August 18, 2014
I am sitting opposite the Latin Bridge in Sarajevo, where the First World War started one hundred years ago this month. Six weeks after the assassination by Gavrilo Princip of Franz Ferdinand came the actual outbreak of war.
No one really thought the war was possible. Europe was so economically integrated. Financial markets were sophisticated and all the major players were trading with each other to such an extent that the mainstream view was there was too much mutually at stake for war to happen. But it did.
Once the war started, the top brass were faced with the reality of trench warfare, which they didn’t expect. Rather than change tactic to suit the new reality, they organised the slaughter of young men by sticking to the old policy of ”going over the top”.
At the time, the generals stuck to the mantra of ”there is no alternative”.
Sometimes, when I hear the European elite say there is no alternative to austerity, I am reminded of those moustachioed generals and the appalling human consequences of their inability to see that neither tactics nor strategy were working.
Today, the European economy is shuddering to a standstill. Both Germany and Italy contracted in the last three months. Meanwhile, France has stagnated for the second consecutive month.
Yet, just three months ago, the EU Commission announced in its Spring 2014 forecast: ”The EU economic outlook is strengthening. While leading indicators point to GDP growth gaining momentum in the near term, the conditions for a sustained recovery in the medium term are also improving. Among the largest economies, economic growth is expected to be sustained in Germany while the recovery is firming in Spain and slowly gathering pace in France and Italy”.
So much for that!
Germany, Europe’s biggest economy and driving force, is contracting; and that’s before we see the real impact of Russian sanctions. On Friday, when Ukraine attacked a Russian humanitarian convoy entering its territory, the news caused a surge of money into German bonds and sent the yield on the ten-year bund below the 1 per cent mark for the first time in its history.
Following the revelation that France’s GDP has remained stagnant for the past two quarters, its finance minister Michel Sapin admitted that, ”as a direct consequence of sluggish growth and insufficient inflation, France will not meet its public deficit target”.
In turn, the French have cut their 2014 growth forecast of 1 per cent in half. This is not good news for the eurozone, which in total produced a growth rate of 0 per cent, while EU GDP grew by 0.2 per cent this quarter.
Much more worrying for Europe’s generals is the persistence of deflation. Prices are actually falling in five countries – Spain, Portugal, Greece, Bulgaria and Slovakia – and were flat in Italy, Estonia and Poland. Once deflation sets in, it is extremely hard to reverse. Just ask the Japanese.
Only once during a bout of deflation in the modern era has a government managed to get prices up again, and this was under president Franklin D Roosevelt in the Great Depression in 1935.
Unlike the war generals, president Roosevelt realised that in the Depression he was fighting a terrifying enemy that demanded a radical change of tactic to win. As a result, he knew he had to be radical.
He abandoned orthodoxy, took America off the gold standard, told investors that the American government would not pay them back in gold but in dollars printed by the Federal Reserve – and he printed money.
At the time this was branded as heresy by the economic mainstream. But it worked. Within months of the US gold default, agricultural prices in the US started to rise, prompting more production from farmers. In time, producer prices started to rise, prompting more production, and the economy began to recover from the Depression.
So what is Europe going to do?
Mario Draghi, like Roosevelt, has to consider printing money, which is termed, in the vernacular, ”unconventional monetary policy”. Sapin issued a statement urging the ECB chief to act and with a potential slowdown in Germany, perhaps the Germans will become more worried.
While the euro continues to hover around $1.337 against the dollar, the currency has to weaken much further, much faster, for the economy to begin to reverse its slide.
Now here’s the question: once the ECB accepts that it has to print money, does it matter what form this takes?
At the moment, the mechanism – borrowed from the Fed in the US – is to give the banks as much free money as they like and let the banks decide what to do with it.
The Americans hoped that this would prompt banks to lend to the public. The free money would then find its way, via the banking system, into people’s hands and then people would spend it.
But this didn’t really happen. The banks only loaned money in significant quantities to very rich people and corporations – so-called low-risk recipients. So while the central bank turned on the taps, the money didn’t flow down to the economy because, at every stage, the banking system proved to be more of a bottleneck than a funnel.
It’s a bit like trying to water your garden in a hot summer by turning on a giant firehose, which is then attached to a garden hose, a narrow pipe and then ultimately to a party straw. Such a contraption forces all the water pressure back up towards the tap and ultimately only a trickle will drip out on to the parched earth. Why not, once you’ve decided to water the garden, just turn on the firehose and drench the place?
Similarly, if you have decided to print money to combat deflation, why not just give people money directly, rather than letting the banks stand in the middle? Encourage people to spend this money and, as the economy starts to recover with the extra spending, rein in the amount of money you hand out. This is exactly what QE (quantitative easing) is when you strip back all the complications, fancy arrangements and efforts to make respectable what is, in essence, money-printing.
The cure to deflation is inflation, and the way to get inflation going and prices rising, is to get people spending money again. If they have it, give it to them, at very low or even zero rates of interest.
This may sound radical, but it isn’t really. It is exactly what the central banks are trying to do without the bank bit in the middle. Clearly, this type of radicalism demands a rethink of the way we run the economy.
Roosevelt, by defaulting on gold, was prepared to entertain these revolutionary notions, with positive results. In contrast, the First World War generals weren’t able to change their script, with catastrophic consequences for all of Europe.
What would you prefer: the risk of experimentation, or the deadening certainty of inactivity?