Bondage and Discipline
When inflation rates in most countries soared during the 1970s, economists reacted by developing ad hoc theories about why this was inevitable with discretionary monetary regimes and governments that had a short term focus. The ink was hardly dry on all these acclaimed “time-inconsistency” theories when they were decisively refuted by events. Inflation fell sharply all over the world, in good countries and also in countries lacking “discipline.”
But economists hold on to clever theories even after they’ve been refuted; after all, the world should work that way. Thus the theories are still taught in textbooks.
And I believe this way of thinking may have helped to create the current euromess. Consider the following two systems:
1. The current eurosystem.
2. A fixed exchange rate regime where all countries have their own national euros, which trade at exchange rates of one. For instance, imagine the US, Canada, and Australia all fixed their dollars to each other at an exchange rate of 1.0. (We’re actually pretty close right now.)
If I’m not mistaken, the Europeans do have something similar in the coinage area, where each country has its own distinctive coins. Why not do that for bills as well? In that case the adoption of the euro would have still involved the same sort of “currency reform” (say 1500 lira for one Italian euro) but Italy would have preserved its own national currency.
Now lets think about the advantages and disadvantages of my alternative.
1. Advantage: Italy could devalue in a crisis. It could avoid a macroeconomic disaster.
2. Disadvantage: Italy could devalue in a crisis, delaying needed fiscal reforms.
I don’t see the disadvantage as being all that important. Even with your own currency, markets will still impose “discipline” in the form of higher interest rates. There is no free lunch for deficit countries in a world of rational expectations. Thinking you can continually fool markets with inflationary policies is not a strategy, it’s a delusion. In addition, the peripheral countries were arguably better behaved in the pre-1999 EMS (when they’d better behave or they’d face higher rates) then in the post-1999 eurozone, when they could borrow at German interest rates and throw a wild party. Indeed the system I am proposing (similar to the old EMS) was one where the peripheral countries were behaving in an increasingly responsible fashion, sharply reducing their inflation rates. And before anyone jumps in and says “they were only doing that because they needed to in order to join the eurozone,” consider that the vast majority of non-European countries were also reducing their inflation rates during the 1990s. Even countries with much worse fiscal traditions than Italy and Greece.
So why wasn’t my proposal adopted, if it was as clearly superior as I claim? If you are a non-economist you are going to find the following hard to comprehend, but trust me, it’s true. Even though the time-inconsistency theory was totally discredited by events, it still holds a powerful sway over the minds of the world’s macroeconomists. Discipline is the key. If you allow just a bit of inflation, it’s like giving a drunk a sip of whiskey. All hell will break lose.
The Aussies showed that 6% to 7% trend NGDP growth keeps nominal interest rates above zero, allowing them to avoid liquidity traps. Also allowing Australia to avoid recessions, and without inflation shooting up to double digits. Yet the theory says this policy can’t work. So we’ll just close our eyes to reality and pretend Australia doesn’t exist. We’ll set up a regime that you can check into, but you can’t check out of. Because we don’t trust democracy. People might at some future date come to the realization that the system is not optimal, indeed it is a disaster. And we can’t allow them to change their minds in that case. It’s all about the time inconsistency problem. Discipline and more discipline.
By the way, bondage disasters know no cultural boundaries. In the early 1930s the discipline imposed by the gold standard destroyed the German economy–ushering the Nazis into power. During 1998-2001 discipline wrecked the Argentine economy. Now it’s damaging other economies. There’s no telling where it will hit next.
Countries really do need self-control. All the success stories exhibit that cultural trait. But you don’t get there by putting your monetary system into a straight-jacket and throwing away the key. Only by changing your culture.
PS. I still have lots of grading to do. I’ll get to old comments this weekend.
PPS. What if bloggers ran the world? These two posts suggests that not much would change:
Here’s Tyler Cowen:
At this point you have to be asking whether it is better to simply end the eurozone now, no matter how painful that may be. Unless of course you are an optimist about Italy reaching two percent growth, or Germany becoming fully cosmopolitan. As a politician I probably could not bring myself to pull the plug, but as a blogger I wonder if that might not, at this point, be the wiser thing to do.
And here’s Matt Yglesias:
If I were an elected official, I’d be extremely reluctant to pull the plug on this endeavor even though it was misguided from the start and isn’t functioning in practice. But I’d be leaping at the opportunity to be the second prime minister to bail on the whole thing if someone else went first.
Well! If I was a politician . . . I’d . . . I’d . . . yeah, I’d probably wimp out too.
Tags:
16. December 2011 at 06:02
Uncompelling.
You aren’t giving the correct upside to Italy being FORCED to reduce pensions to 50% of last salary.
That kind of positive thing simply can’t argued with.
The faster it happens, the better off Italy is long term. Period. The end.
The problem is public employees, it will be public employees until the world is radically more like Texas.
16. December 2011 at 06:31
“But economists hold on to clever theories even after they’ve been refuted; after all, the world should work that way. Thus the theories are still taught in textbooks.”
Steve Keen’s recently spent a whole book refuting clever theories. As a layperson, how accurate his analysis is I don’t know but Economists do seem to exist in silos made from clever theories. As an aside the French still print receipts in both Francs and Euros.
16. December 2011 at 06:34
“2. Disadvantage: Italy could devalue in a crisis, delaying needed fiscal reforms.”
Actually, if you read what the Euro FinMins are talking about as the incentive for joining, it was getting lower interest rates. The disadvantage to having a separate currency is not a delay in fiscal reforms (from their perspective), but the knowledge among lenders that they could devalue which increases borrowing costs.
The issue is this – if the gain was cutting borrowing costs and rates are 7% anyway because of growth-killing ECB policy causing increase in default perception risk, what is the incentive to stay?
Default perception risk is self-fulfilling, much like a demand crisis can be self-fulfilling without an exogenous monetary authority to stabilize the equillibrium.
16. December 2011 at 06:50
“We’ll set up a regime that you can check into, but you can’t check out of. Because we don’t trust democracy. Peope might at some point come to the realization that the system is not optimal…”
There is some correlation and causation in changing culture that goes beyond single reforms. Our democracy is set up for single reforms and the battles they require. What it is not equipped to do is to say, wait, we have made a series of mistakes that perchance need sets of reforms which in fact could work in concert with one another. In other words, we don’t have a restart button to acknowledge that mistakes were made which might actually be remedied through the democratic process. With such a restart button, for example, real dialogues might be possible to address the artificial split between the producer and the consumer, and the real split between desire to use resources, and the way resources are actually structured to be utilized. For all of the above affects monetary stability, and the stability of humanity itself.
16. December 2011 at 07:15
Scott, while I generally like the idea of not putting monetary policy in a strait jacket and think that if Draghii and the EU thought more like you it would be a marked improvement I will push back on this talk of discipline a little.
If lack of discipline is a budget dedicit why do we not see any proof that “There is no free lunch for deficit countries in a world of rational expectations. Thinking you can continually fool markets with inflationary policies is not a strategy, it’s a delusion.”
I mean fright now on these terms, both the U.S. and Britain are getting a free lunch and I don’t see that changing anytime soon. U.S. debt is views as the safest with Britain a close second yet both have big deficits. What we see right now is Krugman’s Rubicon Effect. Those who don’t have their own printing press are getting killed regardless of defidict or no deficit. Those who do are seen as safe investments and that’s what they are.
16. December 2011 at 07:21
The US is not getting a free lunch, it is squandering what could be accomplished geo-politically if it kept to KING DOLLAR.
Money printing and deficits interfere with the good cause of capitalism… basically government CHEATS to try and compete with their betters.
16. December 2011 at 08:05
?????
“In the early 1930s the discipline imposed by the gold standard destroyed the German economy-ushering the Nazis into power.”
The Germans destroyed themselves — and they did it well before the 1930s.
16. December 2011 at 08:43
Mike Sax,
I think that the point is about underfunding of debt rather than debt as such. Scott’s not saying that countries can’t become heavily indebted without a debt crisis (just look at Japan) but rather than they can’t inflate their way out of debts without being punished with higher interest rates.
The broad principle is that a person’s desire to be a creditor is based on their expectation of a real return on extending that credit. You can defy their expectations temporarily, but not systematically.
16. December 2011 at 09:30
Scott:
Should 5 percent nominal GDP growth just be a preference? Or sould it be a binding rule?
16. December 2011 at 09:42
The fundamental difference between your system and the current Euro system is that in your case an Italian Euro would not be equal to a German Euro, while in the actual system it is. And you are mistaken about the coinage system, the coins do indeed have country specific symbols but this has no systemic implications but is rather a symbolic thing (it’s comparable to the US states quarters, where each state gets to decorate its own, but in practical terms there is no difference)
16. December 2011 at 09:44
Scott, regarding your comments about unemployment benefits and incentives, this is an interesting article, albeit anecdotal.
16. December 2011 at 09:50
W. Peden,
“The broad principle is that a person’s desire to be a creditor is based on their expectation of a real return on extending that credit. You can defy their expectations temporarily, but not systematically.”
Isn’t this principle symmetric? I.e., a person’s desire to be a debtor is based on their expectation of nominal income growth with which to repay that debt? You can defy their expectations temporarily, but not systematically!
16. December 2011 at 09:52
Sumner is criticizing “faith-based macroeconomic and monetary policy.”
This is one time in which I do not believe in “keeping the faith.”
16. December 2011 at 10:07
Steve,
“Isn’t this principle symmetric? I.e., a person’s desire to be a debtor is based on their expectation of nominal income growth with which to repay that debt? You can defy their expectations temporarily, but not systematically!”
Absolutely, though I think that it’s the nominal RETURN that’s important, not just nominal income. If I expect the return from investing a variable-rate loan to be wiped out by a relative rise in interest rate on that loan due to a rise in inflation, then I’m not going to take that loan out. I might be surprised by an unexpected inflationary shock, but if such inflationary shocks are frequent then I’m going to seriously change my behaviour.
Consider also the cause with borrowing and deflation: I take it to be obvious that, if you expect a 1% decline in the price level before you have to start paying back a loan, you are going to be less willing to expect a fixed-interest rate loan with a preset 2% interest rate increase. On the other hand, a surprise 1% decline is going to put you up the creek without a paddle. Finally, if you are systematically put in the latter situation, you are going to start factoring in that price instability into your borrowing behaviour.
In this case, rational expectations means nothing more than extending a principle we use all the time in our everyday lives (operating on our expectations of people’s behaviour and changing them when we come to realise systematic patterns) to our relationship as individuals with the state. Bond-holders don’t just take the possibility of a straightforward default into account, but also the possibility of a default-through-inflationary-expansion, and put a weight on that possibility. Since neither possibility is at all likely in Japan, the Japanese government is able to have huge debts and yet pay low interest rates on those debts; the expected return from borrowing to Japan is very good, especially (I would think) if you’re lending them yen for yen-denominated debt since the yen’s value in relation to the Japanese price level is much more stable than the yen’s value in relation to other countries*.
* I am unsure of this last point, but it would explain why the domestic effective demand for Japanese government debt is so strong relative to the external effective demand. Or does the Japanese government actively seek out domestic creditors?
16. December 2011 at 10:13
Yes,
“All the success stories exhibit that cultural trait. But you don’t get there by putting your monetary system into a straight-jacket and throwing away the key. Only by changing your culture.”
I always said the euro would not diminish our cultural differences. So has been. Worse, now it is increasing our hate for each other.
Very good post.
16. December 2011 at 10:31
I agree in pronciple but doesn’t Australia make a poor example? Aren’t they a large commodities exporter benefiting from a tight market?
16. December 2011 at 11:24
Morgan, I can’t wait for when Tuscany and Venice look more like Texas!
Nevorp, Oddly, I still believe in many theories that others think have been discredited. (EMH, Ratex)
Statsguy, I agree.
Becky, Having your own currency allows for that reset decision.
Mike Sax, You said;
“I mean fright now on these terms, both the U.S. and Britain are getting a free lunch and I don’t see that changing anytime soon.”
I don’t agree. The US is not running a inflationary policy, inflation has average less than 1.2% since September 2008.
Greg, The Germans destroyed themselves through their decsion to stay on gold when prices and NGDP were flaling.
Bill, I’m happy with 5% or 4% or 3% NGDP targeting being a binding rule, as long as it’s level targeting.
John Thacker, Thanks, but I can tell you from experience that other commenters will insist those are all lies, that he’s making it up.
Thanks Ben.
Thanks Luis.
Benny, Actually, commodity prices fell in half during 2009, so that’s not it. In any case they had no recession in 2001 either, and commodities weren’t high back then. They simply have better monetary policy than we do. They haven’t had a recession since 1991.
16. December 2011 at 11:29
Floplo, Under my system the Italian and German currencies would trade at par, so they would have identical values as long as Italy adhered to the fixed exchange rate regime.
I certainly do understand how the coins work, I was just using it as an illustration. I understand that my proposal contemplates a very different arrangement.
16. December 2011 at 11:49
If I’m not mistaken, the Europeans do have something similar in the coinage area, where each country has its own distinctive coins. Why not do that for bills as well?
For printed money the first character of the serial # denotes the country of origin. In theory (I have seen speculation on ft and elsewhere), all the “X” bills – for Greece – could be devalued and Greece pays all debts with only “X” euros. how that works with the electrons at the bank i have no idea. In the surreal up-is-down monetary world we currently live in though, it makes as much sense as anything else.
don’t forget the market discipline George Soros imposes – the UK was kicked out of the exchange rate bands in the early 90s because their inflation was too high, soros made a billion. I am sitting here wondering not whether someone mounts a speculative attack but when and how they will do it.
16. December 2011 at 11:49
…link
http://en.wikipedia.org/wiki/Euro_banknotes
16. December 2011 at 12:18
dwb,
As I understand what Soros did, the key thing was not so much that UK inflation was high (it was about 3.7% and falling at the time of Black Wednesday) but that the value of the pound was very low and the UK government was reluctant to squeeze demand further precisely because we were experiencing a big short-term Philips Curve effect, with falling inflation & a jobless “recovery” from the 1991 recession.
A country can control its real exchange rate or it can control its domestic price level, but not both simultaneously. When the two goals diverge, situations like Black Wednesday become a possibility.
16. December 2011 at 13:08
Scott we are nowhere near inflation. In my opinion I wish we had a little inflation. Even the 2% target is lower than the average during the time of the Great Moderation. I don’t know why if we have to do inflation targeting we couldnt even use the average of the GM which I imagine would be more than 3%
I was speaking about the budget deficit whihc some have sounded out alarm bells as if the bond vigilantes are around the corner.
The beauty of this claim is we have empirical proof that they’re wrong-yields are at an all time low.
16. December 2011 at 16:44
Scott: thanks for reminding folk of the real-life example. But I see you got the standard “it’s all commodities!” response. Sigh.
17. December 2011 at 01:01
It’s clear that national currencies are superior in some aspects. But the goal of the euro is not only better monetary policy, but also the deepening of the economic union. It’s about transaction costs both real and mental.
Splitting a currency via pictures on coins and serial numbers? C’mon…
If you think about splitting up the euro and want your proposals to make sense, double check it by thinking it trough for the dollar. Suppose Florida wants its own currency. If it doesn’t work for Florida, most likely it doesn’t for Greece.
17. December 2011 at 08:42
dwb, Yes, but those features aren’t distinct enough to be practical. People would confuse the bills all the times.
W. Peden, I agree.
Mike Sax, I certainly agree on the bond vigilantes. I’ve been saying that high rates are NOT around the corner ever since the crisis broke in 2008. That’s one area where market monetarism has been far superior to old style monetarism.
Lorenzo, Yes people love to tout models they agree with, but if they don’t agree they always find differences, reasons to dismiss. Thus progressives tout high-tax Sweden, and when I tout even more successful low-tax Switzerland, they say “not relevant, a tiny country of 7 million people.” Sweden has 9 million!
Franz, You obviously don’t understand my proposal. The US Canada and Australia all use dollars. It can be done. They are currently all about the same value. If we went back to a Bretton Woods regime with all three currencies at par, then you’d have what I am talking about. Denmark has it’s own currency, which is fixed to the euro (albeit not one for one.) I don’t see any big transactions problems in Denmark. If the danish currency was 1 for one with the euro, it would be even better (Accounting would be greatly simplified for multinationals.) There is no reason it couldn’t be done, and as long as the rate stayed fixed then businesses in other European countries would probably accept them.
As we move to electronic money, the residual problems (parking meters, etc) would be less of a problem.
17. December 2011 at 14:56
I get your point, I simply doubt that it’s a workable system.
If those costs are negligible – which arguably can be achieved through the right legislation – and everybody believes that devaluation is practically impossible, the currencies work the way we want. That is the world would look exactly the same it does now but for nation labels in contracts and bank accounts. Those are big ifs though.
Given everybody believes it will never break, you can implement it in a way that allows the breakup. But why should you, given you believe and have to signal that it will never break? Even if you’re not a politician and it’s only about economics. The only advantage of this arrangement in contrast to a full fledged currency union is an a bit easier break-up, so introducing it that way undermines the expectations you need for the thing to work in the first place.
And let’s don’t forget Black Wednesday. If all you have is a peg, that’s a possibility.
The rigid euro is insensitive to expectations, an elaborate peg depends on nothing else.
17. December 2011 at 18:55
Scott, Have you read Nial Ferguson’s _The Pity of War_ on the German economy?
What books on the German economy do rely upon for this financial and economic history?
Germany was mismanaged & politically pathological in all sort of ways that were at least as important than 1930-1933 gold policy.
The gold policy = Nazis equation is retarded as “sophisticated” historical story telling.
18. December 2011 at 08:19
franz, You don’t seem to understand. The EMS worked, it could have continued working. It worked much better than the euro has worked. It’s a better system. The system I am proposing is unambiguously better than the EMS. It has not a single drawback relative to the EMS. And yet it has one advantage. All eurozone accounting statements can be done in euros.
flexible euro > EMS >>>>> inflexible euro.
Greg, The Nazis were going nowhere in 1929. By 1933 they were in power. Why is that?
Ferguson is not an economist. I don’t doubt that Germany had all sorts of problems, but historians have a flawed method for analyzing events. They work backward from a crisis and look for the “deep roots” of that problem. I look at the asset markets. They had confidence in Germany in 1929. That means the causes of the crisis occurred after mid-1929.
Historians should focus on asset markets, but they don’t.