July 13, 2011
Exactly three years ago this week, this column argued that this financial crisis might result in Ireland (and others) leaving the euro. The argument was not based on any ideological/political antipathy to the currency but on some basic economic analysis about how debt crises and associated recessions end.
Unfortunately, it is very easy to use the “anti-European” slur to dismiss legitimate questioning and, as a result, discussion on this crucial topic has remained largely stifled. But the problem is not going away. The evidence from all over Europe is the opposite — it has become more acute.
In Ireland, querying the currency is tantamount to treason in establishment circles. These people prefer to replace hard thinking with mantras. One of the mantras is that dissent on the euro is “anti-European”. But mantras are no substitute for thinking and we should consider the obvious possibility that the single currency is doing untold damage to the political unity of Europe. Looked at this way, the euro itself is “anti-European”. Right now, as the euro bond markets face a massive debt crisis, it is worth revisiting the logic of the single currency argument.
First let’s consider Ireland’s dilemma and why the single currency exacerbates it.
If the economy is in a currency union and is suffering from a ‘balance sheet recession’ where the private saving rate has skyrocketed because those with money are petrified and not spending, there is only one way out. It involves changing the currency, making it considerably cheaper and inflating away the debt. Otherwise, the country defaults. Given that the response to default might be more fiscal federalism in Europe, with us losing our corporate tax sovereignty, alternatives are worth considering.
Why are people saving in Ireland? One reason might be fear of the future — they are hoarding for the rainy day. With increases in taxes, negative equity and unemployment, this seems like a reasonable claim. The other reason might be that people have seen retail prices falling around them and believe that if they hold off spending today, they will get a bargain tomorrow — so they hoard. This pattern is precisely the opposite of the behaviour during the boom when rising house prices forced people to bring forward spending.
At the same time, the Irish banks are not functioning as banks. Whatever savings are going into them are not being recycled as investment elsewhere in the economy. The banks are nothing more than safe deposit boxes, strangling the flow of credit throughout the economy. So the economy seizes up and the debt mountain — at prohibitive interest rates — spirals out of control, bringing default closer. This is what Keynes called a “liquidity trap”.
This is the position in Ireland and amazingly, the troika deal of last year, which was heralded by the economic establishment, just adds more debt to this debt mountain in the hope that something will turn up. Well, something has turned up — a contagious debt crisis — hardly the outcome the so-called troika expected, but one that people with a passing knowledge of financial markets and economics correctly forecast. So what is the way out?
What we need in Ireland is not deflation but inflation and not just random unexpected inflation, but targeted inflation.
We need our central bank to engineer inflation. (Sounds like heresy if you have been schooled on a diet of zero inflation, but stay the course).
At the moment, the ECB has an inflation target of 2pc or less. This is appropriate for a country with an old, rich workforce with a perennial current account surplus, but not for a highly indebted country with a young workforce.
A generous inflation target would mean that debts (once converted, which they would be) would be gradually inflated away and more importantly, as people see inflation rising, they would bring forward spending, driving down the savings rate and generating the growth that is necessary to ease the debt burden.
This is how economies recover from debt binges. But it is also crucial to understand cause and effect. In an ideal world, most economists wouldn’t advocate this; but we are not in an ideal world, we are in a crisis and crises demand new thinking. Inflating away debt is the consequence of, not the cause of, too much debt in the first place. So how do you do this?
The country that wants to do this must revert to its own currency and adopt a moderate inflation target of let’s say 8pc to 10pc. This would cause people to reverse their saving behaviour. If we don’t do this we will be faced with years of low growth, debt default, emigration and unemployment.
Yet anyone suggesting modest inflation might be a “good thing” will face huge opposition, despite the fact that countries with moderately high inflation perform no worse than those with very low inflation, in fact, in terms of growth they perform much better.
But people will rightly say: “Hold on, if the new currency fell by say 40pc against the euro, wouldn’t our euro debt jump overnight in the new currency?” This is true, but the same is true for the present policy of “internal devaluation”. The present austerity and internal devaluation policy, where the Government grinds down wages and prices over a number of years, is designed to have exactly the same effect. Your euro wages will just fall for longer and you will still not be able to pay the euro debt you took out in the boom when your income was much higher.
So the internal devaluation is just a slow version of the overnight devaluation. Why do things slowly and prolong the agony?
A good way to think about devaluations is to consider what happens when we turn the clocks back. Each October, we have a choice in order to make the days longer. We could all get up an hour earlier and go to work an hour earlier, or we can all ‘agree’ to turn the clocks back and get up the next day and pretend that it is 8am when we all know that it is really 9am. But we all agree that 9am becomes 8am because this is easier than forcing the whole nation to actually get up an hour earlier.
Devaluations work the same way.
We know that austerity won’t cure something that was not caused by excessive government spending but by profligate private lending in the first place. And as austerity causes deflation, it can only make the debt mathematics worse.
Moderate inflation is the answer. A vibrant inflation target, plus tighter fiscal targets with a government financed by new domestic inflation-linked bonds is a way out. It has worked before in many countries. To arrive at such heresy, we all have to go through a process of replacing mantras with hard thinking and replacing steadfast rules with nimble flexibility. We are in a crisis.
Einstein said the definition of stupidity was doing the same thing over and over again and expecting different results. The result of the last three years’ nonsense has been continuous crisis. It’s time now for a totally new plan B.