Wednesday, February 17, 2010

I think that's it

Simon Johnson in today's WSJ

Since these struggling countries share the euro, run by the European Central Bank in Frankfurt, their currencies cannot fall in this fashion. So they are left with the need to massively curtail demand, lower wages and reduce the public sector workforce. The last time we saw this kind of precipitate fiscal austerity—when nations were tied to the gold standard—it contributed directly to the onset of the Great Depression in the 1930s.

This is how our era rhymes with the Great Depression.  Places that see massive credit fueled bubbles need some means to devalue in one swell foop if they are not to spend an eternity working out from under their debts.  What you need is some mechanism for writing them off quickly rather than slowly.  Devaluation is the time tested way of doing this.

The neo-classicists (such as Helicopter Ben) almost understood this.  BB made his mark by demonstrating that the depression eased as countries went off the gold standard (aka devalued).  He thinks the depression was caused by bad monetary policy, and that if you just expanded the monetary base enough soon enough (even if you hadn't had anything to devalue against) the interlocking debt situation would have sorted itself out.  When he hears "devaluation" he just sees "increase in the money supply".  After all, in aggregate, debt doesn't even exist.  Unless he's badly blinkered ideologically (and it seems not), I doubt he believes it's that simple anymore. 

This analysis would be true if you could get the general price level to automatically rise by increasing the money supply (aka inflation) or if the whole works was the result of a sudden and irrational panic that triggered a debt-deleveraging cycle.  If it was just a panic you can prime the pump and ignore debt entirely, things will start again.  If not, you can always generate inflation and real debts would be written off in this case.  But there's a big difference between devaluaing and increasing the monetary base if nobody wants to make the loans that would put the base to work and spark inflation.  Without the possibility of devaluation, you will get a balance sheet recession.  This is what we're finally coming to understand.

Money is real and debt is real.  And now there's nothing to devalue it against.  The weaker Euro members are stuck with Germany, and the US is stuck with Europe and especially China.  None of the places that are deep in debt can spark a recovery by devaluing because they are pegged to the people they need to devalue against.  If you can't devalue, you get debt-deleveraging and the accompanying serious deflation.  Or you do what Japan did and the state borrows and spends to mitigate the deleveraging and keep the deflation mild.  But politically, the state can't borrow enough, so you get stagnation.  Devaluation is the only quick way, and it no longer exists. 

Who knew that going off the gold standard would actually make us less able to control the effective money supply when times got tough?

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