Europe’s debt crisis and Keynes’ green cheese solution
May 23, 2010 8:00pm
By Thomas I. Palley
The great German physicist Max Planck remarked that “science advances one funeral at a time.” The situation is worse in economics, which is subject to regress, as happened when the valuable but imperfect insights of Keynesianism were supplanted by the ideological blinkers of neo-liberalism.
The effects of this regress have again been on display in the confused discussions and policy responses to Europe’s sovereign debt crisis. The fact is that countries which borrow in their own currency and control their money supply will never default because they can always issue the money needed to repay their debts.
For such countries, central banks should respond to speculative debt crises with “bear squeeze” tactics that have them buy existing debt. In this fashion, countries can buy back debt below par value, in effect repaying it on the cheap. It is what the European Central Bank should have been doing on behalf of its member countries.
Not only does a bear squeeze assist debt reduction, it also punishes speculators and lowers interest rates, enabling countries to refinance on favourable terms. In a sense, this is what the Bank of England and the Federal Reserve have been doing on behalf of their respective governments by buying gilts and treasuries. Though such policy does increase the money supply, this is desirable at a time of big demand shortage and excess capacity when inflation is a distant danger.
The eurozone has cheated itself of these benefits because of the neo-liberal design of the ECB. That design ignores the fact that having central banks act as the government’s banker and to help manage the national debt was one of the original reasons for the establishment of central banks. This is no accident as neo-liberalism intentionally aimed to sever the fiscal – monetary policy link, but in doing so it discarded an essential tool of macroeconomic management.
The most damaging aspect of the crisis is the global boost it has given to the arguments of those advocating fiscal austerity. That is a cure which will almost certainly kill the patient by causing deep recession that lowers tax revenues and aggravates budget difficulties, while also causing bankruptcies that threaten an already weakened banking sector.
Governments cannot limitlessly increase debt and the money supply without cost. If such policies were continued, once the economy was back to normal there would eventually be a price to pay in the form of higher inflation and reduced confidence in money as a store of value. That means there is need to design policies and institutional arrangements that guard against such an outcome. But that is a wholly different proposition from saying governments and central banks should not use their powers to create money to addressing problems of excessive debt, speculation, financial panic and deep recession.
Central banks were slow to adopt quantitative easing (QE) to address the run on the financial sector in 2008 when money markets froze and banks could not refinance. That cost the global economy dearly. Now, the mistake is being repeated in the eurozone with the slow embrace of QE to address the run on public debt.
Europe, and perhaps the global economy, again confronts the possibility of a run for liquidity. In such circumstances there is only one thing for central banks to do: supply it. Keynes wrote of this in his masterful General Theory:
“Unemployment develops, that is to say, because people want the moon; — men cannot be employed when the object of desire (i.e. money) is something which cannot be produced and the demand for which cannot be readily choked off. There is no remedy but to persuade the public that green cheese is practically the same thing and to have a green cheese factory (i.e. a central bank) under public control.”
Yet, policy continues to respond with too little, too late, and then goes on to compound the damage with inappropriately timed austerity and doubling-down on policies of wage suppression that have already wrought such havoc.
The root problem is the dominance of flawed neo-liberal economic thinking. This problem is particularly acute in the ECB and European finance ministries which are dominated by economists trained in Chicago School neo-liberal macroeconomics. Ironically, social democratic Europe has been much more virulently infected by this strain of thinking than the US where politicians’ pragmatism has moderated economists’ extremism.
The Great Recession may have lowered economists’ public standing but it has not yet changed their thinking or swept away the top policy appointees who have failed so disastrously. When it comes to economics, Max Planck was too optimistic about scientific progress.
Thomas Palley is Schwartz Economic Growth Fellow at the New America Foundation