May 31, 2012
In early 1931, the German government under the stewardship of its finance minister, Bruhning, was facing an enormous economic challenge. The economy was contracting rapidly but Germany was dependent on loans from the US to maintain the Gold Standard’s exchange rate. In order to qualify for these loans, the Germans followed orthodox policies, the sort that peripheral Europe is following now, to stay in the monetary union.
But qualifying for loans is very different from being able to pay them back. If you doubt this, ask the thousands of Irish people who “qualified” for loans in the credit splurge and now find themselves in an impossible position.
But as long as Germany followed austerity policies in the face of the recession, which soon became a depression, it secured the financing of its government deficit. So although the deficit was still in place (like Ireland now), the government’s commitment to austerity was enough to allow it to qualify for the loans from the US.
But the economy kept contracting.
Bruhning wanted to keep the flow of US money coming, so he had to stick with the austerity agenda. The plea to the German people was: “If we don’t keep up the programme, we won’t get financed.”
By June 5, 1931, with unemployment rising, retail sales and asset prices rising, Bruhning changed tack and announced that to make the austerity palatable at home, he would have to tear up the reparations from World War One. Germany couldn’t bear austerity and pay back the reparations at the same time.
In the event, Germany kept with the austerity, amplifying the deflationary effects on the economy, which ultimately made a problem, which was that there was already too much deflation, worse. In 1932, Bruhning et al lost their jobs in elections, paving the way for Hitler.
We see that the immediate cause for Hitler’s victory was not the hyperinflation of 1923 but the hyper-deflation of 1932-33 — almost 10 years later.
This episode should resonate with us in Ireland because it seems that the treaty debate has come down to whether we qualify or not for further loans, which will finance our deficit after 2014.
Like Bruhning’s obsession with securing loans to finance his deficit and stay in the Gold Standard, this policy is ignoring what’s happening on the ground in the economy.
We are following a policy of securing loans but, if the economy doesn’t recover, this new credit line we might qualify for will just destroy more wealth, not protect wealth.
Let’s try to explain why credit lines, if you can’t pay them, destroy rather than preserve wealth.
It’s good to see that financial crises don’t destroy wealth; a crisis tells us how much wealth has already been destroyed by too much borrowing in the so-called boom.
In Ireland, if we look at household debt, which according to Citibank in a report last week stands at 220pc of income although it was only 98pc of income in 2000, we can see that it was the borrowing in 2000-08 that destroyed wealth. The crisis only signals this.
The huge debts cause what is called a liquidity trap and this has its roots in the state of the national balance sheet.
Many Irish people’s balance sheets are broken because on the one side we have assets — houses, land and apartments — which are falling in value, but on the other we have debts, which are fixed. At a time when income is falling due to rising unemployment and taxes, this means the debt burden is getting heavier every day relative to income.
As a result, people with savings are saving yet more. Those with debts are trying to pay them down. The same goes for companies. Ireland’s savings ratio has exploded to 17pc of income; it was -5pc in 2007.
People don’t want to borrow because they have too much debt and banks don’t want to lend because they have too much bad debt. Yet the deleveraging is destroying their capital base, too. Again, the paradox is that deleveraging my balance sheet might make my position better, but when we all deleverage at the same time, we drive down asset prices further, demanding yet more deleveraging.
If everyone is saving, who is spending? The rise in government spending is the logical reaction to, not the cause of, the liquidity trap.
By qualifying for loans now that the economy can’t make good on, we risk destroying yet more wealth.
People will argue that the Government is just buying time until 2014. This is a fair point and it goes back to the idea of kicking the can down the road in the hope that something will turn up.
But the metaphor we should be looking at is not kicking a can down any road but rolling a snowball down a hill. The more we roll, the more the ball gains momentum and destructive potential, so that by the time it smashes into reality, the destruction will be much, much worse.
Maybe it would be better to call it now and admit we will default in 2014 because growth is anaemic — as evidenced by another fall in monthly retail sales yesterday — and the debt is too big. We know foreign markets are shrinking, we know that the banks are not lending and we know that credit-free recoveries are few and far between.
Armed with this, we could go to the ECB and say, with a No vote, we know that we will default because the ESM isn’t open to us. We will start this process right now by not paying a cent extra to unsecured bondholders. We will not pay money due next month, and you can help us all figure out what to do next.
This forces the ECB to react and this forces it to think about the political legitimacy of continuing to lumber the Irish people with bank debt, the modern equivalent of reparations.
Then we look like a reasonable country. We say we will never default on sovereign debt as normally understood — debt incurred for schools, hospitals etc — but when it comes to all this bank debt we don’t have any choice. Now that we don’t have the ESM to facilitate rolling the snowball down any more hills, we have to negotiate now.
This will focus the minds of everyone and inject urgency into proceedings. The Americans have an expression: “the extreme urgency of now”. Now is urgent.
The situation in the eurozone is not getting any better. The fiscal treaty, by imposing austerity on an already enfeebled economy, will make things worse, prompting more capital flight. Rolling the snowball down the hill is not an honest option.
Mightn’t it be better to open the negotiations properly now?