Oliver Hartwich, the Euro, and the “dangerous naivety” of floating exchange rates

We’re famous!

I’m very happy to see that a debate on the Euro crisis hosted by our Auckland University Economics Group earlier in the month has now slipped into Australia’s wide read Business Spectator.

Oliver Hartwich from the NZ Initiative talked to our Group a few weeks back on The Never-Ending Euro Crisis - the Anatomy of an Economic Policy Disaster, in which he

covered the history and pre-history of European monetary union, Europe’s fiscal and monetary problems, the eurozone’s governance issues and their political implications.
    But in the ensuing discussion, one of the economics professors, a renowned Austrian School theorist, asked two questions that were both unbelievably simple and incredibly sharp. The first: “So what does this euro crisis really have to do with money?” And the second: “Why have you not talked much about markets in your presentation?”
    At first, I was a little startled by these two questions. After all, when you give a whole lecture on the failings of a monetary union, surely this must have something do with money, right? And secondly, didn’t the euro crisis play itself out in the markets? Isn’t that where all the drama of these past years happened? How could I not have talked about markets?
    After the initial shock, I managed to give a reasonable answer to both his questions. However, I have been thinking about them for the past few days. And the more I do, the more it seems to me that they are not only valid questions: they also provide the answers to many of Europe’s current problems.

He’s right. They do. But because he’s left himself in the intellectual straitjacket of thinking that floating exchange rates would be the only way out, he doesn’t see that answer. 

How do economies adjust?

You see, Oliver insists

without the euro currency many of the problems we now observe would have never developed… trade imbalances between European nations probably would have corrected themselves through adjustments in the exchange rate. This is how such tensions had always been overcome when Europe still had many national currencies, and it certainly would have provided temporary relief…

Temporary relief only, because as he identifies, the real crisis “is really the crisis of the countries’ respective economies” :

These are economies that are in desperate need of economic reforms. Their problems have little to do with monetary union as such; the union merely brought their problems to light. Without the escape route of flexible exchange rates, their deep-seated problems could no longer be glossed over.

Note the first and last sentence: “These are economies that are in desperate need of economic reforms… Without the escape route of flexible exchange rates, their deep-seated problems could no longer be glossed over.”

Now, remove the intellectual straitjacket, and see what happens: The problem of the single currency zone with economies in desperate need of reforms suddenly becomes the solution. If no other escape route is offered them (and herein lies the present problem) the discipline provided by the single currency encourages the reform in those economies that is so desperately needed, and gives the public a reason to demand it.

Maybe the Euro is not so bad after all

The leading Austrian theorist in Spain, Jesus Huerta De Soto makes this point in “An Austrian defence of the Euro”:

The introduction of the euro in 1999 and its culmination beginning in 2002 meant …  the different member states of the monetary union completely relinquished and lost their monetary autonomy, that is, the possibility of manipulating their local currency by placing it at the service of the political needs of the moment. In this sense, at least with respect to the countries in the eurozone, the euro began to act and continues to act very much like the gold standard did in its day.

Simply put, the “fixed exchange rates” of a Bretton Woods system, of a gold standard, or of a single Eurozone currency—in which systems, trade imbalances are corrected through adjustments in prices and interest rates—all impose monetary discipline on a government, whereas the monetary nationalism of floating exchange rates allows printing press money to let rip.

Because Hartwich still seems to contemplate the crisis through the intellectual cracked lens of floating exchange rates however, he doesn’t see this.  He still sees floating exchange rates as the only way to make the markets correct the issue.

But the big Euro problem really is a lack of market process—as our Auckland Austrian theorist above seemed to be suggesting. And the fly in the ointment here is really the central bank.  The main thing lacking in the present arrangement of the Euro currency unit—in which a central bank imposes interest rates across a whole continent—is any mechanism whereby price signals are able to work their magic.  Because if the central bank got out of the way and stopped dictating interest rates across the whole zone, there is a benevolent mechanism present in the system of (essentially) fixed exchange rates that would re-emerge: encouraging investors to withdraw marginal quantities of their money from relatively overheated areas (where prices are higher and interest rates too low), and delivering it to areas shorter of investment capital (where prices are lower, and interest rates paid to investors are higher).

And then instead of acting as a doomsday machine, the main thing that’s destroying the setup presently (the monetary transfer system) would instead become the mechanism encouraging each economy’s reform.

Fixed  versus floating exchange rates

Since this issue, of fixed versus floating exchange rates, is so little canvassed these days it’s worth making it a final postscript—in the hope, perhaps, that you too might rethink the issue.

It was Hayek who in his 1937 book Monetary Nationalism and International Stability argued

flexible exchange rates preclude an efficient allocation of resources on an international level, as they immediately hinder and distort real flows of consumption and investment. Moreover, they make it inevitable that the necessary real downward adjustments in costs take place …  in a chaotic environment of competitive devaluations, credit expansion, and inflation

Which almost exactly describes the modern world of endless currency wars, where desperate economic problems are able to be put off for tomorrow by the printing press—with all the destruction that creates.  De Soto quotes Hayek from 1975, where he summarises his argument

It is, I believe, undeniable that the demand for flexible rates of exchange originated wholly from countries such as Great Britain, some of whose economists wanted a wider margin for inflationary expansion (called "full employment policy"). They later received support, unfortunately, from other economists[4] who were not inspired by the desire for inflation, but who seem to have overlooked the strongest argument in favor of fixed rates of exchange, that they constitute the practically irreplaceable curb we need to compel the politicians, and the monetary authorities responsible to them, to maintain a stable currency. (emphasis added)

To clarify his argument yet further, Hayek adds,

The maintenance of the value of money and the avoidance of inflation constantly demand from the politician highly unpopular measures. Only by showing that government is compelled to take these measures can the politician justify them to people adversely affected. So long as the preservation of the external value of the national currency is regarded as an indisputable necessity, as it is with fixed exchange rates, politicians can resist the constant demands for cheaper credits, for avoidance of a rise in interest rates, for more expenditure on "public works," and so on. With fixed exchange rates, a fall in the foreign value of the currency, or an outflow of gold or foreign exchange reserves acts as a signal requiring prompt government action.[5] With flexible exchange rates, the effect of an increase in the quantity of money on the internal price level is much too slow to be generally apparent or to be charged to those ultimately responsible for it. Moreover, the inflation of prices is usually preceded by a welcome increase in employment; it may therefore even be welcomed because its harmful effects are not visible until later.

Hayek concludes,

I do not believe we shall regain a system of international stability without returning to a system of fixed exchange rates, which imposes on the national central banks the restraint essential for successfully resisting the pressure of the advocates of inflation in their countries — usually including ministers of finance.

In which Keynes and Friedman see eye to eye

Perhaps I could point out too, as Ludwig Von Mises did, that floating exchange rates were much loved by Keynes…

Stability of foreign exchange rates was in [big-spending governments’] eyes a mischief, not a blessing. Such is the essence of the monetary teachings of Lord Keynes. The Keynesian School passionately advocates instability of foreign exchange rates.

Much loved they were too by Milton Friedman, who in this area as in so much else shakes hands with John Maynard Keynes. 

David Stockman, who in his recent book recounting the destruction of western capitalism by its supposed defenders, gives Milton Friedman the punch in his gut he deserves for his role in fulfilling the floating Keynesian dream, nailing him and US President Richard Nixon who between them put the final nail in the gold standard and instituted the modern world of floating exchange rates.

It was Friedman who first urged the removal of the Bretton Woods gold standard restraints on central bank money printing, and then added insult to injury by giving conservative sanction to perpetual open market purchases of government debt by the Fed.  Friedman’s monetarism thereby institutionalized a regime which allowed politicians to chronically spend without taxing…
    Nixonian cynicism and Professor Milton Friedman’s alluring but dangerously naive doctrines of floating exchange rates and the quantity theory of money picked up where Franklin Roosevelt left off. Notwithstanding Friedman’s aura of intellectual respectability, Nixon's crass political manoeuvres amounted to a primitive economic nationalism that harkened back to the worst of the disaster that Franklin Roosevelt had first sown in the 1930s…
    [B]y unshackling the Fed from the constraints of fixed exchange rates and the redemption of dollar liabilities for gold, Friedman’s monetary doctrine actually handed politicians a stupendous new prize.  It rendered trivial by comparison the ills owing to garden variety insults to the free market, such as rent control or the regulation of interstate trucking…
    The very idea that the FOMC would function as faithful monetary eunuchs, keeping their eyes on the M1 guage and deftly adjusting the dial in either direction upon any deviation from the 3 percent target, was sheer fantasy…

He gave more reasons for his disgust in a 2011 speech amounting to another punch to Friedman’s solar plexus.

“That the demise of the gold standard should have been as destructive as it was of monetary probity can hardly be gainsaid.  Under the ancient regime of fixed exchange rates and currency convertibility, fiscal deficits without tears were simply not sustainable – no matter what errant economic doctrines lawmakers got into their heads. Back then, the machinery of honest money could be relied upon to trump bad policy.  Thus, if  budget deficits were monetized by the central bank, this weakened the currency and caused a damaging external drain on the monetary reserves; and if deficits were financed out of savings, interest rates were pushed up – thereby crowding out private domestic investment.”

and

“During the four decades since [Richard Nixon closed off the last monetary tie to gold], the rules of the game have been profoundly altered.  Specifically, under Professor Friedman’s contraption of floating paper money, foreigners may accumulate dollar claims or exchange them for other paper monies. But there can never be a drain on US monetary reserves because dollar claims are not convertible. This infernal regime of fiat dollars, therefore, has had numerous lamentable consequences but among the worst is that it has facilitated open-ended monetization of US government debt.”

and

“So at the end of the day, American lawmakers have been freed of the classic monetary constraints.  There is no monetary squeeze and there is no reserve asset drain.  The Fed always supplies enough reserves to the banking system to fund any and all private credit demand at policy rates that are invariably low. The notion of  fiscal ’crowding out’ thus belongs to the museum of monetary history.”

and

“In fact, the United States is clocking a 10-percent-of-GDP-deficit for the third year running because this latest budgetary fling is just another episode in the epochal collapse of US financial discipline that began 40 years ago at Camp David.”

I think Messrs Stockman and De Soto might have a point.

Don’t you?