Wednesday, November 26, 2014

The Crises of Summer

PRINCETON – Europe’s crisis is now poised at the moment that divides recovery and renewal from decline and death. Whereas a few weeks ago, commentators and financial analysts argued that only a few months remained to rescue Europe, leading politicians, lurching from summit to summit, have recently talked in terms of days.

Summer crises are a familiar feature of European history – and of financial history. Indeed, the twentieth century was shaped by three summer crises, whose seriousness was heightened in each case by the absence of major policymakers, who were on vacation.

In two years, Europeans will commemorate the centennial of the assassination of Archduke Franz Ferdinand on June 28, 1914, and the subsequent “July crisis” that triggered World War I that August. On July 13, 1931, the German banking system collapsed, ensuring that what was previously an American economic downturn became the worldwide Great Depression. On August 15, 1971, President Richard M. Nixon ended the United States’ commitment to a fixed gold price, leading to a decade of global currency instability.

Each of these crises involved a highly technical issue, but also a much broader set of political problems. And, in each case, the intertwining of the technical and the political produced disaster.

In July 1914, diplomats were trying to devise a solution that would permit the Habsburg Empire to deal with the cross-border police investigation that was inevitable after a terrorist attack. Political leaders were thinking about national revival and assertion.

In 1931, the experts were preoccupied with the complexities posed by the combination of reparations and war debts arising out of World War I with large private-sector indebtedness. Populist political movements in many countries were still thinking about national revival and assertion.

In 1971, the technical issue concerned the role of the dollar in the international monetary system. But politicians in other countries also felt uncomfortable about the continuing centrality of the US in the postwar order.

In each of these summer crises, addressing the technical issue was not enough to solve the problem. That is true today as well.

Indeed, Europe’s current crisis reflects exactly the same mixture of elements, each requiring a different type of solution. On the one hand, a complex set of national fiscal crises and Europe-wide banking problems calls for a comprehensive and detailed rescue operation. On the other hand, an underlying European governance problem – at both the national level and that of supranational European Union institutions – has been intensifying since the early 1990’s.

What is now required to resolve the technical issue is some mechanism for assuming existing debt and preventing excessive borrowing in the future. In the US, Alexander Hamilton famously negotiated the federal assumption of states’ debt in 1790, but many states behaved badly in the early nineteenth century, with multiple bankruptcies, until they adopted laws or amendments to their constitutions requiring balanced budgets.

The EU needs some fiscal authority of its own if it is to make Europe’s economic and monetary union work. It is already a profound peculiarity that customs duties in a customs union are still administered nationally.

Hamilton made federal customs houses the key element of his proposal. A Europeanization of some part of value-added tax would be a tremendous advance in combating the massive fraud that the existing system nurtures. Labor mobility is also incomplete without a common pensions and benefits system: under current arrangements, a worker who spends five years in France, five years in Greece, and five years in Germany is left with a fragmented collection of small entitlements. The crisis has already increased the extent of such migration within Europe.

But any solution will be unacceptable unless it finds broad acceptance across Europe, in debtor and creditor countries alike. There is no reason why a constitutional solution that involves debt limitation should not command a large measure of public acceptance, especially in debtor countries, which have experienced the political and economic damage caused by previous profligate governments.

What has produced the populist backlash is the spectacle of political authorities devising technically complicated solutions that lack credibility. Simply put, the experts need to stop treating Europe’s citizens as if they were stupid.

That is why Europe needs a longer-term constitutional renewal, through new treaties, as much as it desperately needs a short-term fix. Working around existing treaties just looks like more of the same old recipe – a denial of a massive problem that everyone sees. The public can be forgiven for choking on this kind of stuff.

Consider the European crises that produced good outcomes. On June 16, 1940, Winston Churchill proposed a Franco-British political union in the aftermath of the German invasion of France. A decade later, West German Chancellor Konrad Adenauer proposed a Franco-German political union. That is the kind of boldness that is now needed.

In the past, it was war, immense dislocation, and suffering that could weld nations. Is Europe’s current crisis severe and dislocating enough to generate an analogous effect? The more Europe suffers, the more its people will correctly perceive an incrementalist agenda for reform as nothing more than an exercise in futility.

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    1. CommentedProcyon Mukherjee

      This is in response to Gary’s repeated reference to public debt and taxation and its equivalence and costs. Let me try to bring in a dynamic that goes beyond the simplistic paradigm that Gary has constructed. The first part of the dynamic is that the tax revenues are cyclical with a slight phase lag with the business cycles and there is therefore the attempt made towards ‘tax smoothening’. The second part of the dynamic is the attempt towards inflation targeting and making a one-on-one increase in the nominal interest rate versus a larger increase and how the market participants respond to it; too much of restraint by the market participants renders the passive fiscal policies infeasible therefore. The third is the threshold level of public debt and beyond which monetary policy independence is doubtful. There is beyond this the issue of general price level, private wage and general employment level dynamics.

      Procyon Mukherjee

        CommentedGary Marshall

        Hello Procyon,

        I have already addressed your points in a previous post.

        The short proof only shows that Taxation has no financial benefit for a nation.

        If a nation were to borrow instead of Tax, the assets created will equate to the sired liabilities.

        The proof may be simple, but its intended to be simple so that one may easily understand it.

        As Taxation has no financial benefit, then why does any nation Tax to fund its public expenditures?

        I know that tax revenues are cyclical. The government expends most when the economy is at its peak. It then expends less when the economy recedes. The very opposite of what prudent policy should be. This time around, governments expended greatly at the height of the business cycle, and then far more during the recession, greatly enlarging government participation in the economy and ensuring enduring high levels of participation.

        I don't know what you mean, Procyon, by some attempt at tax smoothing. What exactly is the practice and how does it apply to current public finance practices?

        By abolishing Taxation and solely borrowing, a nation's public expenditures will reach a maximum when the interest rate reaches a minimum, and a minimum when the interest rates a maximum. This should greatly temper ruinous fiscal tendencies inherent in Taxation and save the nation a hell of a lot of pain.

        With borrowing, government will be forced by its petulant and perpetual banker to justify every public expenditure. As funds will now come with a capital charge, the government will be compelled to ensure returns greater than all costs. This measure should get rid of all that public squander and destructive inflation now infesting every public expenditure undertaken with borrowed money. As there shall be no inflation, there will not be no further need for inflation targeting by any monetary authority. As there shall be little squander, the nation shall produce at rates far greater than previously, ensuring a wealthier nation for all.

        Employment will soar when the deterrent effect of Taxation is removed from the economy. Individuals and firms will no longer have to factor in the harmful effects of Taxation in calculating economic outcomes on their household or commercial activities.

        General price levels will fall with the great constraints now placed upon ruinous fiscal policies or squander in troubled times and in good times. And productive employment shall rise to a maximum with constraints upon the unproductive employment highly encouraged by government fiscal squander and perverted tax policies.

        The only monetary policy I have seen is either inherently destructive or impeding of market forces of supply and demand, or its innocuous. The nation will be far better off without it.

        What a better world it shall be.

        And the meek shall inherit the earth!


    2. CommentedGary Marshall

      Hello Mr. James,

      The individual European countries have the means to remedy their current problems with ease. There is not need of some collective fiscal measure or coordinated prescription.

      The means to that end is contained in the little proof below for the abolition of Taxation, which novelty may be absurd on its face, but not so when examined.

      If you or anyone can find the flaw in this proof, I shall be more than happy to give the reward of $50,000. None have yet been successful. Perhaps because so few have tried.

      Its not the end of Europe or the world, but a new beginning.



      The costs of borrowing for a nation to fund public expenditures, if it borrows solely from its resident citizens and in the nation's currency, is nil.

      Why? Because if, in adding a financial debt to a community, one adds an equivalent financial asset, the aggregate finances of the community will not in any way be altered. This is simple reasoning confirmed by simple arithmetic.

      The community is the source of the government's funds. The government taxes the community to pay for public services provided by the government.

      Cost of public services is $10 million.

      Scenario 1: The government taxes $10 million.

      Community finances: minus $10 million from community bank accounts for government expenditures.
      No community government debt, no community
      government IOU.

      Scenario 2: The government borrows $10 million from solely community lenders at a certain interest rate.

      Community finances: minus $10 million from community bank accounts for government expenditures.
      Community government debt: $10 million;
      Community government bond: $10 million.

      At x years in the future: the asset held by the community (lenders) will be $10 million + y interest. The deferred liability claimed against the community (taxpayers) will be $10 million + y interest.

      The value of all community government debts when combined with all community government IOUs or bonds is zero for the community. It is the same $0 combined worth whether the community pays its taxes immediately or never pays them at all.

      So if a community borrows from its own citizens to fund worthy public expenditures rather than taxes those citizens, it will not alter the aggregate finances of the community or the wealth of the community any more than taxation would have. Adding a financial debt and an equivalent financial asset to a community will cause the elimination of both when summed.

      Whatever financial benefit taxation possesses is nullified by the fact that borrowing instead of taxation places no greater financial burden on the community.

      However, the costs of Taxation are immense. By ridding the nation of Taxation and instituting borrowing to fund public expenditures, the nation will shed all those costs of Taxation for the negligible fee of borrowing in the financial markets and the administration of public

      Gary Marshall

    3. Portrait of Michael Heller

      CommentedMichael Heller

      Harold James:

      I recall you wrote in The Roman Predicament - “Kindelberger defended his view that crisis solution depended on the ability of brilliant men to devise innovative and novel solutions, and that pedantic following of rules was unwise and counterproductive”. A little later in the same book, you concluded “Rules may be a way of ensuring that the genius of Terminus does not in practice terminate experiments in the extension of the principles of legal certainty and order”.

      I guess Europe needs -- as implied by your article today -- both a brilliant strong leader, perhaps a woman, and a well designed innovative set of constitutional rules. It is classically the make-or-break crisis window-of-opportunity when leadership and ideas can trump incremental evolution. Thanks for the provoking and positive analysis.