bad luck” in their weakened performance. In 1998 I had many conversations with Brazilian central bankers, including the president of the central bank, Gustavo Franco, about taking advantage of high confidence in Brazil to borrow long-term at rates actually below the then-current 1-year rate of 20% (we were prepared to raise $1 billion of five-year money at 19%). The central bank decided against doing so at least in part because they were confident that the market was responding mainly to the quality of their monetary policies, and that as they were determined to maintain these policies, they felt it did not make sense to extend maturities until interest rates had dropped by far more. My carefully worded suggestions that at least part of their success was the result of an implicitly speculative balance sheet, and that it might make sense to reduce that risk, were not well-received.

Of course when interest rates shot up, no one doubted the role of balance sheet structures in the subsequent crisis. My point here is not a cynical one about the vanity of policymakers. It is that when a country responds very positively to policy reforms it is genuinely difficult for most economists to distinguish between growth caused by the reforms and growth caused by the self-reinforcing nature of inverted balance sheets, and the more highly inverted a country’s balance sheet, the more dramatically will good policies seem to be rewarded. Over the long term, however, because the same virtuous circle can become an equally powerful vicious circle, inverted balance sheets always automat