December 13th, 2014
in Op Ed
by Dirk Ehnts, Econoblog101
At the end of October, Hans-Werner Sinn published an article on the question of how to set up a monetary system. Sinn is Professor of Economics and Public Finance at the University of Munich, is President of the Ifo Institute for Economic Research and serves on the German economy ministry's Advisory Council.
This is what he wrote about US economic history:
Indeed, the Fed, unlike the ECB, does not buy any bonds from individual states; investors must bear the costs of any state insolvency. In 1975, New York had to pledge its future tax revenues to its creditors in order to remain solvent.
Of course, the US was not always so strict. Shortly after its founding, it tried debt mutualization, with Alexander Hamilton, America's first Treasury secretary, describing the scheme in 1791 as the "cement" for a new American federation. There was another round of debt mutualization in 1813 during the second war against Britain.
But, as it turned out, the mutualization model fueled a credit bubble, which collapsed in 1837 and thrust nine of the 29 US states and territories into bankruptcy. The unresolved debt problem exacerbated tensions over the slavery issue, which triggered the Civil War in 1861.
The way that he puts it, it seems that everything is crystal clear. Let me contrast this with an excerpt from a text from the NY Fed's blog Liberty Street Economics, that describes the same period in time (first half of the 19th century):
Then U.S. cotton prices plummeted in January 1819 after British investors substituted to Indian cotton, a development that coincided with a general fall in demand for agricultural imports to Europe as European harvests improved. As Glaeser notes, ". . . the boom busted, the country went into recession and Alabama land values plummeted."
As Coffey explains, after the Bank attempted to resume a tight monetary policy through deflation, prices fell, housing and real estate values collapsed, and over-indebted banks and homeowners went bankrupt. Those maladies in turn spread to farming and manufacturing, which increased unemployment. The panic and recession were on.
So, the Second National Bank of the US was what we would now call a central bank, although there was not a monopoly on government money as we have it today. The Fed NY has a text on their blog (which it does not necessarily agree with) that claims that "after the Bank attempted to resume a tight monetary policy through deflation, prices fell, housing and real estate values collapsed, and over-indebted banks and homeowners went bankrupt". So, tight monetary policy in times of crisis is bad, as we know since Bagehot's Lombard Street (1873) if not before, and I thought that economists all over the world would agree on that and those that think otherwise would not get very far. Nevertheless, Sinn's article from above continues:
Furthermore, the ECB should reintroduce the requirement that TARGET2 debts be repaid with gold, as occurred in the US before 1975 to settle balances among the districts of the Federal Reserve System. Perhaps even the fiscal compact itself should be reconsidered.
This is outlandish. Reintroducing gold as a means of settlement for intra-euro zone payments between central bank is something which I would not have expected to hear from a German economist professor. Just a brief explanation of what the meaning of this is: As it stands, if more euros are transferred from Spanish bank accounts to German bank accounts (as an example), the banks need to settle. The Spanish banks owe the German banks a net sum of, say, a billion euros. One possibility to settle would be that Spanish banks borrow reserves (deposits at the ECB, via national central banks) from German banks. If that doesn't happen, they can borrow from their national central bank, Banco de España. Banco de España creates new reserves, always against good collateral. When these reserves are transferred to German banks, this shows up as TARGET2 liabilities of Banco de España and TARGET2 assets of Bundesbank, the German central bank. As the system works now, this is where it ends. So, some countries have TARGET2 net assets and some net liabilities (see here).
What Sinn now proposes is that the Spanish central bank should transfer an amount of gold equivalent to the amount of reserves that was transferred by Spanish (mostly private) banks to German (mostly private) banks. Needless to say, that this will stop the Spanish central bank from making any more loans to Spanish banks. Banco de España has about 9 million ounces of gold, which at a little above $1,000 is about a billion euro. Try to save your banks, with balance sheets of hundreds of billions of euro, with that. So, Hans-Werner Sinn is in effect arguing for deflationary policies in times of economic depression based on his cherry-picked reading of US economic history.
I am not the only one who would be arguing against Sinn's point of view. Ben Bernanke, former Fed governor, is following the Friedman-Schwartz view (which I don't agree with), but even with that theory the position of Sinn is way out of what are the lessons of the Great Depression for practical central bankers. Here is an excerpt from Ben Bernanke's speech on the occasion of Milton Friedman's 90th birthday (2002) (my highlighting):
For practical central bankers, among which I now count myself, Friedman and Schwartz's analysis leaves many lessons. What I take from their work is the idea that monetary forces, particularly if unleashed in a destabilizing direction, can be extremely powerful. The best thing that central bankers can do for the world is to avoid such crises by providing the economy with, in Milton Friedman's words, a "stable monetary background"-for example as reflected in low and stable inflation.
Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.
Sinn, however, seems to think that unleashing the monetary forces in a destabilizing direction can be extremely powerful and helpful. And whereas Bernanke understands that letting banks fail during the Great Depression was a huge mistake, which he did not allow to be repeated, Hans Werner Sinn seems to believe that the lesson of the Great Depression is to liquidate all banks that have problems with their balance sheet.
Another issue that Sinn overlooks in his debate of US 19th century economic history is that president Andrew Jackson managed to pay off the national debt in 1835. Since Sinn argues that national debt is a problem, he should be delighted to find an episode in US history with no national debt! While there are different views of the results, there is no disagreement that two years later there was something called the Panic of 1837. Rousseau in his NBER paper writes that one cause of the crisis has been a law called Specie Circular that allowed pubic lands to be sold against gold (specie) only. This is a tightening in monetary policy.
Public reaction to the Specie Circular can be characterized by initial confusion followed by deep concern about its possible effects on the money market. It was widely believed that the Circular would drain specie from banks in New York, Philadelphia, and New Orleans to points in the Midwest and cause reserve shortages and loan curtailments in those cities. There was also a (not entirely unfounded - see Section IV below) belief that the Government by accepting specie for land would effectively "lock it up" (i.e., remove it from circulation). The initial drain of specie aggravated existing monetary pressures in the Summer of 1836, and by early September rates on short-term business paper in New York had risen to 24 percent from only 12 percent in early June.
There is hence another crisis episode in 19th century US economic history which says that monetary tightening has caused the crisis. Also, it probably did not help that the US government did repay its debt since this meant that there were no government bonds circulating that could have been used alternatively as an asset for clearing. Having an interest rate hike from 12% to 24%, of course, was madness. This is why today, with fiat currency issued by the central bank (often on behalf of the government), we are much better off than back then: there are no market panic-induced gyrations of interest rates like in the 19th century. So the whole neoclassical idea of the interest rate as a price of money that is to be left alone has been discarded in modern times for good reasons: the financial markets cannot be trusted to get it right. That is why a government agency called central bank has taken over this task in all modern nations.
US-American and German/European economists have been divided over the euro. They are divided over how to handle this crisis. The euro area is having huge economic problems, with countries like Spain or Greece in depression. The US, however, is adding jobs at a very good pace, with the government deficit falling because the private sector has started spending again. In Europe, the economy is weak because of austerity policies.
Let me end this article with the last two pages of the General Theory by John Maynard Keynes, because obviously we have been there before:
International trade would cease to be what it is, namely, a desperate expedient to maintain employment at home by forcing sales on foreign markets and restricting purchases, which, if successful, will merely shift the problem of unemployment to the neighbour which is worsted in the struggle, but a willing and unimpeded exchange of goods and services in conditions of mutual advantage.
Is the fulfilment of these ideas a visionary hope? Have they insufficient roots in the motives which govern the evolution of political society? Are the interests which they will thwart stronger and more obvious than those which they will serve?
I do not attempt an answer in this place. It would need a volume of a different character from this one to indicate even in outline the practical measures in which they might be gradually clothed. But if the ideas are correct - an hypothesis on which the author himself must necessarily base what he writes - it would be a mistake, I predict, to dispute their potency over a period of time. At the present moment people are unusually expectant of a more fundamental diagnosis; more particularly ready to receive it; eager to try it out, if it should be even plausible. But apart from this contemporary mood, the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas. Not, indeed, immediately, but after a certain interval; for in the field of economic and political philosophy there are not many who are influenced by new theories after they are twenty-five or thirty years of age, so that the ideas which civil servants and politicians and even agitators apply to current events are not likely to be the newest. But, soon or late, it is ideas, not vested interests, which are dangerous for good or evil.
Given Germany's consistent trade surpluses, we are repeating the Great Depression problems and their theories almost one for one. Gerhard Schröder, chancellor of the social democrats (1998-2005), was present at the 2012 meeting of the Verein für Socialpolitik, the German economics association, and said:
Wenn überall um uns herum in Europa die Arbeitslosigkeit steigt und die Beschäftigung abnimmt, während bei uns - trotz Eurokrise - immer noch das Gegenteil der Fall ist, dann sollten wir uns fragen: woran liegt das? Den Kritikern der Agenda 2010 sei gesagt: Diese Erfolge auf dem Arbeitsmarkt sind nicht wie Manna vom Himmel gefallen. Sie sind - auch - Folge von zum Teil schmerzhaften Arbeitsmarktreformen.
Let me translate: when around Germany the unemployment rate rises and employment falls, while in Germany even though we have the euro crisis the opposite happens, then we should ask ourselves: why is that? To the critiques against the Agenda 2010 [cutting unemployment benefits and duration, establishing a low wage sector] let me say: the success on the labor market did not fall from the sky like manna. They are - also - the result of painful labor market reforms. Schröder received standing ovations after his speech. Paul Krugman has recently blamed German policy makers for being bad Europeans. There is a major intellectual struggle going on in the discipline. Europe stands at a crossroads, with some like Hans-Werner Sinn apparently ready to pull the plug, and others pushing for reforms of the euro zone, led by ECB president Mario Draghi.
Sadly, this discussion takes place behind the closed doors. German media gives almost no time at all to critics of Hans-Werner Sinn and his companions, so that the public is denied the opportunity of informing itself and then trying to judge what reforms we would prefer for what reasons. If this is about ideas, then denying ideas to compete will have consequences if for some reason the media has united behind the wrong set of ideas.