March 24th, 2014
in Op Ed
by Joseph Salerno, Ludwig von Mises Institute
[Editor’s Note: This article is adapted from Joseph Salerno’s foreword to the new third edition of Brendan Brown’s book Euro Crash: How Asset Price Inflation Destroys the Wealth of Nations.]
Brendan Brown is a rara avis — a practicing financial economist and shrewd observer of financial markets, players, and policies, whose prolific writings are informed by profound theoretical insight. Dr. Brown writes in plain English yet can also turn a phrase with the best. “Monetary terror” vividly and succinctly characterizes the policy of the Fed and the ECB (European Central Bank) to deliberately create inflationary expectations in markets for goods and services as a cure for economic contraction; the “virus attack” of asset price inflation well describes the unforeseeable suddenness, timing, and point of origin of asset price increases caused by central bank manipulation of long-term interest rates and the unpredictable and erratic path the inflation takes through the various asset markets both domestically and abroad.
Indeed Dr. Brown’s prose is reminiscent of some of the best writers in economics and economic journalism such as Lionel (Lord) Robbins and Henry Hazlitt. And like these eminent predecessors, Brown is generous to a fault in carefully evaluating the views of those he criticizes, while rigorously arguing his own position without waffling or compromise. Best of all, Brown is fearless in naming names and ascribing blame to those among the political elites and the upper echelons of financial policymakers whose decisions were responsible for the chaotic state of the contemporary global monetary system.
In this book, Brown deploys his formidable expository skills to argue the thesis that the current crisis and the impending collapse of the EMU (European Monetary Union) are attributable to profound flaws in the original monetary foundations of the euro. These flaws rendered the EMU particularly vulnerable to the asset price inflation virus which was originally unleashed on an unsuspecting world by the Federal Reserve shortly after the euro saw the light of day in 1999.
In the course of presenting his case, Brown courageously stakes out and defends several core theoretical positions that are in radical opposition to the prevailing orthodoxy. For example, Brown strongly dissents from the conventional view of what constitutes monetary equilibrium. He explicitly rejects the position associated with Milton Friedman and Anna Schwartz that is now deeply entrenched in mainstream macroeconomics and central bank policymaking. This superficial doctrine arbitrarily and narrowly construes monetary equilibrium as “price stability” in markets for consumer goods and services, while completely ignoring asset markets. In contrast, Brown formulates a much richer and more profound concept of monetary equilibrium that draws on the ideas of Austrian monetary and business cycle theorists, namely Ludwig von Mises, Friedrich Hayek, Lionel Robbins, and Murray Rothbard.
In Brown’s view, a tendency toward monetary equilibrium obtains when monetary policy refrains from systematically driving market interest rates out of line with their corresponding “natural” rates. Interest rates determined on unhampered financial markets are “natural” in the sense that they bring about spontaneous coordination between voluntary household decisions about how much to save and what profile of risk to incur and business decisions about how much and in what projects to invest. Such coordination ensures accumulation of capital and increasing labor productivity and a sustainable growth process that maintains dynamic equilibrium across all goods and labor markets in the economy. The main thing that is required to maintain monetary equilibrium in this sense is strict control of the monetary base as was the case, for example, under the classical gold standard regime. In the context of existing institutions, which is Brown’s focus, monetary equilibrium requires a rule strictly mandating the Fed to completely abstain from manipulating market interest rates and, instead, to exercise tight control over growth in the monetary base.
Brown’s concept of monetary equilibrium therefore countenances — indeed, requires — price deflation over the medium run in response to natural growth in the supplies of goods and services. This was the experience during the heyday of the classical gold standard in the latter part of the nineteenth century when declining prices went hand-in-hand with rapid industrialization and unprecedented increases in living standards. For Brown, it is precisely the attempt to stifle this benign and necessary price trend by a policy of inflation targeting on the part of “deflation phobic” central banks that inevitably distorts market interest rates and creates monetary disequilibrium.
Brown explains that such monetary disequilibrium is not necessarily manifested in consumer price inflation in the short run. In fact, it is generally the case that the symptoms first appear as rising temperatures on assets markets. Indeed some episodes of severe monetary disequilibrium, such as those that occurred in the U.S. during the 1920s, the 1990s, and the years leading up to the financial crisis of 2007-2008, may well transpire without any discernible perturbations in goods and services markets. Yet overheated asset markets are completely ignored in the Friedmanite view of monetary equilibrium that underlies the Bernanke-Draghi policy of inflation targeting. Brown perceptively argues that one reason for the wholesale neglect of asset price inflation is the positivist approach that is still dominant in academic economics. Speculative fever in asset markets is nearly impossible to quantify or measure and thus does not neatly fit into the kinds of hypotheses that are required for empirical testing.
Having laid out his theoretical approach, Brown uses it as a foundation to construct a compelling interpretive narrative dealing with the origins, development, and dire prospects for the euro. In the process, he pinpoints and details the flawed decisions and policies of the ECB and the Federal Reserve that account for the current condition of the euro. But Euro Crash tells more than the story of the currency of its title; it unravels and makes sense of the complex tangle of events and policies that have marked the parlous evolution of the global monetary system since the 1990s.
This book is a radical challenge to the prevalent, but deeply flawed, doctrines that have defined monetary policy since the 1980s. Be forewarned: reading it is a bracing intellectual experience. Like a headlong dive into a cold pool, it will refresh your mind and awaken it to a wealth of new ideas.