A German economist acknowledges their contribution to the crisis

In a post earlier this year I made the case that German efforts to suppress wage growth within Germany and achieve high net exports did severe damage to the Eurozone by essentially sucking up euros from fellow eurozone members. This is pure beggar-thy-neighbour mercentalism and in the past would have been considered an act of aggression because of the damage it does to net importers. They were left defenceless by EU rules that implicitly encouraged this behaviour by preventing any of the usual defenses against mercantilism from being deployed. When, eventually and inevitably, the surpluses became too great to be ignored it was the deficit countries that were required to do the adjusting, even though it is well known from history that this is effectively impossible without devaluation.

I received some criticism for making this point. I am pleased to see that a German economist has frankly admitted that their policy was indeed mistaken and that it is Germany that as a surplus country they should be doing most of the adjusting by increasing wages, boosting demand and recycling their surpluses.

The tragedy is that all this was known and understood 70 years ago, but the current generation of economists have become so infatuated with their beautiful but absurdly unrealistic macroeconomic models that they rewrote history and ignored reality so that they could justify continuing to use them.

The IMF see the light

It is heartening that the IMF seems to recognise the flaws in our current monetary system and is proposing radical change.

The proposal is full reserve banking, which is gathering increasing support elsewhere, as described in a previous post.

This takes away from private banks the role of creating our money supply. Instead, all money would be issued by the reserve bank and held in commercial banks' reserve bank accounts. This would eliminate, at a stroke, bank runs and the need for taxpayers to bail out banks in future. It would also massively reduce debt since money creation would no longer be accompanied by debt creation.

The only people that would 'suffer' are bankers, as they would lose their richly rewarded and much abused right to create money. They would only be able to intermediate between savers and borrowers. Banks would then actually work like the average person, and at least one nobel prize winning economist, mistakenly thinks they work.

Political discord may save the Euro

Readers of my blog will be well aware of the fact that I view the central problem afflicting the global economy at the moment as excessive private debt, which was allowed to grow to unprecedented levels before the global financial crisis because mainstream economists did not think it was a matter for concern. The collapse of this debt bubble is causing severe stress as the private sector desperately tries to repay its debts. Simple accounting dictates that the private sector as a whole cannot accumulate savings unless the public sector runs a deficit (i.e. spends more into the economy than it removes through taxes). That is why it is important for governments with over indebted private sectors, like the USA and the UK to run large public sector deficits. Unfortunately conventional wisdom suggest, completely incorrectly, that government deficit and debt, like private deficits/debt, are bad things and should be avoided. In fact in countries with their own currency government deficits and debt are simply private sector savings. I pointed out in a previous post that political discord in the the US congress has meant that it has been impossible for politicians to do what conventional wisdom dictates, which is to decrease the US deficit. As a result the deficit stays large, which is the reason that America, unlike the UK or Europe, has not entered a double-dip recession and is forging ahead, already surpassing its size before the financial crisis. Long may US politician do the right thing by acting foolishly!

Something similar is happening in Europe. The fundamental problem in the Eurozone is that the Eurozone public sector as a whole (i.e. all government collectively) cannot run a deficit because the ECB is forbidden from purchasing government securities or otherwise supporting deficit spending. In effect Eurozone governments are like other members of the private sector, currency users, and therefore cannot easily add net financial assets to the Euro by deficit spending. This makes it difficult for the aggregate private sector to save and to pay off its debts. There is therefore, in my view, a fundamental need for a radical policy change in which the ECB, like central banks elsewhere, provides the funds needed to support deficit spending, and, in doing so, add net financial assets to the Eurozone system.

Up until now this type of solution has not been in prospect. Instead most of the measures that have been proposed to 'save' the Euro have involved persuading existing savers to provide further loans to debtors. Savers are understandably reluctant to do this as they are worried that they won't get all their money back, which the Greek experience suggests is almost certainly correct. It has turned into a zero-sum game. So no agreement has been reached and these measures have stalled.

This is actually helpful because these are measures, which just redistribute aggregate private sector debt without reducing it, won't work. Furthermore, this impasse is forcing the ECB to resort to what it considers radical, last-ditch measures to save the Euro, namely providing the funds to support fiscal expansion by, for example, purchasing government securities. If they don't do this Spain and Italy will not be able to obtain funding, will default, and the Euro will collapse. The ECB has made it crystal clear in recent weeks that they won't let this happen, and it seems as though they now have the political support from all Eurozone countries, including Germany, for this. This means they will create money to buy government bonds, and thereby introduce net financial assets into the Eurozone system, supporting deficit spending and enabling the private sector to save and pay off its debts.

In short, political stalemate is leading to the correct policy. Like America, this is an example of how the failure of politicians to agree on a way of implementing a gravely mistaken policy, has resulted in the correct policy being implemented! Call it the wisdom of crowds....

Light at the end of the tunnel?

Now that the ECB have finally said they will support government deficit spending (by buying sovereign debt) and eurozone politicians, including Germany's, seem united in support of this, it seems meltdown is likely to be avoided. However, unless there is a massive fiscal stimulus of the sort seen during World War II the best outcome can hope for is a prolonged period of stagnation, as in Japan.