Let's end this nonsense: Reagan's military buildup did not cause the Soviet Union to collapse

Let's put this to rest now. The idea that Reagan caused the Soviet Union to collapse has been said so many times over the years but the facts just don't back it up.

The idea goes something like this:

Ronald Reagan increased US military spending. He introduced the "Star Wars" technology to protect the USA against enemy missiles. In response to this, the Soviet Union increased military spending dramatically which, in turn, caused the collapse of the Soviet Union.

No, Sorry. Wrong.

Of course Reagan DID spend up big, no doubt about that.

And he DID introduce the "Strategic Defense Initiative" (SDI) which created some huge problems for the Soviet military and the politburo

But did the Soviets increase military spending? The data says no.

The above graph comes from Arming America: Attention and Inertia in US National Security Spending by James L. True (1998). Link here. Graph is on page 17 of 42 of the pdf file. (Edited 2015-08-14)

. Things to note:

• This graph measures spending in comparative dollars. Since the US had a larger economy than the Soviets, we can assume that if a 1:1 comparison between the two was made in terms of percentage of GDP, the Soviet Union would have a higher result. If you compare 1985 levels, for example, the US is probably spending around 6-7% of GDP on defence while the Soviets were spending around 13-14% of GDP.
• The Soviets passed the United States in the early 70s and peaked  around 1982.
• The US increased spending dramatically under Reagan, with a peak around 1985 and greater than the USSR.
• Soviet defence spending plateaued between 1981 and 1988.
• Soviet defence spending collapsed from 1989 onwards.
• Much ink has been spilled over the years by economists and defence analysts in trying to determine reliable Soviet defence spending figures. If you want to complain about the standard of Soviet data, remember that experts have been dealing with this for decades. In short, if your argument against my position involves attacking the reliability of the statistics in question, please complain to the thousands of experts over the past few decades who have made it their business to work out reliable stats. Appeal to authority? You bet.

The graph clearly shows that, in real terms, the Soviets did not increase military spending much in response to Reagan. In fact the opposite appears to be the case: Reagan was responding to the Soviets. Soviet defence spending in the 1970s was pretty big and Reagan obviously did spend up big in response. But did the Soviets respond to Reagan's spending by increased spending? No they didn't.

Of course the idea that Reagan defeated the Soviets has been around for years. This 1994 article in The Atlantic - only three years after the collapse of the USSR - already contains the facts I am re-stating here:

The Soviet Union's defense spending did not rise or fall in response to American military expenditures. Revised estimates by the Central Intelligence Agency indicate that Soviet expenditures on defense remained more or less constant throughout the 1980s. Neither the military buildup under Jimmy Carter and Reagan nor SDI had any real impact on gross spending levels in the USSR. At most SDI shifted the marginal allocation of defense rubles as some funds were allotted for developing countermeasures to ballistic defense.

If American defense spending had bankrupted the Soviet economy, forcing an end to the Cold War, Soviet defense spending should have declined as East-West relations improved. CIA estimates show that it remained relatively constant as a proportion of the Soviet gross national product during the 1980s, including Gorbachev's first four years in office. Soviet defense spending was not reduced until 1989 and did not decline nearly as rapidly as the overall economy.

So what did cause the USSR to collapse? In short: the economic stupidity known as Perestroika, a policy so bereft of common sense that it caused factories to produce less and less industrial goods. From 1987 onwards, the economy of the Soviet Union began to collapse with severely reduced output and hyperinflation. The downturn was so severe that birthrates declined - an indication of the personal stresses that Russian households were being subjected to. The economy shrunk significantly for around 4 years before communism was abandoned and the economy collapsed even further. By the mid-90s GDP was probably half of what it had been in 1987. There are more details about this in a previous post I have written.

What caused the Soviet Union to collapse?

I'm writing this as an adjunct to some fascinating study I did recently into the Soviet Union. It's not often I do historical studies here at my blog, but I think I have discovered the reason for the economic collapse of the Soviet Union in the late 1980s. This collapse, in turn, was followed by the collapse of Communism itself and a period of about ten years when Russia collapsed even further. David Christian, my Russian history lecturer at Macquarie University, mentioned that Russia lost about half of its Gross Domestic Product in this period.

At present I'm only going to focus on the economic issues involved. Gorbachev, when he instituted Glaznost, essentially created a monster that turned the Russian people against the Communist party. The collapse of communism in Russia itself may have been prevented had an economic collapse not preceded it.

What we need to remember is that in the years before communism collapsed, the Soviet economy collapsed. Economic output decreased alarmingly and inflation turned into hyperinflation.

The first inkling I had of this problem was when I looked at Russian/Soviet birth and death rates from this article at Wikipedia:

What you can see here is that birthrates in the USSR dropped dramatically before the collapse of Communism. It was only after the collapse of Communism that death rates shot up and the population began to shrink. But certainly in the period before 1987, birth and death rates were healthy.

So the question is, why did birth rates drop so drastically from 1987 onwards?

Economic conditions do affect birth rates. Birth rates dropped considerably during the Great Depression. While a 1:1 causal relationship does not exist, a sudden change in birth rates are always the result of some change occurring in society. It's well proven that the experience of continual hardship amongst animals results in lower birth rates, and humans are actually no different in that regards.

So the seeds of destruction were sown in 1987. What happened?

I was inspired to write this article because I read the 1991 IMF working paper Forced Savings and Repressed Inflation in the Soviet Union by Carlo Cottarelli and Mario I. Blejer. In that article, written before the collapse of communism, the two authors analyse the economic situation of the Soviet Union in the 2nd half of the 1980s. Their conclusion was that the Soviet Union was experiencing what is known as Monetary Overhang, a peculiar economic situation experienced historically only by communist states. Monetary Overhang meant that there was not enough goods and services for the economy to purchase for the money available, which led to ever increasing levels of savings. This, in turn, led to hyperinflation. In a market economy, an overabundance of savings has a deflationary effect but in a communist command economy it has an inflationary effect. This is because the flow of money is not determined by a market made up of many independent actors, but by the determination of bureaucrats acting as part of central planning. This meant that as production dropped off, income remained the same. Enterprises that were producing less goods and services were still receiving government money and paying their employees their wages.

But enough of the monetary conditions - what was it that caused a drop in production? Something happened from 1987 onwards which led to Soviet Enterprises producing less goods and services - and not just a small drop, but a considerable drop which led to scarcity and social and economic hardship amongst ordinary Russians.

It is popular to assume that the collapse was due to Soviet inability to cope with American rearmament under Reagan. The idea behind this was that the Soviets increased military spending and military output whilst simultaneously reducing the production of consumer items and things such as food. Certainly there was an increase in military spending by the Soviets in response to Reagan's military spending increases, (edit 2017: this was actually not the case, see my follow up article) but such an increase in production would not have led to monetary overhang. This would be because any change in production (moving from consumer goods to military goods) would have had a neutral effect upon the money supply. Certainly if such a huge swing had occurred the Russian people would've suffered, but they would've suffered without the effects of a monetary overhang. The presence of a monetary overhang indicates beyond doubt that from 1987 onwards, the total production of goods and services in the Soviet Union dropped. Military spending may have increased, but total levels of production changed.

I believe the cause was due to an edict made by the Supreme Soviet of the Soviet Union in June 1987 - the Law on State Enterprise. Under the short reign of Yuri Andropov, the Supreme Soviet had been radically altered to include younger, more reform minded individuals. By 1987 and with Gorbachev leading the forefront of reform, a decision was made to further improve economic performance. In hindsight, this State Enterprise law caused a drop in production, an economic collapse and, subsequent to it, conditions ripe for another revolution.

I'll let Wikipedia say it for me:

The law stipulated that state enterprises were free to determine output levels based on demand from consumers and other enterprises. Enterprises had to fulfill state orders, but they could dispose of the remaining output as they saw fit. However, at the same time the state still held control over the means of production for these enterprises, thus limiting their ability to enact full-cost accountability. Enterprises bought input from suppliers at negotiated contract prices. Under the law, enterprises became self-financing; that is, they had to cover expenses (wages, taxes, supplies, and debt service) through revenues. No longer was the government to rescue unprofitable enterprises that could face bankruptcy.

From an economically liberal point of view you can see what the Supreme Soviet was trying to do: It was trying to use market forces as a way for enterprises to determine output and encourage surplus production. Moreover it would be assumed that these enterprises would have to, at the very least, be capable of paying its own expenses rather than having them covered by the state. Laudable, yes. But the reform was fatally flawed for one very good reason: prices were still determined by the state. As each enterprise began to reform itself to become more profitable, costs needed to be covered. Since it was likely that the enterprise could neither retrench its workers or reduce their pay, the only choice they had to become profitable was to spend less on purchases. This meant that enterprises, with no other solution available, were forced to buy less materials for their production. Because the law applied all over the Soviet Union, one enterprise's decision to stop buying goods resulted in a reduction in another enterprise's demand which, in turn, forced that enterprise to reduce supply even further. Obviously these enterprises were not even meeting targets set by the Supreme Soviet, which was problematic, but, forced to balance their own books (which was failing), Soviet industrial production entered what could be termed a negative feedback loop: any attempts to solve the problem ended up making it worse.

By 1991 the economy had collapsed. Conditions were ripe for a revolution, and one arrived. It's only been in the last few years that Russian household wealth has returned to pre-collapse levels.

What I have learned from this? Simple. An economy will experience inflationary decline whenever production drops before demand does. As a corollary, an economy will experience deflationary decline whenever demand drops before production does. My views on Monetary policy thus remain fixed upon the idea that stable prices are essential whatever condition the economy is in, and that other policy tools need to be used by governments to boost economic growth and/or reduce debt levels.

We can also assume that inflation will be the norm whenever supply problems in an economy persist, and will be experienced by Peak Oil, as well as food production once Climate Change begins to bite.

Additionally, you could argue quite easily that economic collapse can lead to political and social collapse.

How I would solve the EU Sovereign Bond Crisis and stop it from happening again

1. Pool all sovereign debt into a central fund. At the end of 2010, this amount totaled €7,822,443 million. Source.
2. This central fund will be run by a supranational entity under the control of the European Union, much like the ECB.
3. A Eurozone-wide financial services tax is introduced. This would be based upon either a Tobin Tax or a Market Capitalisation Tax. The purpose of this tax would be to pay off the sovereign debt that has been pooled into the central fund.
   
4. Because nation governments have shown that they cannot be trusted to maintain the fiscal agreements of the Maastricht Treaty, a Eurozone-wide supranational entity - let's call it the European Revenue Service, or ERS - is set up to a) determine a nation's tax rates, and b) take over the tax collection duties of member nations. This will necessitate the ceding of tax setting and tax collecting by all levels of Eurozone government.
   

Let me expand on these idea further.

The central fund and the financial services tax.
The pooling of debt into a single fund and then paying it off by a Tobin tax or Market Capitalisation tax takes care of the current mess. Individual Euro governments will no longer be responsible for the debt that they have accrued up until this point. It's a way of both "cleaning the slate and starting again" while still setting up structures to ensure that the debt gets paid off (and not defaulted upon). Moreover, the tax that is instituted is aimed squarely at the financial industry (who helped set up the current crisis) rather than upon ordinary wage earners. A central Eurozone-wide fund is better than a series of national funds simply because the central fund (preferably backed by the ECB) would be given clear parameters and not be subject to the whims of individual nations.

The short-term goal of the fund is to provide market confidence in the payback of sovereign debt.
The long-term goal of the central fund is to pool together and eventually retire all levels of Eurozone sovereign debt by way of a financial services tax.

The European Revenue Service.
The setting up of the ERS is certainly a controversial proposal - but it is a proposal that will ensure that this crisis never occur again. Ceding the sovereign authority  to set and collect taxes may sound frightening to those who do not support an ever-closer union, or who think the EU should no longer exist. Yet it is essential for the future of the EU - since it will prevent the blowing out of sovereign debt again.

Under this system, each member country has the power to spend as much they usually do - the ERS will not be responsible for spending decisions. What each nation will no longer have is the ability to set tax rates or tax law or have the ability to collect taxes - these things will be left to the ERS. The ERS will then set tax rates and tax laws for each member nation of the Eurozone to match the amount of spending they indulge in. Scandinavian nations, like Finland or Sweden, will continue to have big spending governments, which means that the ERS will set up high tax rates in those nations. Nations who have smaller governments in proportion to the economy will have lower tax rates. If a country decides to expand government spending, then the ERS will naturally increase the taxes in that nation over the long term; similarly, if a nation decides to cut spending, then the ERS will lower taxes over time. If a nation wants to "run a surplus" in order to create a sovereign wealth fund, then they will simply file this investment under spending, and the ERS will set taxes accordingly.

The ERS will also be the supranational tax collection agency, ensuring that the same quality of operations exists across the entire Eurozone.

The ERS will also have the authority to change tax rates in individual nations, or across the entire Eurozone, in response to certain economic conditions such as recessions or expansions. This would be done in conjunction with the ECB. Keynesian stimuli enacted by member nations will also be conducted in conjunction with ERS policy.

Individual nations can "reduce taxes" on certain industries if they wish through subsidies, which would have a net effect upon the taxes on that industry.

The short-term goal of the ERS would be to set tax rates in member countries, collect them and distribute them to these member countries.
The long term goal of the fund is to ensure that all nations maintain zero net sovereign debt over the course of the business cycle.

Notes:

The fund and the ERS will only operate within the Eurozone. Members of the EU who are not members of the Eurozone will not be subject to these entities (eg UK, Denmark). However, once an EU country joins the Eurozone, these policies will affect them: their sovereign debt will be transferred to the central pool and their tax system will be run by the ERS. The idea that sovereign debt may be paid off on entry to the Eurozone gives potential member nations a huge incentive to join.

As for the importance of government bonds in the European Financial industry, the ECB would be able to issue enough bonds to cover this need. Just because debt is being/has been retired does not mean that government bonds need to disappear as well.

Writing Dreams

Two recent events have rocked the world of a couple of internet denizens.

The first is David C. Simon, the creator of the webcomic Crimson Dark. Simon, a talented user of computer graphics and scriptwriting, has been nabbed by the Game company that is producing "Star Wars: The Old Republic". Simon's role will be mainly in writing, but there's no doubt that his skills in creating Crimson Dark were an important part of this process.

The second is that a Redditor named Prufrock451 with a good script idea is now in talks with a Hollywood company. While this is early days yet, it is the culmination of a very quick few weeks in which the Redditor began writing a sci fi/fantasy story in which a Marine battalion in Afghanistan is transported back in time to ancient Rome. The story, called Rome Sweet Rome, started off mere weeks ago as an experiment in writing that somehow gained a huge following amongst Redditors. Just the mere idea of Machineguns mowing down Praetorian Guards got people involved, not just in reading but also in editing. I suppose you could call it a Saw and Sandal epic (see here).

A proposed solution: Co-ordinated international fiscal and currency policy

Synopsis: A new international agreement between China, Japan the US and the Eurozone should be made to boost economic growth: The US Dollar should be actively depreciated against the value of the Japanese Yen and the Chinese Yuan; Japan and China should enact substantial stimulus programs while the US dollar drops in value. This should boost internal demand in Japan and China which would result in a higher amount of goods and services exported from the US. The Eurozone should also enact a stimulus program while depreciating the Euro slightly. This would ensure both an increase in overall economic growth in all nations while solving the current account imbalances which helped create the economic crisis in the first place.

Due to the inter-relationships between various economies and the imbalances that occur between them, it strikes me that one of the better solutions to the world's current malaise would be to enact some sort of co-ordinated fiscal and monetary policy.

I am one who believes that our current situation has arisen mainly due to imbalances in world investment. Huge current account surpluses in some nations have led to a permanent culture of saving while huge current account surpluses in other nations have led to a permanent culture of borrowing. As a result, certain nations have become "geared" to either saving & production or borrowing & consumption. The response to the economic crisis so far has not resulted in a move away from this imbalance but has rather sought to entrench it further. For example, policy in the US is all about the importance to reviving consumption, either via various stimulus packages or quantitative easing - all of which are designed to boost consumption and reduce saving. Meanwhile, China and Japan and other nations geared towards saving and production continue to manipulate forex markets to keep their nations producing and their citizens saving, all the while waiting for the US to begin consumption and borrowing again.

Well let me suggest the opposite as a solution.

If we want to rebalance the world economy at the same time as boost it, then there needs to be a shift towards balanced current accounts. This would mean that the US would no longer be the world's borrower and consumer, and Japan and China no longer be the world's saver and producer. It would work something like this:

1. A new "Plaza accord" is agreed upon between the US, China and Japan and the Eurozone. This agreement would see a depreciation in the value of the US dollar against the Japanese Yen and the Chinese Yuan. A small depreciation in the Euro would also occur.
   
2. At the same time as this occurs, the governments of China, Japan and the Eurozone enact substantial fiscal stimulus programs to boost internal demand.
3. The increase in internal demand from Japan and China combined with a lower US Dollar will result in an increase in US production.
4. All three nations, along with the Eurozone, agree to have a currency board to ensure that a balanced current account exists between them. This currency board would not exist to peg the three currencies but to merely ensure that the current account remains balanced within the limits of a floating currency.

What this will do is ensure that future Chinese and Japanese economic growth is no longer linked to US consumption and borrowing. The stimulus program in China and Japan should increase the demand for US goods and services. This would increase aggregate demand in the US without relying upon US government spending. Now to some questions about this:

How does the Eurozone fit in?
The Eurozone already has a balanced current account. Unlike many commentators I support the notion of the Eurozone and believe that it is an optimal currency area, which means that any internal current account imbalances amongst Eurozone countries is not as important as the current account of the whole. At present, the Eurozone's current account is nicely balanced, which means that any new Plaza accord should aim to change the current account balances of China, Japan and the US, but not the Eurozone. Of course the stimulus program in the Eurozone would only be useful if the current account remains balanced, which is why only a small depreciation in the Euro is required.

But the US doesn't produce anything!
This is plainly wrong as any judicious person knows. The US has the world's largest manufacturing base. Any increase in external demand will result in an increase in US manufacturing. In order to boost manufacturing and create jobs (especially for those with lower skills) a balancing of the current account must be undertaken.

Can we trust the currency boards?
So long as there is an agreement between the nations involved, so long as the boards are kept free from political and market influence and so long as they are answerable for the decisions they make, then they should be trustworthy.

Can Japan afford it?
Japan's long period of economic malaise has been accompanied mainly by a lack of internal demand. Balancing the Japanese current account and enacting a stimulus would ensure that any boost in economic performance arising from the stimulus is felt mainly in internal demand. In short, Japanese consumption - which is problematic - will be boosted; simultaneously US production - which is problematic - will be boosted. Accompanying this new economic situation will be a decrease in Japanese savings levels - which are too high - and an increase in US savings levels - which are too low. The result of this should be an increase in Japanese economic growth and, with it, an increase in tax revenue. Japan's public funds are certainly problematic, and so I would suggest an increase in tax rates accompany the increase in government spending. The short term boost in spending - which would boost economic growth - would then give way to a longer term sustainable economic performance which, because taxes are higher, would result in increase government revenue and more government debt being paid off. It stands to reason that the Bank of Japan change its policy to, at the very least, prevent long-term deflation (a phenomenon that is felt more by the Japanese GDP deflator than in the CPI).

What about Wall Street?
Let the follow rather than lead. With an increase in US manufacturing and exports, Wall Street should begin investing in companies that actually produce goods and services. Then Wall Street will be doing its job properly.

What about the rest of the world?
With China, Japan, the US and the Eurozone combined, this agreement accounts for over 75% of world GDP. The other 25% will probably need further international agreements - but at the moment we can leave that for the future.

What about US Conservatives?
This agreement won't need much in the way of further government spending for the US. US Conservatives couldn't care less about Japanese, Chinese or European big government spending. Actually, they should be happy that US goods will be increasingly sold in China. They should also welcome the profits made by US industrialists.

The US Government needs more revenue

Oh dear, Standard and Poors rating agency has maligned the US by dropping its Triple-A bond rating. Strangely enough this event has brought both progressives and conservatives together in maligning the rating agency itself, which is a fair call considering the cluelessness of ratings agencies generally in failing when 2008 hit.

Nevertheless there is a rather huge reason for the US being downgraded. I just played around with another spreadsheet comparing US and Eurozone debt, and I get the following:

Okay, first of all you need to understand that this is an index - everything is assumed at 100 at the beginning.

Secondly, these numbers are based upon total government spending and revenue, which includes Federal, State and Local government. This is to ensure that US oranges are being measured against European oranges. You can find US figures here (on pages 345 & 347 of 360) and European figures here.

Thirdly, also understand that while these figures have been indexed, the difference between Eurozone and US revenue and spending as a percentage of GDP is substantial. In the Eurozone the two figures are around 50% of GDP spending and 44% revenue, while in the US, the figures are around 25% spending and 15% revenue.

Fourthly, the figures for EA17 and EU27 are pretty much the same, which is why I didn't include EA27 (the entire European Union) in the graph.

So what can we learn?

The most important line in that graph is Eurozone revenue, the orange line in the middle. Despite the onset of the GFC, despite the tumult at the so called "periphery", Eurozone revenue has only dipped slightly. This means that the deficit, the space between revenue and spending, has been mainly caused by increased spending. Thus in a recovery, spending would drop off as the unemployed return to work while revenue from income tax would increase.

The second most important line in that graph is US revenue. The financial crisis since 2008 has decimated US tax revenue. Previous to 2008, US revenue and spending were around the same level (though obviously with less revenue than spending) but since then there has been a massive drop off in revenue. And while State and Local governments have certainly added to this, the main offender is the Federal Government. A recovery, therefore, would have to be more substantial for the US to ensure that the deficit is paid down.

This is not to say that Europe isn't in trouble. Nor does it ignore the fact that certain European nations have huge problems. Nevertheless in light of the recent debt wrangles in Congress you can understand the fragility of the US economy, the downgrading of debt and China's angry response to the problem.

However the biggest problem here continues to be the Tea Party Republicans and their decision to flatly refuse any revenue raising policies. When seen in light of the graph above, such an extremist position is seen for what it is: madness.

There's one more piece of bad news: since the chances are high that another recession for the US is on its way, we can expect the US budget deficit to widen even further before the end of 2012. While the debt ceiling has been raised enough to prevent any congressional wranglings before next year's presidential election, the question now is whether the new recession will blow government finances out so badly that another debt ceiling vote is needed before the election. God help us.

Some simple facts about the Utøya shooting

The perpetrator:

• Opposed Muslim immigration.
• Was once a member of a dominant conservative political party.
• Espoused anti-government sentiments.
• Hated Marxism.
• Detonated a bomb near the office of the Prime minister, who belongs to a left-wing political party.
• Shot and killed at least 86 young people who were members of the left-wing political party.
  

In short, he is a classic right-wing extremist in the same mould as Timothy McVeigh.

While I don't deny that left wing extremists exist and have also perpetrated violence upon people, I would just like to point out the simple fact that, at least in the West, violence caused by left-wing extremists has been dwarfed by the violence of right-wing extremists. And when you consider the fact that it is the right-wing who are espousing all sorts of radical views using violent rhetoric, you can understand why.

Note: The words "Marxist Hunter" appear on the patch on his left arm in the picture above.

In defence of the Eurozone and its policies

John Quiggan has written an interesting critique of the Eurozone that is far more objective and detailed than other critiques I have read. Nevertheless I believe it to be wrong.

One of the effects of the "great moderation" was the idea that (preferably independent) central banks should use monetary policy to keep inflation within a certain band. Now that neo-classical economics has been discredited, the time is obviously right for questioning this policy. To my horror, however, the consensus seems to be that the inflation band should be looser and higher - I have argued that it should be tighter and lower, and that absolute price stability be the goal.

The result of this debate is an eventual "Godwinisation" of each other's point of view. The new economic consensus of higher inflation is critiqued by those who yell "hyperinflation" and remind everyone of the 1970s, while the old economic point of view is critiqued by those who yell "deflation" and remind everyone of the 1930s. The result seems to be the assumption that anyone who reminds anyone else of a time period when prices either rose or fell as the basis of their argument automatically loses the argument (see Godwin's Law)

The lessons of the 1930s and the 1970s is very clear - price stability is essential. In the 1930s, deflation in the US hovered around 10%; this was not price stability since prices kept dropping. In the 1970s, inflation in the US hovered around 10%; this was not price stability either since prices kept rising. During the neo-classical revolution of the early 1980s, it was decided that inflation should be handled exclusively by monetary means (increasing or decreasing interest rates) in order to keep inflation within a "band".

Yet the desire for price stability - neither too much inflation nor too much deflation - has its roots more in the Wirtschaftswunder of post war Germany and its policies of Ordoliberalism than in anything post-disco or neo-classical. In fact I would argue precisely that a heavy dose of Ordoliberal policies is exactly what Europe and the US needs.

But then we need to add to this mix the theory of optimum currency areas proposed by Robert Mundell. Quiggan is the first econ-blogger I have seen who has actually mentioned this principle when critiquing the Eurozone. Others, including Krugman, have been railing recently against the existence of the Euro but have failed to even mention Mundell or his theories. Mundell, of course, was instrumental in creating the theory of an optimum currency area and his work eventually led the European Union to introducing a single currency.

But is an optimum currency area a neo-classical idea? That appears to be the assumption amongst critics of the Euro, which means that their dismissal of the Euro as a practicable idea neatly fits into their dismissal of neo-classicalism. Yet there are no neo-classical economists in the English speaking world who supported the Euro's creation back in 1999. We certainly didn't see neo-classical economists arguing for a unified North American Currency shortly after NAFTA. In fact, most neo-classical economists derided the Euro as yet another example of creeping socialism in western Europe, usually while writing words such as "inflexible" and "sclerotic" and "old" and "too generous".

My argument is that neither the Eurozone nor price stability is a result of (now discredited) neo-classical economics. I myself have come to the inevitable conclusion that neo-classicalism has run its course and ideas that "governments can't do anything right; the free market is more efficient; deregulate" are now subject to massive qualifiers (eg taxpayer funded universal health care is more efficient and more effective than a system dominated by the free market, such as in the US). Rather than minimising government influences upon the economy, policy makers must now reconsider re-regulation of certain industries to ensure that the market reaches its potential without causing harm to the society it exists in; to reconsider nationalisation of certain industries where it can be proved that government control is more efficient and serves society better. If that sounds like a good solution to neo-classicalism, you're right: it's Ordoliberalism, and Ordoliberalism applied across a continent of separate countries can achieve far more when prices are stable and when a single currency is used.

For us in the English-speaking west, we are quite ignorant of the hoops that nations have to jump through in order to become members of the European Union and to then, after time, adopt the Euro. A series of measurable outcomes must be met, called the Community Acquis. Many of these outcomes are neo-liberal in tone, such as free trade between member nations, and free movement of capital. Others are almost socialist in tone, including environmental laws, competition policies and employment policies. In short, Acquis is very Ordolibeal in tone, and offers the assurance of a level playing field for a single currency to operate in.

It is my opinion that many in the English speaking west desire the Eurozone to collapse, either to vindicate their positions or as a way to move their focus away from the US and its problems. Europe and the Eurozone certainly have major problems, not the least being the debt crisis that they are in. Yet those who have actually studied debt levels closely (such as myself) have argued that the US is in a worse debt situation than Europe, yet no one speaks about the breakup of the US or the rise of state based currencies - the US is, after all, its own optimum currency area. Since such an outcome is unlikely in the US it should be similarly, if not more, unlikely to happen in the Eurozone.

Europe's debt crisis will wane somewhat as the recovery continues. Germany is already posting strong GDP numbers (which contradicts Quiggan's statement that "in GDP terms, Germany's recovery has not been that strong") and this will help boost the economy of the Eurozone as a whole, including the problem PIIGS.

I'm sorry, but I agree with Eurozone economists on this issue: Price Stability must be maintained no matter what the economic situation, and a single currency will always be better than many.

I concur with Rebecca

Rebecca Wilder at Angry Bear has pointed out that there is a large divergence between unemployment rates in the Eurozone.

Since I am a defender of the Eurozone I leaped at the chance to prove her wrong with data, which did not happen. I'm not going to post huge graphs here but I will post something directly from a spreadsheet.

The point I am always trying to make with Progressive Eurosceptics is that the Eurozone needs to be compared directly to the United States when it comes to comparing data. Just as the United States is a bunch of 50 states, so is the Eurozone a bunch of 17 countries (16 in 2010). Comparisons should therefore be made with US states when applicable.

Anyway, here's what my spreadsheet told me about November 2010 Eurozone unemployment statistics:

And here is a breakdown of the November 2010 unemployment figures for each US state (sorry for small font size):

The standard deviation of the Eurozone, 4.1, is nearly double that of the States of the US, 2.1. That indicates unemployment in the European Union is certainly diverging wildly, as is Rebecca's argument. Interestingly, median unemployment in the Eurozone (7.9%) is lower than the US (8.6%), but such a result needs to take into account equal weighting given to smaller states or nations like Alaska, Wyoming, Malta and Luxembourg.

Iceland vs Ireland: Which is worse?

Much has been said recently about the contrasting fortunes of Ireland and Iceland. In 2008, both nations were seriously affected by the global financial crisis with both economies declining substantially. Recent commentators, most notably Paul Krugman, have argued that Iceland's response to the crisis has had a better outcome than Ireland's. Iceland, with its own currency, allowed the Krona to depreciate substantially - a process which caused an inflationary bout. Ireland, on the other hand, is part of the Eurozone and while capital flight has been felt in the Irish bond market, the Irish economy has not undergone a currency depreciation - a process which has caused a bout of deflation.

So in order to discover which nation has had a worse economic experience, I have mined some data at official sites. For Irish GDP data, I downloaded the latest Quarterly National Accounts; for Icelandic GDP, I looked up data at Statistics Iceland. In order to ensure harmony between the two datasets (and thus ensure apples are being compared to apples) I cross checked the data with the latest Eurostat GDP release. Then, via a spreadsheet, I have created an Index comparing the economies of the two nations. Here is that index:

As you can see the current situation is hardly good for either nation. According to this index, Ireland's economy has shrunk by 13.4% since 2007 Q4, while Iceland's has shrunk by 11.7%. The advantage that Iceland has over Ireland in terms of GDP is quite small. Moreover, Ireland's economy has been in trouble longer than Iceland's - it wasn't until 2008 Q4 that Iceland's troubles really began while Ireland's had begun 12 months previously.

Nevertheless, one important indicator shows a huge difference between the two: unemployment. The latest figures from The Economist show that Ireland's unemployment is currently 13.6%, while Iceland's unemployment is 7.5%. Another important indicator is the budget balance. The Economist tells us that Ireland's budget balance is -37% of GDP, while Iceland's is only -7.7%. While both nations have serious problems, these figures seem to show that Ireland's is far worse.

Of course one of the reasons why Iceland and Ireland are so different in their experience of the economic crisis is the one that Krugman likes to champion: devaluation. Iceland has allowed the Krona to devalue while the Irish are "stuck" with the Euro. Yet this argument assumes that exchange rate variations don't really matter - at least over the medium to long term. It is obvious, though, that Iceland's GDP has reduced in value in comparison to the Eurozone simply because of the Krona's devaluation. When we factor in the devaluation of the Krona when comparing the two nations, the difference is much starker:

The data for the Krona's performance against the Euro can be found here. I averaged out the monthly mid-range figures for each quarter. For example the Euro-Krona exchange rate for 2007 Q4 was 88.7466926667 while for 2008 Q1 it was 101.325026. I then assigned an index of 100 for the 2007 Q4 and used the math in the spreadsheet to multiply each quarter's decline in currency to the GDP figures.

According to this graph, Iceland's GDP, as measured in Euro, has declined by a whopping 52.1% since 2007 Q4, which is due to a combination of economic decline and currency devaluation. While Iceland's unemployment rate may be lower than Ireland's, holders of the Krona (ie the citizens, businesses and government of Iceland) have had their wealth taken away... not by taxes, not by spending cuts, not by austerity measures, but by the foreign exchange market.

Ireland has a number of choices, none of them good. One choice is to default on debt. Another choice is to take money away from households and businesses in the form of spending cuts and/or tax increases. Iceland, by contrast, has had these choices forced upon them by the currency devaluation. If Ireland had the choice of default, Iceland has already done this as international creditors have lost out on their investment. If Ireland has the choice to take money away from households and businesses, Iceland has already had this done as the purchasing power of the Krona has been essentially halved.

The Iceland/Ireland battle is an interesting one because it lines up different views of economics: Iceland is favoured by Krugman and those who believe in using inflation as a means to reduce real debt; Ireland is favoured by Europhiles and those who believe that currency devaluations and inflation damage economies; Iceland is favoured by those who are not too concerned about sovereign debt default; Ireland is favoured by those who believe that debt should be paid back, especially sovereign debt; Iceland is favoured by those who believe that the Eurozone and its "one size fits all" monetary policy is doomed to failure; Ireland is favoured by those who see inherent advantages in having a common currency and monetary policy which ensures that the currency retains its value; Iceland is favoured by those who believe that monetary policy should be used by central banks to help grow the economy when needed; Ireland is favoured by those who believe that price stability should be a central bank's sole concern, and that fiscal policy should be used by governments to grow the economy when needed.

My bet, of course, is with Ireland - the Eurozone recovery, led by Germany, will create a demand for Irish goods and services, grow the Irish economy and reduce Irish unemployment. Nevertheless it will be fascinating to see how these two nations perform as years go by.

With Sovereign Bankruptcy must come a change in Sovereignty

It appears as though Ireland will accept a bailout from the IMF. Without this, and without help from its European partners, the Irish government is likely to default on its debts. While Ireland's sovereign debt level is not as bad as some, a budget deficit of 38.5% of GDP has passed the point of ridiculousness. Even though the economy is improving, it has not improved enough to make an impact on the nation's finances.

Ireland, like Iceland and Greece, has been the creator of its own problems. In normal times, political and economic stupidity and profligacy can be forgiven and eventually papered over. Not this time. The Global Financial Crisis has led to social and economic misery around the globe. Like a cyclone or hurricane it caused major damages to whichever country it hits, but especially upon those who were unprepared and whose financial and economic systems were already dangerously unbalanced.

Ireland's biggest advantage is that it is part of the European Union and that it is part of the Eurozone. This means that it was not tempted to destroy its people's wealth through a currency devaluation - the error that Iceland has made and one which the United States is likely to make. Whatever can be said about architects of Ireland's demise, at least those who saved responsibly have retained their savings and their purchasing power. This will help in Ireland's recovery.

But just as bankruptcy leads to the closure of a business, so should a sovereign default result in a change of sovereignty. This is not to say that Ireland should cease to exist as a political entity - far from it. What needs to change is the nation's constitution and its political system. And this is not code for a new election and some constitutional amendments - rather it is the creation of a completely new nation with a new constitution and a newer way of doing things.

The modern Republic of Ireland came into being during the 20th century. Independence from the United Kingdom resulted from a bloody but thankfully short-lived war. The nation was proclaimed a republic in 1949, completely seceding from the commonwealth of nations and setting up an Irish presidency to replace the British crown as the nation's executive.

Of course none of these political achievements of sovereignty need to be repealed. Nor should the efforts of individuals in gaining such sovereignty be ignored or forgotten. Yet the Republic of Ireland has had its day. A new nation needs to be created from the ashes of the old.

France is in its Fifth Republic. The current political entity of France came into being in 1958. Of course France existed long before 1958, even longer than the four republics and other institutions that governed since 1789. Yet despite the idea that France is an "older" country than Ireland, the current iteration of France is actually nine years younger. Countries have dissolved themselves in the past and reformed themselves into newer entities.

What is needed is an Irish Second Republic.

Some time in the near future (1-2 years), the people of Ireland need to vote in a new constitution. Specifics of the electoral system will be voted on. Moreover, the political parties currently involved in the government will be dissolved - their assets stripped and sold off and the money given to the treasury of the new government. No politician who served in the first republic will be eligible to serve in the second republic. The new political parties will have to go back to the drawing board in garnering popular support. Once the constitution has been approved by the people, the second Republic will be "born" and a new country will result.

Naturally you might ask the question why? Why should sovereign bankruptcy lead to a change in sovereignty?

Part of my reasoning on this is that nations, like individuals, need to suffer the consequences of their actions. Since Ireland as a nation is responsible for its current plight, then Ireland as a nation should cease to exist and be replaced by a new entity. Just as a bankrupt business needs to close permanently, so should a country shut itself down permanently. Yet a nation is not like a business in that it consists of people, and people exist no matter what happens to a business - so the only reasonable solution is that when the nation is "shut down" it undergoes a new birth into a new national identity. So should the current Irish republic shut down and a new one replace it.

Moreover there is the idea that Ireland's plight is not just due to the stupid decisions made by those in power, but by the political system that brought such people into power into the first place. As a result, the political system itself needs to change. From a business perspective, it isn't just sacking the board and electing a new one that will solve the problem - it is the entire system of how the board was voted in, and how the business runs itself, that needs to be changed.

Some may find my business/nation analogies here to be simplistic or offensive. They're not meant to be. Yet just as a company board acts on behalf of shareholders, so too do elected officials act on behalf of the people who make up the nation. Since Ireland's current political system led the nation into bankruptcy, it only stands to reason that a new political system be set up. Wipe the slate clean. Start again as a new country.

Of course, one alternative solution would be for the Irish to simply take the money and keeps things running the same way. Not only does this not punish those who failed, but it leaves in place a clearly defective political system that may just fail again in the future.

Another solution might be to subsume Ireland into the territory of another nation. A nearby friendly nation could, in theory, offer to pay off all of Ireland's debts if Ireland become part of their... kingdom. Naturally such a suggestion is ridiculous.

World trade needs to be rebalanced - here's my suggestion

International trade has been around for centuries and has been the creator of both good and bad world economic conditions. What has evolved now, though, is a trade and capital imbalance that is one of the causes of the current economic crisis. If a new economic order is to be created out of this mess, world trade and capital flows need to change.

In the bad old days, mercantilism ruled the waves and nations would compete against each other to gain the best export advantages. This was a self destructive process, since it resulted in trade tariffs and quotas. Mercantilism was part of a broader scheme called "economic nationalism" which saw international trade as a win/lose battle against other nations. Instead of fighting against another nation with armies, countries would fight each other economically. Fortunately economists appeared whose arguments proved beyond reasonable doubt that international trade was actually a win/win - though with a number of caveats.

Sadly, mercantilism is still around. It is practised most notably by China and Japan, with a number of smaller nations (eg Singapore) jumping in. When one nation has a mercantilist trade policy in world trade, the result is a large trade surplus. This trade surplus generates large amounts of foreign currency, which the countries then use to reinvest back into their trade partners. So in Japan and China's case, their trade surplus with the United States leads to large US dollar profits which, rather than being converted into Yen, are reinvested back into the United States. It is a circular process which creates a "virtuous cycle" - US demand for Japanese & Chinese goods leads to US Dollar profits for Japan & China, which leads to reinvestment of these profits back into the United States, which results increased domestic US demand, which results in increased demand for Japanese & Chinese goods. The problem is that this "virtuous cycle" has been exposed as just another bubble that is in the process of bursting.

Theoretically, mercantilism has been abolished. The Word Trade Organisation and its members take a very dim view of member countries setting up trade barriers or quotas. Japan and China get around it however, thanks to the actions of their Central banks. Instead of creating trade barriers, the Central banks of Japan and China sell their own currency and purchase US government bonds (treasuries). This keeps the Yen and the Yuan/Renmimbi cheaper while simultaneously making the US dollar more expensive. With cheap domestic currencies and a customer country with an expensive currency, Japan and China naturally end up having a trade surplus with the United States. Having a cheap currency allows the development of cheap labour thus undercutting any competition from US based companies.

This situation is reflected in a fairly basic economic indicator called the Current account. Nations which have a Current account surplus are nations who receive large amounts of foreign currency for goods and services they sell, as well as from investments that they have in foreign nations. Nations which have a current account deficit are nations who borrow lots of money from nations with current account surpluses.

It is best to look at the current account as an accounting measurement. If our world economy consists of two countries, and country one has a $1 billion current account surplus, then the other country will have a $1 billion current account deficit. You can't have these two nations in this model both running current account deficits or both running current account surpluses. When we take this model to the wider world we realise that one nation's current account deficit is another nation's current account surplus.

So which is better? It might sound better to have a current account surplus, but this is actually mercantilist thinking. In reality they are just as good or just as bad as each other. If we think that the US current account deficit is bad, then we must conclude that the Japanese current account surplus is bad too.

The problem with running large, long term current account imbalances is that, over time, the economy becomes "geared". In the case of the United States, the economy has been "geared" towards the importation of goods and services, it has become "geared" towards borrowing money from overseas - in short, it is an economy that is geared towards consumption and borrowing. By contrast, China and Japan have been "geared" to complement the United States - they are geared towards producing goods and services, and they are geared towards saving. In short, Japan and China are geared towards production and saving.

The figures for these three countries are stark. The United States is running a current account deficit of 3.3% of GDP; Japan is running a current account surplus of 3.3% of GDP; China is running a current account surplus of 4.9% of GDP. Smaller economies have even more notable imbalances (eg Singapore with a current account surplus of 18.4% of GDP, Turkey with a current account deficit of 5.4% of GDP)

Now of course China and Japan DO purchase goods and services from the United States, and people in China and Japan DO borrow money from the United States, and the United States DOES manufacture goods that it exports to China and Japan, and the United States DOES save money. But what we're talking about here is the net result. Just because the United States gets most of its manufactured goods from China and Japan doesn't mean that the United States doesn't manufacture anything. What I'm trying to point out here is that in the back and forth of buying and selling and borrowing and investing that makes up international trade, that current accounts reflect an overall, net position. This means that various industries within these countries stand to gain from any changes in the exchange rate, whichever way it goes.

But the problem with gearing is that any changes in the exchange rate will impact both consumer-friendly nations and producer-friendly nations. Just as investment bubbles will inflate, burst and destroy wealth in the form of stock market busts or property busts, so too can it happen on an international scale. The US, for example, has been running as a consumer-friendly nation for a long time and, as a result, the bubble is about to burst. The United States is naturally the world's financial capital, yet debt has ballooned out of control over the years. The GFC is the beginning of the end of the consumer-friendly United States. Steps need to be taken to gear the United States into a more producer-friendly economy. This doesn't mean becoming mercantilist and running a current account surplus, but it does mean policies to ensure a balanced current account.

The current accounts of Japan and China should therefore no longer be running at a surplus, but should become balanced (ie neither surplus nor deficit) over the long term. This means that the current account of the United States should no longer be running at a deficit, but should become balanced as well. Put simply, the United States needs to produce more and consume less, and save more and borrow less. On the other side of the coin, this means that China and Japan needs to consume more and produce less, and borrow more and save less.

Retooling the United States to become a more producer friendly economy will be painful and it will take time (ie years) to bear fruit. Similarly, retooling Japan and China to become more consumer friendly will be painful too, and will take a similar amount of time to bear fruit.

One solution to the problem of international trade and current account imbalances is to have a common currency. That is what Europe has done with the creation of the Euro. Within the Eurozone, current account differences do occur: Germany has a current account surplus, Spain has a current account deficit. But that doesn't really matter since comparative advantages are very real in international trade, while internal current account issues within the Eurozone will be dealt with by the market without having problems caused by differing currencies. What does matter is the Eurozone's current account overall (presently a current account deficit of 0.4%, which is close to being balanced)

But since the chances of Japan, China or the United States joining the Eurozone (and all that such a joining would entail) is virtually none, another solution must be found.

The solution I have is for the creation of a new international trading agreement that ensures all member nations have balanced current accounts. This would involve the creation of national currency boards in each member nation whose role will be the maintenance of a balanced current account (as opposed to the traditional role of a currency board to maintain a fixed exchange rate). If a nation has a current account deficit, as the United States does, then the currency board (acting with various government bodies like the central bank and/or treasury) will sell off its local currency and purchase foreign currencies on the foreign exchange market, most obviously the currencies of nations who run current account surpluses. Of course these currency boards will have a reciprocal arrangement with the currency boards of the nations they are dealing with. So in the case of the United States and Japan, the US currency board would sell off US dollars and purchase Yen, while the Japanese currency board would sell off US dollar and purchase Yen as well - with the eventual aim of ensuring a balanced current account between the US and Japan.

This system still allows floating currencies but the forex market will be initially dominated by the actions of national currency boards buying and selling currencies in order to create balanced current accounts throughout. This would be better than instituting fixed exchange rates or returning to a gold standard. Since the currency boards will be operating with their respective central banks, money creation by fiat followed by the selling of this currency will be one way to devalue a currency. These currency boards would then only act to ensure a balanced current account. So long as a balanced current account is maintained for their nation or currency zone, they will stay out of the forex markets. Long term current account maintenance will, however, result in regular forays into the forex market - but each foray being only as large as it needs to be to maintain a balanced current account.

Moreover, the more nations which join this agreement, the more natural comparative advantages between nations can be maintained. Rather than ensuring that each nation has a balanced current account with every other nation, the agreement will simply ensure that member nations have a balanced current account overall. For example, in an international economy of three nations, nation A might have a $500 billion current account deficit with country B, country B might have a $500 billion current account deficit with country C, while country C has a $500 billion current account deficit with country A. In this situation, each nation has an unbalanced current account with individual nations, but the overall result is a balanced current account for each of the three nations.

Once this situation is imposed, international trade and capital flows will be easier for the market to handle, since the market will act in the knowledge that currency values will only move within a certain band - and that band will be determined by the currency board and only acted upon according to the status of the current account. There will be less market speculation and more real trade being achieved. This should also result in more predictable, more sustainable economic growth for all nations involved. The win/lose attitude of mercantilism should be replaced by the win/win of balanced international trade.


Addendum

Of course the theory I am working with here is that balance ensures better economic conditions for all. Ensuring that nations (or more correctly, currency zones) run balanced current accounts is one "pillar" of the new economic order that I see should emerge over the next few decades. These three pillars are:

• Each currency zone has a balanced current account - neither current account surplus nor current account deficit over the long term.
• Each currency zone has governments that run balanced budgets over the long term - neither budget surplus nor budget deficit over the long term
• Each currency zone maintains absolute price stability - neither inflation nor deflation over the long term.
  

I believe that if these three pillars are set up and maintained, the chances of devastating economic downturns (eg great depression / GFC) will be minimised.

Krugman's inflation suggestion: not a good idea

Paul Krugman is good man. He's brilliant too, and deserves that Nobel Prize he got. Moreover he and I both warned of the coming economic crash. So I respect him.

But since 2008 our paths have diverged. Krugman and Joseph Stiglitz, brilliant though they are, are arguing that a dose of inflation is needed to recover the economy. In the other corner lies OSO, Kenneth Rogoff and those who run the European Central Bank, who argue that price stability must be maintained whatever the circumstances, and that efforts must be made to reduce sovereign debt levels.

One of Krugman's arguments of late is that increasing the money base won't help the economy to recover and points to the experience of Japan, who increased their monetary base back in the 90s without seeing an commensurate increase in inflation (at least not enough to reduce deflation). Money printing will not work during a solvency crisis he argues.

Maybe I'm a little too monetarist to agree with Krugman here. My response to the idea that money printing won't lead to inflation is to naturally point at Mugabe's Zimbabwe and Weimar Germany. Certainly these two examples are extreme but they do provide an extreme example of what can happen if governments resort to seigniorage to fund government spending. You can be assured that if the US government organised a similar scheme with the Fed the result will almost certainly be the same. Moreover, had Japan in the 1990s followed the same policy (Mugabe Zimbabwe/Weimar Germany money printing) the result would've been the same.

So how do I explain the facts around early 90s Japan that Krugman uses as evidence? It's simple: Japan didn't increase the monetary base enough. Erring on the side of caution and concerned that they didn't want hyperinflate, Japan's increase of the monetary base was simply too small to make any impact on M2. Since a central bank can theoretically create an infinite amount of money, nothing really prevented Japan from increasing the monetary base beyond what is shown on Krugman's graph.

This is important to realise because I believe that a new system of monetary policy needs to be created, using some of the more radical monetarist ideas of years past. Moreover, unlike Krugman and Stiglitz, I would argue that the inflation target should not be "high" (Krugman argues for 4% inflation) but should be even tighter than what was practised over the past 30 years. Absolute price stability (whereby there is neither inflation nor deflation over the long term) should be the new goal, and it is something that I have been presenting as a solution for some years now. Certainly at the outset of the financial crisis I asked the question of whether the current system needed to be changed. It seems that the thinking of progressive economists has been "yes", but in the opposite direction to what I would argue.

I had assumed that the question of whether inflation was good or bad was solved once and for all by Paul Volcker, who ended the stagflation of the 70s by raising US interest rates and killing off inflation - a process which put the US into a deep recession but which resulted in a low inflation recovery. Moreover I also remember the post-war commitment to Ordoliberalism in West Germany, which created the Wirtschaftswunder - and the importance of low inflation in creating an effective post-war nation.

My argument is this: the closer an economy gets to price stability, the more scope there is for sustainable growth. Conversely, the further away an economy gets from price stability (and that includes persistent inflation as well as persistent deflation), the more scope there is for something to go wrong.

Of course money isn't the real issue. The real issue is the production of goods and services and, according to Robert Solow, the ability to make them more efficiently over time (the cheaper production of goods and services over the long term leads to real economic growth). Money is important - it is essential - but how an economy produces & consumes and invests & borrows depends upon whether price signals are accurate or not. Of course no economy is perfect and people with money will not make rational decisions - but when money retains value over the long term, people are less likely to use their money for irrational purchases or investments.

As I have pointed out years ago, there are three things to remember about money:

1. It is used as a unit of exchange to purchase goods and services.
2. It is subject to the laws of supply and demand.
3. It is used to measure relative worth.
   

The problem arises when the effects of 2) interfere with the need for 3). If the value of money changes - either through the process of inflation or of deflation - then it no longer functions effectively as a way to measure relative worth.

As an example of this problem I remember reading the biography of Allan Border in which he purchased a car in the early 1970s for around $300, and then sold it in 1978 for the same amount. Of course in the intervening years the level of inflation was quite high, which meant that while he may have felt he had done well in not losing any money in selling it, the reality was that the depreciation of the value of his car matched the depreciation of the value of the currency he used to buy it in the first place.

Of course these arguments seem to be axiomatic - logical presentations without the influence of hard data - and I admit that this is a failing except in two areas: The effect of low inflation in post-war Germany to help create the Wirtschaftswunder; and the need for Paul Volcker to destroy inflation in the early 1980s to bring about a more sustainable economy.

Aiming for higher inflation, as Paul Krugman argues, is exactly the wrong thing to do. It may result in some level of growth but over the long term it will erode America's economy even further. Price stability must be maintained no matter how good or bad an economy is running. It is non negotiable. Economic problems can't be fixed by abandoning price stability, even though many economic problems may remain while price stability is maintained. Other solutions must be found, which puts the onus squarely upon governments to adjust their spending and tax rates (either by expanding or contracting their spending, depending upon how much in debt they are). In many cases it may simply be a matter of waiting until the market sorts itself out.

Other articles of a similar tone:

2008-10-11 Economic Crises still need price stability
2008-10-13 Random thoughts on money (explains some of my thinking in more detail)
2009-01-28 I still believe in inflation targeting

A response to John Quiggan's "Zombie Economics"

John Quiggan, an economist, political commentator and fellow Australian, wrote an article recently for foreignpolicy.com entitled "Five Zombie Economic Ideas That Refuse To Die". His article fits into the same tone that Richard Werner wrote in "New Paradigm in Macroeconomics" in 2005, namely that neo-classical economic ideology (called neo-liberalism here in Australia) has failed to deliver what was promised.

Before I begin my critique of Quiggan's article, I need to first point out that I regularly enjoy reading Quiggan's blog. I find his point of view interesting and his arguments compelling. Like Quiggan I have a lot of sympathy towards Social Democracy and its tenets, as well as some of the wars he has engaged in (namely an informed disdain for News Limited and defending the science of global warming). I also need to point out that much of my critique of Quiggan's article is not based upon a defence of neo-classical economics but upon policy that I believe is simply the best choice.

Let me start with Quiggan's first point, that of "The Great Moderation". Quiggan says:

More importantly, central banks and policymakers are planning a return to business as usual as soon as the crisis is past. Here, "business as usual" means the policy package of central bank independence, inflation targeting, and reliance on interest rate adjustments that have failed so spectacularly in the crisis.

Quiggan then goes on to quote Jean Claude Trichet's comments about inflation, namely the importance of maintaining price stability in good times and bad. Quiggan points out that this attitude is "startlingly complacent".

My argument is that Central Bank independence should be maintained and that monetary policy should be geared towards keeping inflation down. Unlike many who argue that an "inflation target" should be set, it is my point of view that absolute price stability be the goal of monetary policy, whereby money neither increases nor decreases in value over the long term. Now while neo-classical and neo-liberal economic ideology argues for strict price stability, my reasons for holding this position do not come from either of these movements but from a much older idelogy - Ordoliberalism. This economic school was developed in Germany in the post war years and was responsible for Germany not just recovering from the devastation of World War Two, but becoming the economic powerhouse of Western Europe.

Let me just do a quick history lesson here. Please be patient.

After the hyperinflation of the Weimar Republic years and the disaster of the Hitler years, West Germany suffered under some very vengeful and short-sighted policy by occupying US forces. Joint Chiefs of Staff Directive 1067, signed by President Truman in 1945, attempted to de-industrialise Germany. Even though Germany did gain some relief from the Marshall Plan, the amount of money they were forced to pay in war reparations was greater than anything they received from the US. In short, West Germany, wrecked from the war, faced the prospect of paying the allies (net) war reparations while being forced to de-industrialise and turn into an agrarian economy. The result was disaster for Germany: poverty went hand in hand with growing inflation. In the years following the end of World War II, poverty in Germany grew worse and worse.

JCS 1067 was eventually overturned and the West Germans were granted the responsibility to look after their own economy. The philosophy that guided them was Ordoliberalism - the idea that the state should regulate the free market in order to allocate resources effectively. It was neither the Democratic Socialism that was embraced by the UK and France in the 1950s nor the Laissez-faire model of the US. One of the tenets of this philosophy was low inflation: Price Stability. The Deutschmark replaced the Reichsmark under this change, and stable prices formed the basis of Germany's growth during the years now known as the Wirtschaftswunder.

What we have learned from economic history is that any major swing towards inflation or deflation leads inevitably to hardship. Deflation beset the world during the Great Depression; Inflation beset the world during the 1970s and hyperinflation has led to ruin in numerous nations, including Ancient Rome, Weimar Germany and Zimbabwe today.

So what level of inflation does Quiggan want? Is 5% inflation too high? is 7%? Is 50%?

Ah, Quiggan might respond, what about the US over the last ten years? They had low inflation and that didn't stop the financial crash did it? To which I would respond by pointing out two things: Firstly that interest rate policy alone will not prevent a crisis from occurring, but is one important part of a whole host of things that should prevent a crisis. If a driver gets injured because another car rammed into him, it would be disingenuous of him to blame it on his tyres.

Secondly, that while inflation was historically low in the US for the past ten years, real interest rates were negative between 2002 and 2005. Many economists have pointed out that the US Federal Reserve kept interest rates too low during this period which, in turn, created the property bubble which burst and helped create the current financial crisis. The Washington Consensus, a neo-classical and neo-liberal text that has guided IMF policy for many years, specifically highlights the need for real interest rates to be positive. Had the US actually kept in lockstep with neo-classical ideas, this period of negative interest rates would never have been allowed. The crisis thus did not stem from a complete adherence to neo-classical ideology but from a deliberate rejection of what I consider to be good policy. If we go back to the car analogy, a driver who has injured himself by driving irresponsibly shouldn't blame the laws that he neglected to follow.

It also needs to be pointed out that the Federal Reserve Bank, unlike the ECB and Australia's Reserve Bank, did not have an inflation target to aim for, but kept markets guessing. The Fed certainly had a goal for price stability, but it was amorphous and opaque. This of course shifts the issue to whether a Central Bank should be independent. The original reason for making a Central Bank independent was to insulate it from political pressure in order to enact monetary policy that would be governed by price stability and not political interference. While I still believe in this, I am also willing to admit that Central Banks are not necessarily immune from market influence. The Federal Reserve, for example, has an unusual amount of employees working for it who once worked for Goldman Sachs. The fact that the market has been able to influence central bank policy does not therefore mean that they should come back under government influence, but that steps be taken to insulate it from all forms of undue influence. In other words, I am advocating a Central Bank that is not just independent, but also transparent and accountable.

To summarise my position on central banks and the current economic crisis: Central Banks should focus upon price stability as their main goal and set realistic low inflation targets (and again let me advocate absolute price stability instead of low inflation targets). Central Banks should be independent of government and market influence, while remaining transparent and accountable for their actions. Jean Claude Trichet, head of the ECB, was quoted by Quiggan as saying this, which I heartily affirm (and which Quiggan criticises):

Keeping inflation expectations anchored remains of paramount importance, under exceptional circumstances even more than in normal times.

There is nothing "neo-classical" or ignorant about this policy. In fact one could argue that had this policy been abandoned during the current crisis, we would be suffering even more.

One last thing before I move on: shouldn't central banks have a wider focus of reducing unemployment and fostering economic growth and not just price stability? To me that question is moot. Worrying about economic growth and the unemployed should be the focus of the government, not the central bank. "Pump priming" the economy through Keynesian stimuli should not be ignored as a policy, and nor should increasing the size of government to bring about a better economy over the long term. These I advocate, which plainly shows just how different I am from the neo-classical mould of "keep government small and let the market do everything", though I would point out that the government needs to control the level of debt throughout this process.

Quiggan's points on modern day monetary policy and the so called "Great Moderation" were my main problem. Now let me move on to Quiggan's other points.

The second point Quiggan critiques is the "Efficient markets Hypothesis". While Quiggan and I agree that letting the market do everything is a silly and dangerous policy, so to would be the idea that the government do everything. Quiggan is not a communist who advocates a planned economy, but his article is light on what he thinks should replace the current crazy "markets are always wonderful" idea. My argument has been that there are sectors of the economy that the government is better suited to controlling and sectors which the market is better at controlling, and that there are even areas where a combination of government and market result in the best outcome. Health Care, for example, has been shown to work best when a government run universal health care system operates alongside a smaller market system aimed at those who wish to pay more for their health. It is this combination of majority government and minority market which works so well in Western European Social Democracies and in countries like Canada, Australia and New Zealand. The US system, in which government healthcare is limited and which the market is dominated by health care companies, has been shown to be less efficient and less effective than the one employed by social democracies.

So while I agree with Quiggan that the "efficient markets hypothesis" is bunk, I would also argue that some markets are efficient while others are not - and those that are not should have some level of government intervention, which ranges from a stricter regulative environment at one end to complete government control at the other end. This again shows my belief in Ordoliberalism.

Thirdly Quiggan points out the stupidity behind Dynamic Stochastic General Equilibrium. I'm certainly in complete agreement with him on this one, as with his fourth point, that of the complete failure of "trickle down economics" to trickle anything down to lower income earners. Median wages in the US have certainly stagnated in the last ten years, and were affected most by Reaganomics, which cut taxes for the rich. While I admit that income and wealth disparity will (and should) always exist, there is a point at which it becomes ridiculous. Aiming for a GINI coefficient of under 30 should be a policy goal for any nation who wishes to intelligently reduce poverty levels.

Quiggan's final point concerns privatization: the selling off of government assets and economic sectors and their replacement by private companies. Again this is one area that I am in partial agreement. There are some government entities that definitely needed to be privatised. In the case of Australia, Qantas, the Commonwealth Bank and Telstra were progressively privatised over many years and I have no problem with these changes. Why should the government compete in the airline industry if private industries can do it better? Nevertheless the privatization debate is grounded on the efficient markets hypothesis, which I have written briefly about above. Privatization might lead to better economic and social outcomes, but then again so might nationalization of some industries. The guiding principle here should be pragmatism and social and economic harmony.

Like many post-crash commentators, Quiggan's points are a mix of good and bad. There is no doubt that the previous policy regime needs to be challenged but there is a point at which the proverbial baby is thrown out with the bath water. Marxism and Communism made the mistake of treating capitalism as an enemy that should be destroyed, while modern-day market advocates treat government as a similar enemy. Different ideologies, same blindness. Neo-classical / neo-liberal economics has certainly failed, but in developing alternatives we cannot ignore some of the truths hidden within its failure: Not all markets are efficient, but some are; Not all government programs are efficient, but some are; Price stability won't solve everything, but it does solve some things.

GDP predictions for Q3 2010

Based upon my study of Real Interest Rates over the past three months (government bond rates minus inflation), I am making a judicious prediction of a number of countries.

Note: GDP measured here is change from the previous quarter in annualised form

Economies that were growing in Q2 and will grow faster in Q3

• Australia: > + 4.9%
• Canada: > +2.0%
• China: Growth (quarterly GDP figures not readily available)
• Euro Zone: > +3.9%
• France: > +2.8%
• Germany: > +9.0%
• Japan: > +1.5%
• South Korea: > +5.2%

Economies that are growing in Q3 at around the same rate as they were in Q2

• Argentina: +12.3% steady
• Britain: +4.7% steady
• Italy: +1.8% steady
• Mexico: +13.5% steady
• New Zealand: 1.5% steady
• Russia: Steady (quarterly GDP figures not readily available)
• Spain: +0.7% steady
• Sweden: +8.0% steady

Economies that were growing in Q2 but will begin to slow down in Q3

• Brazil: < 5.1%
• India: Less growth (quarterly GDP figures not readily available)Poland: Less Growth (quarterly GDP figures not readily available)
• Switzerland: < +3.5%
• Turkey: Less Growth (quarterly GDP figures not readily available)
• USA: < +1.7%

Economies that were contracting in Q2 but will perform better in Q3

• Ireland: > -4.8%

Economies that were contracting in Q2 and will be even worse in Q3

• Greece: < -6.8%
• Iceland: < -11.8%

If these predictions are correct then what we will experience in Q3 will be a broad and strong international recovery, especially in the Euro Zone, while the US grows only slowly.

Q2 2010 European GDP grows faster than the US

I predicted this about 2 months ago.

Here's what the Eurostat release says:

GDP increased by 1.0% in both the euro area (EA16) and the EU27 during the second quarter of 2010, compared with the previous quarter, according to flash estimates published by Eurostat, the statistical office of the European Union. In the first quarter of 2010, growth rates were +0.2% in both zones.

Compared with the same quarter of the previous year, seasonally adjusted GDP increased by 1.7% in both the euro area and the EU27 in the second quarter of 2010, after +0.6% and +0.5% respectively in the previous quarter.

During the second quarter of 2010, US GDP increased by 0.6% compared with the previous quarter, after +0.9% in the first quarter of 2010. US GDP rose by 3.2% compared with the same quarter of the previous year (+2.4% in the previous quarter).

Actually I love it how people like to report GDP figures differently. 1.0% doesn't sound too much and anyone who read the latest US GDP figures would say "But US GDP grew by 2.4%". Here's two examples:

Example one (Bloomberg, 2010-07-31):

Gross domestic product grew at a 2.4 percent annual pace, less than forecast, after a 3.7 percent first-quarter gain that was larger than previously estimated, according to Commerce Department data issued today in Washington.

Example two (Bloomberg, 2010-08-13):

Gross domestic product in the 16-nation euro area increased 1 percent from the first quarter, when it rose 0.2 percent, the European Union’s statistics office in Luxembourg said today. That’s the fastest in four years and the first time the euro region has outpaced the U.S. since the second quarter of 2009.

As anyone who has been trying to decipher GDP reporting over the years knows, there are three (and possibly four) basic ways to measure GDP growth:

1. Measure the growth from one quarter to the next.
2. Measure the growth from one quarter to the next, and then "annualize it" by multiplying it by four.
3. Measure the growth from the latest quarter to what it was 12 months ago, giving an "annual" (but not annualized) figure.
   

Confusing isn't it? The thing is, when the media reports US figures, it gives the 2nd measurement; when they report EU figures, they use the first measurement. What ends up happening is that the US looks "better". So how do the US and EU really compare?

Of course the recovery has hit Europe one quarter after it has hit the US, which is why the annual figure for the US exceeds that of the EU. Q3 2010 should look interesting, as should further revisions of these GDP numbers for both Europe and the US.

US Dollar history since 1999 and some predictions

This is a graph of the US Dollar Index since 1999.

Annoyingly, the St Louis Fed "FRED" online tool does not have a USDX graph to check, so I had to add in all the different currency values onto a spreadsheet and then apply all the various weightings. This graph begins in 1999 because the Euro was not around before then and, while I'm sure there are equations and whatnot to cover this change, I haven't found them yet!

But as you can see the US Dollar reached its peak at around the same time as the dotcom boom went bust in 2000-2001. It fell steadily to around 2005, when it regained value somewhat and then fell further until early 2008. Of course the steep rise in mid-late 2008 was due to the effects of the credit crunch and a small plateau of sorts developed before further devaluation began and lasted until November 2009, when it began to rise again. The figure for May 2010 was 85.33.

One of the predictions I made for 2009 was a devaluation of the currency to below 60 on the US Dollar Index. Of course this didn't happen but I'm reasonably confident that it will devalue below 60 at some point. The long term trend is downwards, with a high  of 118.98 in February 2002 and a low of 72.11 in April 2008 seeing a maximum decline of approximately 40% (though in May 2010 the decline from February 2002 was around 28%).

At the moment, consumer prices in the US have declined for two months and the effect of the Obama stimulus plan has begun to wear off, which means that we are heading for a more muted economic performance. I think GDP in Q2 2010 will be very low and I am expecting at least one quarter of negative growth this year. At best we'll see some further deflation and at worst a second credit crunch to rival Q4 2008, which means that investors are probably going to push the Dollar up again as they run away from stocks - a process which has already begun if you look at the far right hand side of the graph.

The only fly in this predictive ointment is European GDP growth in Q2 2010. I believe that EU growth will be higher than US growth during this period and investors will be surprised by European economic strength - to the point where yields on PIIGS bonds will drop. How long this will last I don't know, but monetary conditions in Europe in the last three months have certainly been very strongly inflationary (Switzerland will head them all, whilst Greece will be reasonably poor) whereas monetary conditions in the US have more or less been neutral (and tending deflationary).