Wolfgang Kladen: Wishful Thinking On the Euro

July 23rd, 2011
in Op Ed

by Dirk Ehnts

By accident, I found an old article I wanted to comment on and then forgot. Wolfgang Kladen, former chief editor of economics at the SPIEGEL and chief editor of the Manager Magazin in the 1990s, wrote on December 20th 2010 on the euro. Here is the appetizer (those lines on top that should make you want to read more):

Deutschland ergeht sich in Euro-Pessimismus, Untergangspropheten warnen vor dem Zusammenbruch der gesamten EU. Ist die Lage wirklich so dramatisch? Keineswegs – unser Geld steht mindestens so gut da wie der Dollar: Der Wechselkurs ist stabil, die Inflation gering.

Follow up:

In English, it translates more or less like this:

Germany drowns in euro-pessimism, the prophets of doom warn of a breakdown of the whole European Union (sic!). Is it really that dramatic?  Not remotely – our money is at least as good as the dollar: the exchange rate is stable, inflation low.

Well, I found it astonishing back then how you could write this in a magazine like the SPIEGEL, which is supposed to have some quality. The problem was inside the euro zone, not outside, so mentioning the exchange rate of the euro completely misses the point. It is like pointing out that your roof is in excellent condition, keeping the rain out, when the water problem comes from a flood.

As to inflation, again this is not the problem. The economic imbalances have turned some euro zone members into net importers and therefore, net debtors. These now find it difficult to change their position. In order to repay foreign debt, they should export more and import less. Hence, a lower price level would be of advantage. However, on the monetary side a higher price level would be of advantage so that the real burden of debt is lower. These countries are between a rock and a hard place, and it is unclear whether they can get out of this position at all.

Sorry for picking on Wolfgang Kladen in this one, but the fact remains that the media reporting is strongly biased towards those who later turn out to be wrong. The piece by Mr Kladen written to start a debate, but the outcome of the debate was inconclusive, and politicians got away with “saving Greece” until this day while those that point out that it is saving banks, and actually harming Greeks, get almost no coverage. This, I believe, is the price that Europe pays for not researching the reasons of the financial crisis. Somehow, the politicians find it unnecessary to find the flaws in the economic system and correct them. Possibly they shy away from it because it is politically nasty. If politics does not touch the problem, speculators will by selling everything from the periphery short in expectation of a euro zone break-up.

Oh, and by the way: the introduction of euro bonds would solve the monetary problem and kick the can further down the road, but it doesn’t solve the problem of price levels being too high in the periphery and/or too low in the core. A more comprehensive solution is needed than just euro bonds, which I would support if, and that is a big if, they buy time which is used to work out proposals to fix the financial mess of Europe. Re-introducing old currencies must be on the table as an option as well, as this is about economics, and not wishful thinking.

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Dr. Dirk Ehnts is a research assistant at the Carl-von-Ossietzky University of Oldenburg (Germany). His focus is on economic integration and economic geography, covering trade, macro and development. He is working at the chair for international economics since 2006 and has recently co-authored a book on Innovation and International Economic Relations (in German). Ehnts has written at his own blog since 2007: Econblog 101. Curriculum Vitae.


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1 comment

  1. Derryl Hermanutz Email says :

    Dirk wrote, "This, I believe, is the price that Europe pays for not researching the reasons of the financial crisis. Somehow, the politicians find it unnecessary to find the flaws in the economic system and correct them."

    Humans are not rational in the truth-maximizing sense of the term. They do not want to know the whole truth if some parts of truth contradict what they want to happen. Humans are values-maximizing in the short run, not truth maximizing in the long run. We can call this selfish and short sighted, but the fact is most people are incapable of (or uninterested in) seeing the long term big picture. People strive to maximize their immediate interests and let the future take care of itself.

    Indeed, humans are largely incapable of knowing the long term consequences of our actions. In the colorful words of William James (from Principles of Psychology), we are incapable of “tracing their causes from primeval chaos, and their consequences to the crack of doom.” So we focus on what we can see as our interest in the immediate future and hope for the best in the long term.

    This is why we get phenomena like "fallacies of composition" (or “paradoxes of thrift”), where behavior that is beneficial for individuals is detrimental to the system as a whole. It is in most everyone's personal best interest to save a good chunk of their income, but if everyone does this then aggregate demand will be insufficient to purchase available supply and there will be a recession. The neoclassical fantasy that savings will become investment is delusory. Businesses do not invest into a flat or declining demand. So at the same time that saving is increasing, investment will be decreasing, which exacerbates rather than ameliorates the decline in demand. Hence Keynes’ prescription of government borrowing and spending the savings to fill the hole in aggregate demand and keep the economy working at high capacity utilization.

    Euro politicians do not address "the reasons for the financial crisis" because they do not want it to be the case that trade surplus nations must by arithmetic necessity become creditors to trade deficit nations who must become debtors, an inescapable reality that Dirk explains in his article. The classic psychological motivation of mercantilism is this short termism, this desire for the consequences of one's self-interested actions to be other than they actually will be. Germans want to "get rich" by exporting their economic outputs and importing money; and Greeks want to "be rich" by enjoying a debt-financed higher material standard of living provided by German labor and German loans.

    Really, the scheme is nothing other than vendor financing writ large. When my customers run out of money to keep buying my outputs I "lend" them my money to keep buying. I fail to take into account that in order to make my money good, these borrowers must eventually repay me with "economic" goods. What is money but a claim on economic goods? So in the long run, over a long term business cycle, the only way to balance today's trade deficit is with tomorrow's trade surplus. The former surplus nation, in order to be "paid" by the debtor, must become a trade deficit nation to its debtor.

    “Borrowed” money cannot discharge debt. Only “earned” money, income, can permanently repay debt. A nation earns income by exporting more than it imports.

    But Germans don't want to become a trade deficit nation and Greeks don't want to work harder and consume less so they can export more. So the politicians pretend that the monetary magic of finance can somehow circumvent the simple but inexorable logic of arithmetic. Michael Hudson gets it. "Debts that can't be paid, won't be." That is simple arithmetic certainty, the bane of magical thinking.

    Some months ago we were discussing ancient remedies to this enduring phenomenon of human commerce. In every generation there are workers and acquisitors who, over the course of years and decades, end up owning everything and the game of "let's have an economy" comes to a crashing halt. An economy requires both producers AND consumers. If some players routinely produce more than they consume, then by necessity other players must routinely consume more than they produce.

    The German nature is different than the Greek nature. Germans are loath to "become Greeks" and vice versa. Germans end up with all the money and Greeks end up with all the debt. Barring eternal vendor financing of ongoing Greek deficit consumption of German produce, the game of economy ends at this point. Germany can only "collect" by "becoming Greece", and German nature prohibits this, so the trading economy is paralyzed. Germany WANTS to get paid, but they make real payment impossible, so they try to pretend that financial magic will solve their problems and get the economy going again. It won't.

    The ancient Hebrews, and Iron Age cultures prior to them, solved this problem with "Jubilees" or “clean slates”, debt forgiveness. These cultures wisely recognized that the human nature of producers and the human nature of consumers was not about to change. The consumers were not about to become producers and the producers were not about to become consumers. So the solution was to take all the "winnings" of the producers and give them back to the consumers. "Debt forgiveness". The monetary wealth that the producers had built up in the form of debts owed by the consumers was recognized as illusory, as Michael Hudson acknowledges in saying that those debts WILL NOT be repaid. So the only realistic way to get the economy happening again was to clean the slates and start over.

    In the long run, "acquisitiveness" can't work. It is a fallacy of composition just like systemic "savings". What, exactly, are you "saving"? You are saving up a future claim on consumption. But if you will NEVER spend this claim, because you are by nature a saver and not a spender, then it becomes dead money. The economy becomes starved of demand money because savers have it all hoarded away. Without demand there is no further reason to invest and produce. The economy stops working.

    The ancients construed acquisitiveness as the deadly vice of "avarice". Here is the prophet Isaiah's take on this trait,

    "Woe to you who add house to house and join field to field till no space is left and you live alone in the land."

    Isaiah condemns "beggar thy neighbor" economic behavior. If "morality" is based in wisdom, knowledge of how the world works and how it goes off track, then Isaiah's moralizing against acquisitiveness is grounded in the simple arithmetic of surplus and deficit. From the opposite perspective we have the deadly vice of "gluttony". Those who consume more than they produce are just as guilty as those who produce more than they consume. Neither behavior is sustainable. It is morally wrong to try to "get rich" by building up debt claims upon other people's future. And it is morally wrong to live beyond your means by going into debt, for the very pragmatic reason that over the long term these behaviors are self-defeating and lead to crises that are politically very hard to reconcile.

    What politicians, economists and ordinary people are struggling with today is coming to the realization that our past behaviors have defeated themselves and the only way forward involves some form of debt repudiation and starting over. Creditors accuse debtors of immoral profligacy. Debtors accuse creditors of immoral avarice. Both see themselves on the "right" side of the moral equation, and both fail to see the systemic error of their own behavior.

    There can be no creditors without there being an equal and opposite quantity of debtors. The profligates cannot exist without the avaricious, and vice versa. Borrowers cannot exist without lenders. Consumers cannot exist without producers. It takes two to tango. Creditors and debtors are equally culpable for the current impossible imbalances. Nobody is on the morally "right" side of this equation. Both are wrong.

    Are we wise enough to stand back and see this reality objectively? Or do we stand and demand our 'right'? Our 'right' to collect on unpayable debt? Our 'right' to reap the pound of flesh in lieu of payment? In this case the pound of flesh takes the form of the physical assets of debtor nations. Creditors want to take "Greece" in exchange for unpayable Greek debt, and henceforth own Greece as a feudal fiefdom. The 'morality' of this move is predicated on the belief that avarice is virtuous and profligacy is vicious, that Greeks "deserve" serfdom for allowing creditors to lend them too much money, that the poor innocent creditors now "deserve" their pound of flesh.

    Stupid drug dealers sell so much dope on credit to their 'best' customers that the junkies invariably overdose and die, or they default and the dealer kills them in lieu of payment as a "moral example" to others who would renege on their debts. What did the dealer think was going to be the outcome? The desires of avarice do not trump the truths of arithmetic. Debtors spiral down as creditors spiral up. The further apart they get, the more unpayable becomes the debt.

    Debtors and creditors are codependent. The stupidity of lenders equals the profligacy of borrowers in terms of moral culpability. Both are engaged in behaviors that are unsustainable, that can't work. Greeks don't 'deserve' serfdom any more than their creditors 'deserve' to be stiffed on payment. They both got themselves into an impossible situation due to short term value maximizing behaviors. Now that the impossibility is upon us it only remains to decide how to move forward. Neither side is 'right' and neither side is 'wrong'. But either Greece stiffs its creditors, or its creditors refeudalize Greece. There is no magic arithmetic capable of generating some more desirable outcome.

    But where is the objective arbiter to make the parties see the reality of their own culpability? Where is Solon, where is Solomon, to reconcile the irreconcilable, to induce one party or both to yield its 'right' so that we can move forward?

    I do not want to see the world returned to feudalism, plutocracy, rule by the 'winners' of the game of avarice. Nor do I want to see realization of the moral hazard of overt debt forgiveness of the profligate. Both sides contributed to causing the problem, both should contribute to fixing it.

    I favor bailing out the debtors rather than bailing out the creditors. Money created and "given", not lent, to debtors enables them to pay their debts. On a scale sufficient to resolve the insolvency of the world's debtors, this would be inflationary. The creditors' money wouldn't be worth as much goods as they thought it was going to be. But this is an alternative to either outright stiffing of the creditors, or the feudalization of debtor nations. I advocate this as a "compromise", not an outright victory by either side.

    I have written extensively in comments and articles how this could be undertaken, but I'll outline how this could be done in the US.

    In the US, as in all other nations with modern fiat monetary systems, the government is not allowed to issue money. For right or wrong, that authority has been transferred by legislation (Bank Act; Federal Reserve Act) to the nation's banking system. A 1935 change to the legislation prohibited the Fed from directly purchasing and 'monetizing' Treasury debt, so now the primary dealer (PD) banks bid on Treasury auctions and directly create deposit money to purchase Treasury debt. In QE2 the Fed then buys Treasuries from the PD banks in the "secondary market"; the Fed 'pays' for these purchases by creating credits in the "reserve accounts" of the PD banks. The PD banks buy and sell Treasuries to "the public", which is everybody who isn't a PD bank or the government or the Fed.

    So under current legislation any government money creation scheme by which the Fed creates new money for Treasury must flow through the PD banks who take their cut of the action. It may be advisable to suspend this protocol for present purposes, but it would not be necessary, especially if the PD's cut was minimal, a nominal service fee for processing the transactions.

    Essentially, Treasury could issue zero interest "perpetual bonds", and the Fed could buy them with newly created deposit money credited to Treasury's accounts. Perpetual bonds have no maturity date. They can be redeemed, or not, at the discretion of the issuer. So Treasury would never "have to" tax money out of the economy in order to repay its bond loans from the Fed, but Treasury and the Fed "could" do this as a feature of fiscal/monetary policy to reduce monetary inflation.

    Zero interest perpetual bonds are "free" money. Although technically the bonds represent a debt owed by Treasury to the Fed, in fact the Fed can never call in the debt and it never needs to be repaid. At zero interest there is virtually no cost to creating deposit money in this way.

    Treasury would sell sufficient of these bonds to the Fed to fund monthly 'solvency checks' that are paid (electronically in most cases) into the bank accounts of every American over 18 with a Social Security number. I have advocated monthly checks of $1000. On a very rough calculation this amounts to about $2.5 trillion per year.

    A condition of the 'solvency checks' would be that 100% of the money must be devoted to debt paydown by any recipient who owes debt. This would have to be administered by the commercial banking system, and they would need to be paid administration fees for doing it. This would somewhat offset the fact that systemic debt paydown reduces bank balance sheets. Banks' "assets" are the economy's interest bearing "debts", so as debts are paid down banks lose interest income. The upside for the banking system is that their current state of technical insolvency would slowly be resolved as debts are paid down to the (depreciated) value of the underlying collateral assets, most of which relate to real estate.

    Solvency checks would restore most loans to "performing" status, because debt payment takes the first cut of all the checks. Households comprising two adults would receive $2000/month which, in addition to their current income, would probably be enough to allow them to make all their monthly debt payments. I would want to see accelerated paydown of debt, with the full checks devoted to debt paydown even if the current schedule of household debt payments is less than the amount of the household's solvency checks. But if accelerated paydown is too disruptive to the banking system, then simple maintenance of current payment obligations might be ok.

    This strategy restores both households and the banking system to solvency simultaneously. Previous bailouts have given money only to the supply side, the banks, the creditors, leaving the debtors languishing in unpayable debt. Many small businesspeople self finance with home equity financing or credit card debt, so solvency checks given to households would also restore most small business loans to performing status.

    Solvency check recipients who have little or no debt could spend, save or invest their $1000 per month. A couple of hundred million individuals spending and investing their own 'free' money into a demand-refreshed economy is about as close as we can get to a "market" solution to systemic financial insolvency and its associated economic recession. Selective taxation of bubbling asset markets could prevent this windfall from overly distorting market prices, but politically that would be difficult to do so we may have to simply accept asset inflation where it occurs.

    The same mechanism can work in Europe, with the ECB creating debt-free euros and distributing them to Europeans.

    This proposal can resolve the monetary aspects of credit-debt imabalances, but it does not address the underlying economic imbalances that lead to the monetary imbalances. There will always be imbalances between producers' monetary surpluses and consumers' monetary deficits. History shows this to be a permanent feature of human socioeconomic nature. But the sword that is immediately hanging over our collective head is the monetary problem, and I offer one way of solving it.

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