Equity markets and indices are down over 2% today on worries about what most pundits refer to as the “Greek bailout,” which took its (supposedly) final shape over the weekend, with details to follow from the IMF and other parties. The terms, as currently laid out, are brutal, a fact reflected by the intense street protests in Greece and the government’s loss of union support. The theories and practices underlying them are highly questionable and pitifully anachronistic as well, which make it all the more frustrating.
There’s no doubt that Greece has made some mistakes, that the lack of accurate fiscal disclosures by its previous government was extremely unethical, and that labor market reforms may be in order. But there are humane ways to approach and work through the entire imbroglio. Unfortunately, neither the IMF nor major eurozone countries seem to be giving that much thought. And as Marshall Auerback has pointed out, Germany’s longstanding inflation paranoia has it behaving as if it’s 1921 all over again; when to us, reality appears to be much closer to the deflationary late 1920s and 1930s.
We referred to the Greek plan as pitifully anachronistic because it embodies what we might call gold standard era thinking, when the supply of new money was a function of mining output and demand for gold ownership in the private sector. At the turn of the 20th century, economist Knut Wicksell pointed out the need for a “rational monetary system“, while highlighting intellectual obstacles to it:
It is no exaggeration to say that even to-day many of the most distinguished economists lack any real, logically worked out theory of money, a circumstance which has not, of course, been particularly conducive to the success of modern discussions in this field.
Wicksell’s sentiments are still relevant today, and (in our view) have been powerfully echoed and expanded upon by proponents of neo-chartalism, also known as Modern Monetary Theory. Bill Mitchell, an occasionally acerbic but ever prolific member of the MMT club, recently posted the following diagram on his website:
The essential point of the diagram is to illuminate that, under a fiat currency system, the government (whether through its treasury or via a quasi-public central bank) is the sole provider of money. And one of the resulting takeaways of this fact is that under certain conditions, fiscal austerity in the public sector will impose significant costs on the private sector. In turn, that will tend to raise the value of money, all else equal, which is the essence of deflation. And as Wicksell pointed out over a hundred years ago, deflation, like inflation, comes at a cost (emphasis added):
…when a rise or fall occurs in the money prices of all, or of most, commodities…[a]djustment can no longer proceed through changes in demand or through a movement of factors of production from one branch of production to another. Its progress is much slower, being accomplished under continual difficulties, and it is never complete; so that a residue, either temporary or permanent, of social maladjustment is always left over.
By linking the inflation boogeyman to public sector debt levels, prevailing economic theory sometimes leads to poor policy prescriptions and outcomes, as we are now seeing in Greece. It also fails utterly to explain the experience of Japan over the last two decades, and it looks set to fail in both the Eurozone and the U.S. in the coming decade. So far, our contrarian calls for a strengthening USD and a dovish view of long term U.S. Treasury yields has lent support to this thesis.
As with our recent “What Happened?!?” piece, we also think it’s important to tie the Greek “rescue” package to the current U.S. policy outlook. Today, speaking to the Business Council, President Obama once again invoked our “unsustainable fiscal deficit” and argued for immediate reimplementation of PAYGO. Looked at in terms of Mitchell’s diagram above, that implies that at best, the federal government is unlikely to add to the supply of vertical money. It’s also important to realize that a concept like PAYGO essentially restricts the vertical money supply function to the central bank. And yet, according to recent testimony from Fed Chairman Bernanke, the Fed is targeting roughly a 50% contraction in its balance sheet, which also implies a contraction in narrow or vertical money supply (though rising velocity could give the Fed some room to work with). Similarly, it was over tightening in both the fiscal and monetary spheres that led to the 1937 recession after several years of economic recovery.
The upshot of all this is that leaders in the public sectors of both the U.S. and the Eurozone are clearly signalling their intentions to “crowd out” private sector saving and, potentially, income. And unfortunately, electoratal majorities in key countries seem to support this direction. Normally, we expect electoral outcomes to approach optimal, but in this particular case, we suspect that the historic lack of economic and financial education might steer us wrong. Then again, voters with incomes might be making some rational inferences about deficits, austerity, and taxes. If so, the burden of adjustment could rest even more heavily on the on the un- and under- employed (believe it or not, that’s something that a handful of policy pundits have advocated, and that at least one senator briefly pursued).
Either way, deflation will be the inescapable result of excessive restriction or contraction in vertical money. We’re currently getting slight whiffs of it from credit markets and price indices (although the latter are still positive); cooling measures in China are also likely to help it along. As noted in our “What Happened?!?” piece, we don’t expect it to manifest in an economic downturn until 2012 or 2013, but it could show up in market prices before that. We’ll be watching commodity markets closely, as a broad decline in those prices would provide an especially powerful confirming signal. Stay tuned…
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