Deflation – not hyperinflation – brought Hitler to power

This Matt O’Brien in The Atlantic:

“Everybody knows you can draw a straight line from its hyperinflation to Hitler, but, in this case, what everybody knows is wrong. The Nazis didn’t take power when prices were doubling every 4 days in 1923– they tried, and failed — but rather when prices were falling in 1933.”

Matt is of course right – unfortunately few European policy makers seem to have studied any economic and political history. Furthermore, few advocates of free market Capitalism today realise that the biggest threat to the capitalist system is not overly easy monetary policy. The biggest threat to free market Capitalism is overly tight monetary policy as it brings reactionary and populist forces – whether red or brown – to power.

Update: This is from the German magazine Spiegel:

From 1922-1923, hyperinflation plagued Germany and helped fuel the eventual rise of Adolf Hitler.”

…I guess somebody in the German media needs a lesson in German history.

HT Petar Sisko.

PS Scott Sumner has a new blog post on how wrong many free market proponents are about monetary issues.

PPS take a look at this news story from the deflationary euro zone.

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“The Euro: Monetary Unity To Political Disunity?”

The re-eruption of the euro crisis as sparked not only economic and financial concerns, but maybe even more important the crisis is now very clearly leading to serious political disunity exemplified by an article the Spanish newspaper El País in, which Chancellor Merkel (somewhat unjustly) was compared to Hitler. And it is pretty clear that Germans are unlikely to get the same level of service if they go on vacation in Spain, Greece or Cyprus this year.

The political disunity in Europe should hardly be a surprised to anybody who have read anything Milton Friedman ever wrote on monetary union and fixed exchange rate regime. His article “The Euro: Monetary Unity To Political Disunity?” from 1997 has turned out to have been particularly prolific.

Here is Friedman on why the euro just is a bad idea:

By contrast, Europe’s common market exemplifies a situation that is unfavorable to a common currency. It is composed of separate nations, whose residents speak different languages, have different customs, and have far greater loyalty and attachment to their own country than to the common market or to the idea of “Europe.” Despite being a free trade area, goods move less freely than in the United States, and so does capital.

The European Commission based in Brussels, indeed, spends a small fraction of the total spent by governments in the member countries. They, not the European Union’s bureaucracies, are the important political entities. Moreover, regulation of industrial and employment practices is more extensive than in the United States, and differs far more from country to country than from American state to American state. As a result, wages and prices in Europe are more rigid, and labor less mobile. In those circumstances, flexible exchange rates provide an extremely useful adjustment mechanism.

If one country is affected by negative shocks that call for, say, lower wages relative to other countries, that can be achieved by a change in one price, the exchange rate, rather than by requiring changes in thousands on thousands of separate wage rates, or the emigration of labor. The hardships imposed on France by its “franc fort” policy illustrate the cost of a politically inspired determination not to use the exchange rate to adjust to the impact of German unification. Britain’s economic growth after it abandoned the European Exchange Rate Mechanism a few years ago to refloat the pound illustrates the effectiveness of the exchange rate as an adjustment mechanism.

Note how Friedman rightly notes that downward rigidities in price and wages are likely to cause problems in the euro zone in the event of a negative shock to one or more of the euro countries.

These problems cannot be ignored and if they are ignored it will likely lead to political disunity – if not indeed political disintegration. As Friedman express it:

The drive for the Euro has been motivated by politics not economics. The aim has been to link Germany and France so closely as to make a future European war impossible, and to set the stage for a federal United States of Europe. I believe that adoption of the Euro would have the opposite effect. It would exacerbate political tensions by converting divergent shocks that could have been readily accommodated by exchange rate changes into divisive political issues. Political unity can pave the way for monetary unity. Monetary unity imposed under unfavorable conditions will prove a barrier to the achievement of political unity.

Friedman unfortunately once again has been proven right by events over the past couple of weeks.

Greece is not really worse than Germany (if you adjust for lack of growth)

Market Monetarists have stressed it again and again – the European crisis is primarily a monetary crisis rather than a financial crisis and a debt crisis. Tight monetary conditions is reason for the so-called debt crisis. Said in another way it is the collapse in nominal GDP relative to the pre-crisis trend that have caused European debt ratios to skyrocket in the last four years.

That is easily illustrated – just see the graph below:

I have simply plotted the change in public debt to GDP from 2007 to 2012 (2012 are European Commission forecasts) against the percentage change in nominal GDP since 2007.

The conclusion is very clear. The change in public debt ratios across the euro zone is nearly entirely a result of the development in nominal GDP.

The “bad boys” the so-called PIIGS – Portugal, Ireland, Italy, Greece and Spain (and Slovenia) are those five (six) countries that have seen the most lackluster growth (in fact decline) in NGDP in the euro zone. These countries are obviously also the countries where debt has increased the most and government bond yields have skyrocketed.

This should really not be a surprise to anybody who have taken Macro 101 – public expenditures tend to increase and tax revenues drop in cyclical downturns. So higher budget deficits normally go hand in hand with weaker growth.

The graph interestingly enough also shows that the debt development in Greece really is no different from the debt development in Germany if we take the difference in NGDP growth into account. Greek nominal GDP has dropped by around 10% since 2007 and that pretty much explains the 50%-point increase in public debt since 2007. Greece is smack on the regression line in the graph – and so is Germany. The better debt performance in Germany does not reflect that the German government is more fiscally conservative than the Greek government. Rather it reflects a much better NGDP growth performance. So maybe we should ask the Bundesbank what would have happened to German public debt had NGDP dropped by 10% as in Greece. My guess is that the markets would not be too impressed with German fiscal policy in that scenario. It should of course also be noted that you can argue that the Greek government really has not anything to reduce the level of public debt – if it had than the Greece would be below to the regression line in the graph and it is not.

There are two outliers in the graph – Ireland and Estonia. The increase in Irish debt is much larger than one should have expected judging from the size of the change in NGDP in Ireland. This can easily be explained – it is simply the cost of the Irish banking rescues. The other outlier is Estonia where the increase in public debt has been much smaller than one should have expected given the development in nominal GDP. In that sense Estonia is really the only country in the euro zone, which have improved its public finances in any substantial fashion compared to what would have been the case if fiscal austerity had not been undertaken. The tightening of fiscal policy measured in this way is 20-25% of GDP. This is a truly remarkable tightening of fiscal policy.

Imagine, however, for one minute that Greece had undertaken a fiscal tightening of a similar magnitude as Estonia and assume at the same time that it would have had no impact on NGDP (the keynesians are now screaming) then the Greek budget situation would still have been horrendous – public debt would have not increase by 50% %-point of GDP but “only” by 30%-point. Greece would still be in deep trouble. This I think demonstrates that it is near impossible to undertake any meaningful fiscal consolidation when you see the kind of collapse in NGDP that you have seen in Greece.

Concluding, the European debt crisis is not really a debt crisis. It is a monetary crisis. The ECB has allowed euro zone nominal GDP to drop well-below its pre-crisis trend and that is the key reason for the sharp rise in public debt ratios. I am not saying that Europe do not have other problems. In fact I think Europe has serious structural problems – too much regulation, too high taxes, rigid labour markets, underfunded pension systems etc. However, these problems did not cause the present crisis and even though I think these issues need to be addressed I doubt that reforms in these areas will be enough to drag us out of the crisis. We need higher nominal GDP growth. That will be the best cure. Now we are only waiting on Draghi to deliver.

PS The graph above also illustrate how badly wrong Arthur Laffer got it on fiscal policy in his recent Wall Street Journal article – particular in his claim that Estonia had been got conducting keynesian fiscal stimulus. See here, here and here.

The Bundesbank demonstrated the Sumner critique in 1991-92

I have recently written a number of posts (here and here) in which I have been critical about Arthur Laffer’s attempt to argue against fiscal stimulus. As I have stressed in these posts I do not disagree with his skepticism about fiscal stimulus, but with his arguments (and particularly his math). It is therefore only fair that I try to illustrate my view on fiscal stimulus and why fiscal stimulus (on it own) is unlikely to work.

My view of fiscal policy is similar to that view Scott Sumner as articulated in what has been called the “Sumner critique”. According to the Sumner critique if the central bank for example targets inflation or nominal GDP any action by the government to “stimulate” aggregate demand will only work if it does not go counter to the central bank’s nominal target.

Imagine that the central bank is targeting 2% inflation and inflation and expected inflation is at exactly 2%. Now the government in an attempt to spur growth increases the government spending by 10%. In a normal AS-AD model that would shift the AD-curve to the right from AD to AD’ as illustrated in the graph below.

The increase in government spending will initially increase real GDP (output) from Y to Y’, but also push up the price level from P to P’ and hence increase inflation.

However, as the central bank is a strict ECB type inflation targeter it will have to act to the increase in inflation by tightening monetary policy to push back the price level to P (yes, yes I am “confusing” the level of prices and growth in prices, but bare with me – I might just have written the whole thing in growth rates or argued that the central bank targets the price level).

Hence, once the government announces an increase in government spending the central bank would announce that it would reduce the money base (or the growth rate in the money base) to counteract any impact on inflation from the “fiscal stimulus”. The reduction in the money base would push the AD curve back to AD.

This is the Sumner critique – the government can not beat the central bank when it comes to aggregate demand. The central bank will ultimately determine aggregate demand and if the central bank targets for example inflation, the price level or nominal GDP then fiscal policy will have no impact on aggregate demand and note that this is even the case in a situation where unemployment is above the natural rate of unemployment. Hence, we have full crowding out even in a model with sticky prices and wages and underutilization of production factors (involuntary keynesian unemployment).

Furthermore, if the inflation target is credible then investors will realise that any fiscal expansion will be counteracted by a monetary contraction. Therefore, once the fiscal expansion is announce the markets would react by starting to price in a monetary contraction – leading to a strengthening of the country’s currency, falling stock markets and lower inflation expectations – this on its own would counteract the increase in aggregate demand. This is the Chuck Norris effect in fiscal policy.

Obviously in the real world neither monetary policy nor fiscal policy is ever 100% credible and there will always be some uncertainty about the scale and commitment to fiscal expansion and uncertainty about the central bank’s reaction to the fiscal stimulus. However, anybody who have follow developments in the euro zone over the past two years will realise that “promises” of fiscal austerity have been led to a rally in the stock markets (and fixed income markets in the PIIGS countries) as the markets have priced in the impact on aggregate demand of the expected monetary easing from the ECB. This is the reverse Sumner critique – fiscal tightening will not lead to a drop in aggregate demand if the markets expect the central bank to “cover” the short-fall in aggregate demand.

Hence, I think that the Sumner critique is highly relevant for the discussion of fiscal policy today both in Europe and the US. Below I will try to illustrate the Sumner critique with an episode from recent economic history – the German reunification.

The Bundesbank took all the fun out of German reunification 

After the fall of the Berlin wall in 1989 West Germany and East Germany was reunified. Due to the nature of the collapse of communism in East Germany the reunification of Germany happened extremely fast. Hence, most economic-political decisions were highly influenced by political expediency and geo-political and electoral concerns rather than by rational economic considerations.

One such decisions was the imitate political unification of the two Germanys. In fact East Germany was “absorbed” into West Germany. That for example mend that all social benefits and pensions etc., which were available to West German immediately (or more or less so) became available to East Germans and more or less from day one the benefit levels became the same in the entire unified Germany. This obviously led to a rather sharp increase in German government spending. The unification obviously also led to other forms of increases in public spending – for example the Capital was moved from Bonn to Berlin.

It is always hard to estimate how large a fiscal expansion is as the budget situation is not only influenced by discretionary changes in fiscal policy, but also by so-called automatic stabilizers. However, judging from calculation made by the Bundesbank (in the 1990s) the fiscal expansion due to reunification was substantial. In 1989 the cyclical adjusted budget surplus was around 1% of GDP. However, after unification the budget swung into a deficit. In 1990 the cyclical adjusted budget deficit was 2.5% GDP and in 19991 it had increased to 4.2% of GDP. Hence, the fiscal expansion from 1989 to 1991 amounted to more than 5% of GDP. This by any measure is a substantial fiscal easing.

It is very hard to assess what impact this strong fiscal easing had on the German economy – among other things because the Germany of 1989 was not the same country as the Germany of 1990 and 1991. Furthermore, this fiscal easing coincided with significant monetary easing as it controversially was decided to exchange one East Mark for one West Mark. That led to a rather substantial initial increase in the unified Germany’s money supply. However, while it can be hard to assess the direct impact on growth from the fiscal expansion it is much easier to assess the German Bundesbank’s reaction to it.

The Bundesbank was horrified by the scale of fiscal expansion and the potential inflationary consequences and the Bundesbank did not led anybody doubt that it would have to tighten monetary policy to counteract any inflationary consequences of the unification. Secondly, it also pushed strongly for the German government to fast tighten fiscal policy to reduce the budget deficit. Hence, market participants from an early stage would have had to expect that the Bundesbank would tighten monetary policy and that it would “force” the government to tighten fiscal policy. This in many ways is the exact same thing we see in the eurozone today, where the Bundesbank dominated ECB is telling policy makers if you don’t tighten fiscal policy then we will effectively allow monetary conditions to become tighter.

Already in 1991 the Bundesbank moved to counteract perceived inflationary risks and started tightening monetary policy. In a series of aggressive interest rate hikes the Bundesbank increased its key policy rate to nearly 10% in 1992. In that regard it should be noted that the Bundesbank hiked interest rates at a time when global growth was weak due among other things a spike in global oil prices in connection with the first Gulf war. Furthermore, the Bundesbank also put significant pressure on the German government to tighten fiscal policy, which it did in 1992.

There is no doubt that the Bundesbank wanted to demonstrate its independence to the government and probably for exactly that reason chose to be even more aggressive in its monetary tightening that was warranted even according to its own thinking. As a consequence of disagreement between the German government and the Bundesbank the governor of the Bundesbank at the time Karl Otto Pöhl resigned in October 1991 after having initiated monetary tightening.

The monetary tightening in 1991-92 not only sent Germany into a deep and prolonged recession it also was the direct cause of the so-called EMS crisis in 1992-93.

This particular episode in German (and European) monetary history is a powerful illustration of the Sumner critique. It is pretty clear that even substantial fiscal easing (around 5% of GDP) did not have long lasting impact on growth in Germany due to the Bundesbank’s counteractions to curb the perceived (!) inflationary risks.  I do not claim to have proven that the fiscal multiplier is zero, but I hope I have demonstrated that it is that it is unlikely to be positive if the central bank does not play along.

In the case of Germany in the early 1990s the fiscal multiplier was probably even negative as the Bundesbank decided to punish the German government for what it perceived as irresponsible policies. Anybody who is following the political struggle among European governments and European central bankers would have to acknowledge that it is very similar to the situation in Germany after the reunification.

Consequently I think it can be concluded that monetary policy will never be able to lift aggregate demand if the central bank refuse to do so – and that will often be the case if the central bank is worried about its credibility and independence.

I am no Calvinist and I tend to think that some of the calls from certain economists for austerity is rather hysterical given our problems particular in Europe primarily are monetary, however, I do think that the Sumner critique is highly relevant and we under normal circumstances (that is circumstances where the central bank for example pursues an inflation target) should expect the fiscal multiplier to be close to zero.

We all of course also know there are numerous other problems with fiscal easing – for example any temporary increase in public spending seem to become permanent and that is hard good for long-term growth in any economy, but that discussion is more or less irrelevant for the present crisis, which in my view mostly a result of misguided monetary policies rather than failed fiscal policies.

—-

My discussion above was among other things inspired by Jürg Bibow paper “On the ‘burden’ of German unification” (2003) and a discussion with chief economist in the Danish think tank CEPOS Mads Lundby Hansen

Related posts:

“Meantime people wrangle about fiscal remedies”
Please keep “politics” out of the monetary reaction function
Is Matthew Yglesias now fully converted to Market Monetarism?
Mr. Hollande the fiscal multiplier is zero if Mario says so
Maybe Jens Weidmann and Francios Hollande should switch jobs
There is no such thing as fiscal policy

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