Tag Archives: finance

America’s Endless War Over Money, K. Granville and B. Applembaum (via NYT, 08/04/2015)


The “Audit the Fed” debate is the latest manifestation of a conflict as old as the nation, between those who argue that a strong central bank improves economic stability, and those who see an overbearing government engaged in harmful meddling.

Some Background: Strong vs. Weak Currency

Battles over central banking have historically pitted financial elites who wanted to limit the availability ofmoney, thus preserving its value, against farmers, businessmen and other borrowers who wanted money to be plentiful — and cheap. Each side has sometimes regarded the central bank as its great ally in that fight, and sometimes as its bitter enemy.

Since the Great Recession the Fed has mostly sided with the borrowers, creating vast amounts of newmoney and holding short-term interest rates near zero. Inevitably, that has angered creditors, and sparked efforts to swing the pendulum in the other direction.


A cartoon satirizing Andrew Jackson, shown raising a cane labeled “veto,” and his battle against the Bank of the United States and its supporters among state banks.

1. A Philadelphia Story: The Banks of the United States

The nation’s first two central banks, both called the Bank of the United States, were private, for-profit organizations chartered by Congress. The first (1791-1811) was created to help the government pay its Revolutionary War debt, stabilize the country’s currency and raise money for the new government. It was the dream of Alexander Hamilton, secretary of the Treasury, who overcame resistance from Thomas Jefferson (who wrote “I believe that banking institutions are more dangerous to our liberties than standing armies”) and other Southern lawmakers. When its 20-year charter expired, Congress chose not to renew it.

The Second Bank of the United States was chartered a few years later, in the aftermath of the War of 1812, after Congress decided it had a mistake. But it lasted just 17 years. President Andrew Jackson said the bank concentrated too much economic power with a corrupt moneyed elite and vetoed a bill to extend its charter in 1832. Supporters of the the bank rallied around Henry Clay, Jackson’s opponent for reelection that year, but the “Bank War” ended when Jackson won easily. United States Treasury funds were withdrawn and deposited in state banks; the nation would be without a central bank for more than 70 years.

The headquarters of both banks still stand about a block apart in downtown Philadelphia.

“The bank is trying to kill me, but I will kill it!”—Andrew Jackson.



Crowds gather across the street from a failed New York bank in 1908. CreditGeorge Grantham Bain Collection/Library of Congress

2. Perpetual Panic: Life Without a Central Bank

A severe financial crisis drove the economy into a deep recession in 1837, just one year after the demise of the Second Bank. Such crises became a recurring event in American life and, as the economy grew, so did their size and the frequency. Banks created the New York Clearing House as a private-sector backstop, but it proved inadequate for the task. The government also was hamstrung. In the absence of a central bank, the United States regulated the value of its currency by guaranteeing that dollars could be exchanged for gold, and sometimes silver. This meant the government could not respond to financial crises, and the resulting economic downturns, by increasing the supply of money.

In 1907, yet another crisis was brought about by a failed attempt to corner the stock of the United Copper Company. Government officials and financial executives jerry-rigged a response: an emergency lending pool orchestrated by J. Pierpont Morgan. But the crisis proved to be a tipping point in the political debate about the need for a central bank. There was a growing political consensus that Wall Street needed a permanent fire department.

“Unless we have a central bank with adequate control of credit resources, this country is going to undergo the most severe and far reaching money panic in its history.”—Jacob Schiff, a prominent New York banker, in 1907



President Woodrow Wilson signing the Federal Reserve Act of 1913, in a painting by Wilbur G. Kurtz Sr. He is surrounded by members of his cabinet and Congressional leaders. CreditWoodrow Wilson Presidential Library, Staunton, Va.

3. Third Time’s the Charm: The Federal Reserve Act of 1913

In November 1910, Senator Nelson Aldrich met with a group of bankers at a resort on Georgia’s Jekyll Island and hammered out a plan for a new central bank. The idea touched on many of the great political battles of the age: The states against Washington; Wall Street financiers against smaller banks, particularly in the South and West; populists against the Gilded Age elite. The bill that emerged from several years of debate, signed by President Woodrow Wilson, was an awkward compromise: There would be 12 privately owned reserve banks in major cities across the country, preserving the power of financial elites. But the banks would be overseen by a board of presidential appointees, including the Treasury secretary, granting the public a new measure of control over the financial system.

Before the Fed was fully established, however, the old system took a final bow. A financial crisis struck in 1914, and roughly twice as many banks failed as in 1907.

“We shall deal with our economic system as it is and as it may be modified, not as it might be if we had a clean sheet of paper to write upon; and step by step we shall make it what it should be.”—Woodrow Wilson, from his first inaugural address



In 1933, after some banks limited withdrawals to 5 percent or less, customers waited to enter the National City Bank in Cleveland. CreditAssociated Press

4. Recession and Response

Instead of preventing crises, the Federal Reserve helped to cause the Great Depression. The Fed was supposed to manage the gold standard — to make sure the economy was not choked by a lack of moneyand a resulting spike in interest rates. Instead, the Fed was paralyzed by disagreements between regional banks and the central board. It let the money supply shrink by one-third. The result was the worst economic crisis in the nation’s history.

Congress responded to the Fed’s failure by greatly increasing its power and responsibilities. In 1934 it authorized the president to devalue the dollar, beginning the long process of replacing the gold standard with a currency whose value is managed by the Fed. In 1935 it gave the Fed responsibility for “the general credit situation of the country.” The act also removed the Treasury secretary from the Fed’s board and created a new policy-making committee where board members would outnumber reserve bank presidents.

“I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”—Ben Bernanke, then a Fed governor, in a 2002 speech addressing Milton Friedman and Anna Schwartz.



The Federal Open Market Committee in 1966, led by the Fed chairman, William McChesney Martin, seated center. CreditFabian Bachrach

5. The Long Road to Independence

The central bank now had the freedom to encourage growth by printing money, and the responsibility not to print too much. Politicians who were focused on short-term problems were quick to demand money and, for the next several decades, the Fed hesitated to say no.

In 1942, at the request of the Treasury Department, the Fed agreed to hold down interest rates on government bonds to help finance military spending for World War II. It kept rates low for almost a decade, through the beginning of the Korean War, until rising inflation finally induced the Treasury to sign a 1951 accord affirming the Fed’s autonomy to raise rates.

In the 1960s, Wright Patman, a populist Democrat congressman from Texas and chairman of the House banking committee, repeatedly introduced legislation to roll back the Federal Reserve Act of 1913, maintaining that, in the Fed, “a body of men exist who control one of the most powerful levers moving the economy and who are responsible to no one.”

And in 1965, President Lyndon B. Johnson, who wanted cheap credit to finance the Vietnam War and his Great Society, summoned Fed chairman William McChesney Martin to his Texas ranch. There, after asking other officials to leave the room, Johnson reportedly shoved Martin against the wall as he demanding that the Fed once again hold down interest rates. Martin caved, the Fed printed money, and inflation kept climbing until the early 1980s.

“I hope you have examined your conscience and you’re convinced you’re on the right track.”—Lady Bird Johnson, spoken to William McChesney Martin, on his arrival at the LBJ ranch.



Paul A. Volcker, shown in 2009. He was appointed Fed chairman in 1979 with the task of controlling galloping inflation. CreditBrian Snyder/Reuters


6. The Volcker Rule: An Independent Central Bank

Congress finally formalized its demands in 1978. A recession in the mid-1970s had pushed the unemployment rate as high as 9 percent, and Democrats, frustrated by what they saw as the Fed’s inadequate response, won passage of legislation establishing the so-called dual mandate. The Fed was instructed to pursue maximum employment and price stability.

It turned out to be a high-water mark for Congressional interference. Inflation rose by 11 percent the following year, and President Jimmy Carter agreed to appoint a new Fed chairman, the independent-minded Paul A. Volcker. Over the next several years, Mr. Volcker would raise interest rates sharply, driving the economy into a deep recession but ultimately bringing inflation under control. President Ronald Reagan, meanwhile, made a point of respecting the Fed’s independence. Volcker was still subjected to sharp Congressional pressure, but it was mostly political theater. The Fed had declared its independence.

“Every time he had a press conference somebody was urging him to take a slap at the Federal Reserve, but he never did.”—Paul Volcker, referring to President Reagan.



Ben Bernanke, the Fed chairman, takes questions from reporters at an April 2011 news conference. CreditJim Watson/Agence France-Presse — Getty Images


7. Smokescreens and Sunshine: The Fed Opens Up

Between the great inflation of the early 1980s and the Great Recession that began in 2008, the Fed and the economy enjoyed more than two decades of relative peace and quiet, a period that Fed officials sometimes call the Great Moderation. Inflation trended downward and, except for a few short recessions, unemployment stayed down too. And Fed officials came to see these trends as a validation of their newfound independence.

The Fed also began to change its secretive culture. The trend began reluctantly, under pressure from critics who argued that independence required transparency. In 1983, for example, the Fed promised Congress that it would begin to release its Beige Book, a summary of economic reports from its regional reserve banks, as a way of distracting attention from more important reports that it was determined to keep secret. But the Fed gradually concluded that transparency could increase the power of monetary policy. In 1994, it began to announce changes in policy at the end of each policy-making session. In 2004, it began to publish edited accounts of its discussions three weeks after each session. And in 2011, its chairman, Ben S. Bernanke, began to hold quarterly news conferences.

“Since I’ve become a central banker, I’ve learned to mumble with great coherence. If I seem unduly clear to you, you must have misunderstood what I said.”—Alan Greenspan, Fed chairman, in 1987, before the central bank’s communications revolution.

“The Federal Reserve is the most transparent central bank to my knowledge in the world. We have made clear how we interpret our mandate and our objectives and provide extensive commentary and guidance on how we go about making monetary policy decisions.”—Janet L. Yellen, Fed chairwoman, in 2014, after the communications revolution.



Protesters in April 2009, outside an event where Ben Bernanke, the Fed chairman, was speaking. CreditJason Miczek/Reuters


8. The Great Recession, and ‘Audit the Fed’

The Fed’s long run as a political darling came to a crashing end in 2008. Its lax oversight of the financial system was one reason for the severity of the crisis, and the smartest guys in Washington had failed to see it coming. The Fed’s response was also controversial: It provided expansive support for the financial system, preserving some of America’s least popular companies, not to mention foreign banks. And then it embarked on an expansive stimulus campaign to revive the economy.

In the aftermath of the crisis, Congress moved quickly to strengthen the Fed’s regulatory responsibilities. It also imposed some limits on the Fed’s ability to repeat its rescue of the financial system. But it is the stimulus campaign that has prompted the most controversy.

In an inversion of the historical pattern, congressional Republicans have criticized the Fed for printing too much money, arguing higher inflation will be the inevitable consequence. And they have put forward proposals to constrain the central bank. One bill, known as “Audit the Fed,” would authorize the General Accountability Office to review the Fed’s monetary policy decisions. Another approach, backed by the House Financial Services Committee, would require the Fed to publicly articulate a set of rules it intends to follow in making monetary policy, and then explain any deviations.

“The Federal Reserve System must be challenged. Ultimately, it must be eliminated. The government cannot and should not be trusted with a monopoly on money. No single institution in society should have power this immense.”—From End the Fed (2009) by Ron Paul.


The Greek Monetary Back-Story, Jim Grant (17/02/2015)

Raging against its German creditors, the new Greek government is demanding reparations for Nazi-era depredations. Herewith—from the Grant’sarchives—some timely context both for the Greek negotiating position and the underlying monetary issues.

(Grant’s, February 24, 2012) “Statements and assurances from Greece are no longer taken at face value,” a German economics professor, Wolfram Schrettl, has remarked. “Who will ensure afterward that Greece continues to stand by what Greece is agreeing to now?” the German finance minister, Wolfgang Schäuble, has demanded.

Such expressions of German disdain ignite a special kind of fury in Greece. While 21st-century Greek fiscal and financial management may leave a little something to be desired, the record of German monetary stewardship in the Hellenic Republic is supremely worse. During Nazi occupation in World War II, Greece suffered famine, pestilence, wholesale killings and hyperinflation. The last-named plague is the topic at hand.

Let bygones be bygones, they say, and well they might say it in Europe, the land of ancient enmities. However, there can be no understanding the present-day Greek sensitivity to its high and mighty creditors without a rudimentary knowledge of the German-inflicted catastrophes of 1941-44. Nor can there be a full and proper appreciation of the risks inherent in paper money without a basic grounding in such abominations as the occupation-era Greek drachma or, for that matter, the post-occupation drachma—for the liberated Greek central bank took up where the German-corrupted central bank left off. Fiat currency can’t seem to help itself. The insubstantial monetary material sooner or later goes up in smoke, no matter whose hand cranks the presses. These days, of course, the cranking hand is a technocratic one. “Quantitative easing” is the anodyne phrase. Yet in peace as in war, gold is the preferred refuge from state-imposed paper currency.

According to Mark Mazower’s scholarly history, “Inside Hitler’s Greece: The Experience of Occupation, 1941-44,” between 250,000 and 300,000 Greeks died from famine at the hands of the German overlords. “In reality,” Mazower writes, “there was no deliberate German plan of extermination.” The extermination that did occur was rather the result of the calculated destruction of the Greek economy and the stripping of the Greek larder for the Axis armies, the German one in particular. “Who is Mr. Schäuble to revile Greece?” the 82-year-old president of Greece, Karolos Papoulias, demanded last week in response to the German finance minister’s slighting comments about the country for which a teenaged Papoulias fought in World War II.

Famine was a certain, if not deliberately sought, consequence of German occupation policy, but there was nothing accidental about the destruction of the drachma.The German-controlled Bank of Greece printed up the national currency as the need arose. In the opening months of 1941, before the Germans (and the Italians and Bulgarians) came to stay, a British sovereign was worth 1,200 drachmas. As the Germans cleared out, in November 1944, blowing up railroad tunnels, rolling stock, harbors and such as they left, a sovereign commanded 71 trillion drachmas.

A sovereign is a gold coin weighing not quite one-quarter ounce—to be exact, 0.23542 troy ounce. When Britain was on the gold standard, a sovereign was worth one pound sterling, and it circulated as the people’s money. It was a popular coin in Greece, too, as Britain and Greece had joined monetary forces in 1928. Three years later, Britain went off the gold standard, and in 1932, Greece and Britain ended their so-called stabilization relationship. Cut loose from gold, the paper pound began its long descent in purchasing power measured in gold. However, from the Greek vantage point, paper sterling was a better anchor for the drachma than no anchor at all, and in 1936 the Greeks re-lashed their currency to Britain’s, at the rate of 548 drachmas to the pound.

Fast-forward now to the outbreak of war in Europe in 1939. As the pound came under new inflationary pressure, so did the drachma. In Athens, the cost of living was accelerating well before Hitler mounted his attack on Greece in April 1941. In 14 months of neutrality, prices in the Greek capital had jumped by 15%.

Nowadays, Germany is the national face of monetary and fiscal rectitude. It wore a different face in wartime Greece, though the German army of occupation did observe some of the basic commercial forms. “Rather than requisition all required goods and facilities,” write Dimitrios Delivanis and William C. Cleveland in their “Greek Monetary Developments, 1939-1948,” “the occupation armies usually preferred to pay with newly created currency.”

The German visitation lasted for 3-1/2 years, but the real monetary damage was done in the first 18 months. In April 1941, an index of the cost of living in Athens registered 116. In October 1942, the same index stood at 15,192, a gain—if that’s the word—of almost 13,000%, or an average monthly rate of rise of 722%, according to Delivanis and Cleveland. It didn’t help the price picture that the Greek economy was crippled or that the Germans were making off with whatever wasn’t nailed down to aid the Axis war effort. What, especially, didn’t help the price picture was the breakneck growth in the local money supply, up roughly 10-fold between May 31, 1941, and Oct. 31, 1942, or the fact that, in 1942-43, newly printed drachmas financed 81% of public expenditures.

During this first act in the play of the death of the drachma, the currency’s domestic purchasing power fell by 99.34%, its external purchasing power—expressed in terms of the gold sovereign—by 99.73%. These facts we commend to the 21st-century gold bulls on those discouraging days when the eternal monetary metal seems to trade as a proxy for the euro. It isn’t the euro, after all, but almost the opposite. It is money, the genuine article.

“It must be concluded,” write Delivanis and Cleveland, “that the almost complete collapse of the value of the drachma, both internally and externally, was largely the result of enemy exploitation. The enemy occupation authority seized all stocks of commodities that were discovered, exploited for its own benefit the productive facilities and capital equipment of the country, confiscated and exported as much as possible of the current production, and extorted, as occupation costs, payments equivalent to 7,674 million prewar drachmas between May 1, 1941, and March 31, 1942, 2,287 million prewar drachmas between April 1, 1942, and Oct. 31, 1942.”

No bear market is complete without a trick rally, an Act II, and the terminal decline in the Greek currency was no exception. News of the Allied victory at El-Alamein in October-November 1942 caused a rush out of gold into scrip. A sovereign had fetched 37,144 drachmas before the battle that Churchill famously characterized as not the end of the war, nor even the beginning of the end of the war, but, “perhaps, the end of the beginning.” By February 1943, it took just 14,180 drachmas to buy a sovereign—as it turned out, not a bad entry point for the final move up to an average of 71 trillion.

Act III of the eradication of the drachma resembled Act I but with the addition of many more commas and zeros to all the significant currency and inflation data. Hopes of early deliverance from the Nazi occupation dashed, Greeks resigned themselves to the likelihood of a replay of the Weimar inflation of 1922-23, an earlier episode of German-directed monetary chaos. As noted, the Athens cost-of-living index stood at 116 on the eve of the German occupation. It registered 76,171 in November 1943 and 18,850,000,000,000 in the first 10 days of November 1944.

“During the final period of the enemy occupation of Greece,” the Delivanis and Cleveland account continues, “the index of note issue by the Bank of Greece rose to fantastic heights. During the period of 18 months and 10 days [i.e., May 1943 til Nov. 10, 1944], the index increased in magnitude 11,214,823 times, i.e., from 7,368 to the value of 82,630,830,289. The total increase in the period was 1,121,482,300%, representing an average monthly increase of more than 62 million percent as compared with the average monthly increase of 60% during the first period of enemy occupation from May 1941 to October 1942, and the average monthly increase of only 22.5% during the succeeding period from November 1942 to April 1943. The tremendous expansion of the note issue was caused by the growth of public expenditures, principally on account of the enemy occupation and by the cumulative, self-reinforcing effects of monetary inflation.” Toward the end of the German stewardship, the Bank of Greece printed 99% of the receipts of the Greek treasury.

Gold and foreign bank notes were the de facto coin of the realm. The British Middle Eastern forces funneled an estimated 700,000 sovereigns to Greek guerillas. And the Germans, in a vain attempt to tamp down the raging inflation rate, sold gold in exchange for drachmas—as many as 1,300,000 sovereigns in 1943 and 1944. It was the bright idea of the head of the German economic mission to Greece, Hermann Neubacher, to drop sovereigns on the Greek market to try to buck up the drachma. “Astonished Greek businessmen started to question, should we be buying gold, or selling it ourselves?” relates Michael Palairet in his history, “The Four Ends of the Greek Hyperinflation, 1941-1946.” “Buying gold” turned out to be the correct answer.

At a glance, the Greek hyperinflation would seem a pale copy of the Weimar episode. The size of the drachma money supply as the Germans scuttled home in 1944 was a mere 826,308,303-fold greater than the size of the money stock in the year before the outbreak of war in 1939. As for Weimar, marks in circulation in 1923 were 3,250,000,000-fold greater than the German money stock in the 12 months preceding the outbreak of war in 1914. However, note Delivanis and Cleveland, the Greek catastrophe was six years in the making as against nine for the German one. Besides, they say, as the curtain fell on the Greek tragedy, only one-third of Greeks were still transacting in the worthless national scrip, whereas, up to the bitter end, nine-tenths of the German population continued to use marks.

It can’t be said that Greek monetary management represented much of an improvement over the German kind. Having seen off the enemy, the Greek authorities proceeded to print money—new drachmas—with the note issue climbing to 25,762 million from 126 million. The gold bull market and the cost of living in Athens both resumed their upward course. As for the Greek treasury, now crippled by a ferocious civil war, it liberally availed itself of the fruits of the central bank’s printing press. (“Early during the occupation,” Palairet writes, “the German authorities tried to get the Greek government to reform its system of tax collection, but wrote off the effort, such as it was, as unavailing.”)

Sixty-odd years later, the monetary scenery is transformed. A peaceful Europe is united, more or less, under a single currency. A single central bank aims for a rate of inflation in the neighborhood of 2%—no scientific notation required to calculate the rate of currency debasement these days.

However, in the all-important realm of monetary ideas, not so much has changed. Today, as in the war, government-controlled central banks print up the money with which to finance, directly or indirectly, burgeoning fiscal deficits. Today, as in the war, governments have recourse to “financial repression,” e.g., zero-percent funding costs and QE. And today, as in the war, investors with eyes to see are busily exchanging fiat currencies for tangible stores of value. Plus ça change, as they say in Athens.

A predictable pathology, Benjamin M. Friedman (11/02/2015)

We meet at an unsettled time in the economic and political trajectory of many parts of the world, Europe certainly included. In Europe in particular, the setting is neither usual nor welcome. Germany’s finance minister Wolfgang Schäuble has called last month’s elections for the European Parliament “a disaster,” going on to conclude that “all of us in Europe have to ask ourselves what we can do better … we have to improve Europe.” To be sure, an election is a political event. But just as surely, here and now as in other times and places, what underlies the politics is to a large degree the economics. What is happening in many parts of Europe today is not just a pathology, but the predictable pathology that ensues whenever the majority of any country’s citizens suffer a protracted stagnation in their incomes and living standards.

The origins of this stagnation, in the parts of Europe where it is occurring, are broadly understood. More than half a decade ago, Europe imported the backwash of the financial crisis spawned in the American mortgage market and the US banking system more generally. Factors idiosyncratic to one European country or another – fiscal imbalance, eroded competitiveness, an American-style construction boom, an excess of impaired bank assets, and the like – rendered some parts of Europe especially vulnerable. In the familiar way, both monetary and fiscal policies likewise played a role (although in this context it is not clear what one means by a European fiscal policy). But a large part of the story too bears on the subject of today’s conference – “Debt” – and, in particular, the sovereign debt crisis that Europe has also now been confronting for more than half a decade.

The euro area constitutes a remarkable experiment in this regard. The fact that it is a monetary union without a fiscal union behind it is of course entirely familiar. But a seldom discussed implication of this anomaly is that the euro area economy has no government debt. By “government debt” I mean obligations issued by a public entity empowered to print the currency in which the obligations are payable. All other major economies we know – the United States, the United Kingdom, Japan, Sweden, Switzerland and many others – have government debt in this sense. In the euro area, by contrast, public sector debt is entirely what Americans call “municipals” – that is, obligations issued by public entities not authorised to print the currency owed. It is this feature that makes the bonds issued by Massachusetts, or New York, or Texas, subject to default in a way that US government debt is not. The bonds of all euro area states, even those currently regarded as most secure, like Germany’s, are likewise subject to default in the same sense. It would be difficult to exaggerate how unusual an experiment this situation represents. I am unable to think of another modern example of a major economy with no government debt to anchor its financial structure.

A further unusual aspect of Europe’s situation in this regard is that, following the various actions taken to date, what amounts to municipal debt issued by some of the entities whose fiscal condition is the weakest is, increasingly, owed not to market investors generally but to official lenders. This ownership matters because, unlike private market investors, official lenders in principle do not accept defaults. To a certain extent, of course, this is a fiction. But widely maintained fictions often guide actions, especially in public decision-making, and sometimes they do so with highly unfortunate consequences. This particular fiction also strengthens the commonplace European presumption – which strikes many Americans as bizarre – that sovereign default by a euro area member state would necessarily trigger the country’s exit from the currency union. From time to time in America’s history, US states have defaulted on their general-obligation bonds, and it may happen again. In the recent financial crisis, the two states whose bonds the market deemed most at risk were Illinois (because of unfunded pension obligations) and California (because of the state’s overall budget imbalance at the time). It would not have occurred to an American that if, say, Illinois defaulted on its GO bonds it would, on that account, have to exit the dollar currency union. But this principle seems to be the working assumption in much of the current European conversation.

The route by which Europe arrived at this situation is also well known. The governments of fiscally strong countries lent, or gave, funds to the governments of fiscally weak countries, allowing them to service their existing debt and to issue new debt. (This process also allowed the governments of the fiscally strong countries in effect to bail out their lending institutions without acknowledging that they were doing so, thereby maintaining yet another fiction that may or may not be useful.) The fiscally strong countries provided these transfers and new credits mostly in exchange for imposition of contractionary fiscal policies – and, supposedly, structural reforms – in the fiscally weak countries, in both cases with the goal of rendering them better able to manage their debt. But the problem with the former is that, despite economists’ ability to devise theoretical demonstrations to the contrary, contractionary fiscal policy actually is contractionary. The problem with the latter is not just that structural reforms are politically difficult to implement, but that even when implemented they take a long time to become expansionary. Moreover, even then they are often expansionary in a highly non-neutral way, exacerbating already unwelcome trends in income distribution.

In a group consisting mostly of economists, it is useful to recognise that this approach to Europe’s debt crisis, and even more so the underlying attitudes it reflects, are counterintuitive in yet another way. The standard presumption in economics, dating to the conception of “commerce” articulated by David Hume and Adam Smith and their contemporaries, is that market transactions involve two parties, each of whom acts voluntarily and with sufficient information to make a choice. In the case of credit transactions, this means presuming that both borrowers and lenders acted voluntarily. Among borrowers there are familiar exceptions such as the inherited debt of deceased parents, or the “odious debt” issued by a country’s prior regime, and for just this reason they are normally treated differently. Similarly, there is a stronger case for the presumption of informed voluntariness on the part of institutional lenders than individuals, and this difference in information and expertise provides a standard rationale (along with risk diversification) for financial intermediation. By contrast, today’s public discussion surrounding the European sovereign debt crisis mostly presumes that when a bond is in trouble, the lenders – especially institutional lenders – are victims. In parallel, there is an almost religious presumption of guilt among the borrowers.

From a historical perspective there probably is something religious about these presumptions. Although Jews and Christians and Muslims long regarded lending with suspicion (and Muslims still do), by the beginning of the 19th century evangelical Protestants had mostly come to regard borrowing as sinful, even when the debt was serviced and repaid on a timely basis. Non-payment, of course, elevated the negative moral connotation to  a  whole  different  plane.  As  the 19th century moved on, in one European country after another (and in America too) the active frontier of this debate was often the movement to introduce limited liability for what we now think of as corporate borrowers and equity investors: limited liability represented a retreat from what historians often refer to as the “retributive philosophy” of 19th century evangelicalism. By mid-century, public attitudes had begun to change, driven in large part by the new awareness of the possibilities for ongoing economic growth and waning ambivalence toward it. Even so, the lingering opprobrium attached to borrowing persisted, especially in the public sector context. As one long-ago historian of HM Treasury described this development, “An ethic transmuted into a cult, this ideal of economical and therefore virtuous government passed from the hands of prigs like Pitt into those of high priests like Gladstone. It became a religion of financial orthodoxy whose Trinity was Free Trade, Balanced Budgets and the Gold Standard, whose Original Sin was the National Debt. It seems no accident that ‘Conversion’ and ‘Redemption’ should be the operations most closely associated with the Debt’s reduction.”

Today a reversion to the “retributive philosophy” of the 19th century – to the view, in the words of another historian of that day, that “a just economy was more to be sought after than an expanding one” – is clearly in evidence in Europe’s approach to its  sovereign debt crisis. Whether  Europe’s  economy  has  thereby achieved justice is a matter for a different discussion. It has clearly foregone expansion. The imposition of contractionary policies in the most heavily indebted countries has reinforced a perverse feedback between weak economies and questionable sovereign debt, with a further feedback between both of those and troubled banks. Cross-border lending has significantly contracted, and some countries face what amounts to a credit crunch despite the ECB’s expansionary monetary policy. Nor are these simply isolated phenomena, with little bearing on the broader European economy. Back when I was first teaching economics, a plausible exam question was “Why is unemployment in Europe always so much greater than in the United States?” Then, for some years, asking the question in the opposite direction seemed more apt. Today, with the euro zone unemployment rate roughly double that in the United States, we can bring out the old exams again.

The more fundamental consequence is ongoing stagnation of incomes and living standards for the majority of the population in many European countries. The median household income in the United Kingdom, adjusted for what little inflation there has been, peaked in 2007 and has yet to regain that level. France, Italy and the Netherlands have not experienced complete stagnation by this measure, but the real median income in each has seen only a minimal increase. Ireland, Greece and Portugal have all experienced stagnation, or worse, in real median income over this period. Spain did too for half a decade, only last year finally enjoying a solid increase.

A parallel stagnation of incomes has taken place in the United States as well, but America’s federal fiscal structure provides at least some built-in cushioning mechanisms that Europe lacks. Further, in Europe’s fiscally weak countries the usual frustration over stagnant incomes and living standards is today compounded by the sense of being dictated to, in many citizens’ eyes perhaps even exploited, by foreigners. Twenty-five centuries or so ago, if another city-state had conquered the Athenians the then-conventional tribute would have required some hundreds of Athens’s finest youth to trek off to the victors’ lands, to do forced labour, and an equal number of Athens’s fairest virgins to go as well, for purposes best left unspecified. Today’s political conventions are sharply different, but the resulting youth labour flows are similar.

And, as Mr. Schäuble has highlighted, the all-too-familiar consequence of this economic stagnation, together with the widespread absence of employment opportunities, is a turn away from (small-L) liberal values toward xenophobic populism of either the right or the left. The same pathology has emerged before, again and again, in one country after another around the world, whenever the citizenry has lost its sense of forward progress in its material living standard, and lost too the optimism that that progress will resume any time soon. Europe today increasingly looks to be on the verge of repeating key elements of the experience of the years between the two World Wars, with not only the ascendency of extremist political movements but cross-border communication among them. There are differences, of course: in the 1930s the central node of that communication was the rising Nazi movement and then government in Germany, while today it looks as if the facilitating vehicle will instead be the European Parliament. But the effects are parallel, and so are parts of these groups’ programs, today including the campaign to roll back within-EU immigration and EU regulatory authority, not to mention the entire European Union project.

With European monetary policy already expansionary – with the introduction just last month of a negative redeposit rate, innovatively so – and since Europe as such has no fiscal policy, the urgent need today is for debt restructuring and relief for the fiscally weak European countries (and it is useful to recall that in real time it is often hard to tell the difference between the two). In a similar way, in the United States today there is need for relief for underwater homeowners whom the bail-out of US lenders a half-decade ago largely neglected. But the need in Europe is more acute.

Again looking back to the interwar period, there is ample precedent, within Europe, for both debt relief and debt restructuring. Indeed, that experience is also the origin of our host institution this evening. The reparations due from Germany under the Versailles treaty were quickly transformed into the obligation to service two series of bonds, scaled to reflect the recovering country’s ability to pay; but in the end neither bond was ever fully paid. Initially, the Weimar government serviced the bonds to foreign investors at the same time as German states and local governments were borrowing from abroad, so that on net the international flows were mostly recycling while within Germany there was substantial intergovernmental shifting of burdens. The 1924 Dawes Plan and then the 1929 Young Plan further reduced what Germany owed, and each arranged for yet a new foreign loan. The need to facilitate transactions under the Young loan is what led, in 1930, to the creation of the Bank for International Settlements.

The Lausanne Conference in 1932 ended all German reparations payments, in exchange for which Germany deposited with the BIS bonds representing a small fraction of what was originally due; the bonds were never issued, and some years later the BIS burned them. By then Germany had acquired other foreign debts, however. The Nazi government initially serviced the debt but blocked the conversion of the Reichsmarks paid into foreign currency. It then began making payment half in Reichsmarks and half in non-convertible Reichsbank scrip. After a series of further steps, in 1934 Germany defaulted on both the Dawes and the Young loans.

After the war, the 1953 London Debt Conference took up the matter of Germany’s unfulfilled commitments, including government debt, state and local debt, and even private debt. The London agreement reduced the amount due by at least half (most likely more, depending on the calculation) and rescheduled the remainder so that no principal payments were due for five years and the rest strung out over 30 years. A significant part of the debt was further deferred, with no interest due along the way, until such time as reunification might occur – which turned out to be nearly four decades later. The United States also converted into grants most of the loans extended under the Marshall Plan, in parallel with treatment of the other recipient countries, and did the same for loans under the Government and Relief in Occupied Areas programme.

As one historian summarized the approach taken to Germany’s post-war debt relief, “at the time of the London conference most observers had in mind long years of what they viewed as Germany’s irresponsible treatment of foreign debts and property owned by foreigners.” Nonetheless, “The entire agreement was crafted on the premise that Germany’s actual payments could not be so high as to endanger the short-term welfare of her people … reducing German consumption was not an acceptable way to ensure repayment of the debts.” The contrast to both the spirit and the implementation of the approach taken to today’s overly indebted European countries is stark.

There is no economic ground for Germany to be the only European country in modern times to be granted official debt restructuring and debt relief on a massive scale, and certainly no moral ground either. The supposed ability of today’s most heavily indebted European countries to reduce their obligations over time, even in relation to the scale of their economies, is likely yet another fiction – and in this case not a useful one. As the last decade’s financial crisis fades into the past, and market interest rates move up to a more normal configuration, these countries and others too will find their debt increasingly difficult to service. In the meanwhile, the contractionary policies imposed on them are depressing their output and employment, and their tax revenues. And the predictable pathology that follows from stagnant incomes and living standards is already evident.

James Tobin often remarked that there are worse things than three percent inflation, and from time to time we have them. Indeed, we just did. In the same vein, there are worse things than sovereign debt defaults, and from time to time we have them too. They are in progress as we meet.