- A look back at the concerns of Harold James & Otmar Issing
- Will a breakdown of global cooperation lead to even higher inflation?
- Can money be printed indiscriminately & not be inflationary?
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Inflation Concern & The Dissolving of Globalism
July 27, 2021
“Understanding where we’re at and where we’re going, that continues to be an exercise for the McAlvany Weekly Commentary and to see the interconnectedness of ideas between finance and economics, between economics and politics, between politics and foreign policy and geopolitics, the impact of international relations. These are all things that are very relevant to us because they are the context in which we make individual decisions, that’s why it’s important to us.” — David McAlvany
Kevin: Welcome to the McAlvany Weekly Commentary, I’m Kevin Orrick along with David McAlvany.
Last week we talked, Dave, about both Harold James and Otmar Issing. Both critical interviews that you did over the last decade. I think it’s important when we talk about learning from history, one of the best ways to learn from history isn’t just to observe it, but it’s to capture what you were thinking in history. We had those two interviews pulled back up from 2010, from both Harold James and Otmar Issing. Why don’t you explain to the listener a little bit about what we were talking about, why we want to go back sometimes and listen to what happened a decade ago?
David: So, with Otmar Issing, you have the creator, one of the architects of the European Central Bank. It’s important to reflect on why it was created and what its mandate was and if it’s still on or operating off the rails. We’ve had similar conversations relating to the Federal Reserve, our central bank, why it’s created, what are the mandates, and to what degrees is it again on or off the rails, in terms of its operations.
So to look at what is now extraordinary monetary policy here in the United States, we mentioned Christine Lagarde and her comments from the ECB last week, there is a commitment to lower for longer that is lower rates for a longer period of time. The concern is amongst some economists that there is a shift, a structural shift, in the direction of inflation.
Rolling the clock back to 2010, I think it’s helpful to get an architect’s perspective and to sample some of Otmar’s thoughts on the importance of inflation and how it is actually a very regressive tax. Something that has its most extreme impact on the poor. So, inflation’s a real issue. It’s something that’s, I think, worth keeping in focus.
Harold James is going to join us in September. He’s going to join us for a discussion on his latest book, The War of Words. Certainly, Kevin, as far as you and I are concerned, there’s an interest in understanding what’s happening, both in the financial markets and from a cultural and political perspective.
So being clear in definitions, it may seem like a dry task but it’s one of the most important things that you can do before you enter into the best of conversations. Let’s make sure we understand what we’re talking about. In a world, certainly our world here in 2021, which is no less bipartisan and conflicted than it was in 2020, it’s important I think to have that conversation, the war of words.
The conversation, again, with Harold James, going back 10 years ago, was a fascinating one. He had written The Creation and Destruction of Value 10 years before that. Near the turn of the millennium he had written The End of Globalization. It sounds almost doom and gloom, but very insightful in terms of the history of globalization, the positives and negatives and what happens when globalization is challenged. He follows up those themes in The Creation and Destruction of Value. I think it’s very appropriate, as we consider inflation in the current context, 2021 and forward, to review some of these ideas, because again one of the structural shifts that is being argued, including by Otmar in the current tense, is that we have a demographic change. We have globalization being challenged. There are certainly implications.
Kevin: One of the things that I remember from the interview with Otmar Issing was just how powerfully he was motivated to see the European Union work. Part of that was to avoid another war in Europe, because there had been two major wars in Europe in the last century. But the other thing was these long waves of inflation. What Otmar Issing said was the poor people suffer when there’s inflation. I know Harold James, when he talks about globalization and free flow of trade, he also is talking about, poor people suffer if you don’t have that going.
I think we should put in context the year 2010, too, when you’re talking to each one of these men separately. Obama was president. This was two years into the global financial crisis. There was a European crisis at the time. Greece looked like it was in a crisis and it was pulling the whole euro down. But this was one year before Mario Draghi made the amazing comment at the European Central Bank, that, “we will do whatever it takes.” That was the quote.
What they did was, they literally came in and bought up the entire bond market, and central banks have been doing so ever since. That’s led to one of Otmar Issing greatest fears. He just wrote recently—this is what we talked about last week in the last commentary—his latest piece in Project Syndicate was a warning that, wait a second, we’re starting to see signs of inflation. This was what he talked about back in 2010 as being one of his greatest fears.
David: I love rolling the clock back to 2010 to see how important it was to him that we have an exit from extraordinary monetary policies. The interventions in the context of crisis were appropriate to prevent depression, but an orderly exit was important, you can’t overstay those policies.
Here we are over a decade later, and I don’t think we’ve seen the kind of receding, the kind of pulling back, the exit strategy, if you will, that he had hoped for. So it’s perhaps no surprise that we have the issue of a budding inflation, certainly the most recent statistics would suggest that there is something percolating up from below.
Kevin: We know that many of our listeners who’ve tuned in over the last few years may not have been listening 10 years ago. So what we’d like you to do for context, especially going forward, as we possibly interview Harold James and Otmar Issing again, in fact Harold James coming up in September and hopefully Otmar Issing not long after that, we’d like you to hear the context of the conversation that occurred back in 2010. So, from here on out on the program you’re actually listening to a pre-recorded conversation from 2010.
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David: Over the last several years, we’ve had the opportunity to talk to critics of the euro. Today we get to talk to an architect of the euro. Otmar Issing wrote The Birth of the Euro in 2008, a book published by Cambridge University Press, and explores what it looked like in memoir to be a part of the creation of the euro. He began his tenure with the European Central Bank in 1998 and was with them until 2006.
Otmar, what would you say is the present challenge that the European Central Bank faces in the current economic crisis?
Otmar Issing: I think the challenge for the European Central Bank is not so much different from the challenges to other central banks in the world like the Fed or Bank of England, the central banks had to deal with a financial crisis of a dimension we hadn’t seen since 1929 and the following years. I think the fact that the world has not fallen into a depression is due to the strong intervention of central banks in the world. Also, of course, to fiscal policies. But now, the question is how to exit from this policy, which is a very difficult task. Exit should not happen too early, undermining a recovery, and not too late, risking that inflation would be a consequence of this expansionary monitory policy.
David: The European Central Bank has decided to keep rates at 1%, where they’ve been since May of 2009, the UK likewise at a low rate of about half percent, and the US similarly at historically low rates. In your judgment, this challenge of coming out of a low-rate environment, is there any risk at this point of inflation, and would you expect to see rates rising in 2010, or is this something that requires a greater degree of confidence in terms of economic stabilization both in those particular countries and globally?
Otmar: First I beg your understanding that I have sworn I will never comment on monetary policy of my former central bank. There’s nothing worse than the old guys commenting on what the actual incumbent, so to say, should do. But I’m absolutely convinced that the ECB will stick to its mandate, which is to maintain price stability, and if you look into the introductory statements by the president, if you look into the monthly bulletin, et cetera, you see a clear orientation that ECB will not lose sight of its mandate.
David: How different is the mandate of the ECB, focusing on price stability, versus perhaps that of the Fed looking for stability of prices, specifically asset prices?
Otmar: I think the Fed’s mandate and that of the ECB isn’t so far different, as we have a dual mandate for the Fed, being responsibility price stability, but at the same time for employment. In the case of the ECB, the priority is very clear, maintaining price stability.
On asset prices I think this is one of the most important challenges for central banks in the world, how to deal with asset price developments. The ECB, with its two pillar strategy, for which I might claim ownership, I think it’s much better suited to deal with because, as many studies by the BIS and other institutions, ECB included, have shown, there is hardly any asset price bubble in the world in the past which was not accompanied, if not preceded, by strong increases in money and/or credit. So, looking into the development of money and credit, and making it part of the decision on monetary policies, implicitly urges the central bank to take also care about asset price developments.
Have all the states agreed with the notion that central banks should follow what I call an asymmetric approach, not caring when asset prices go up, but do everything when asset prices collapse? Of course, as we have seen the last crisis, once a bubble bursts, central banks have to provide any liquidity which is needed. The question is, what should they do when asset prices are going upwards? Of course, it’s difficult to identify the balances, to identify a bubble in time, but looking into the development of money and credit I think it gives you an anchor for your monetary policy decisions.
David: I remember reading, perhaps a year ago, maybe longer, some comments in the Financial Times by yourself on the value of M3. When you’re looking at money and credit and determining monetary policy, keeping both an awareness of that but doing long range planning, that number is relevant. Is there any reason why other central banks, particularly in the US, would have relegated that to the dustbins of history?
Otmar: Yes, several comments. First, there were headlines once when the Fed gave up even collecting data on M3. This was seen as contradictory to the ECB’s monetary analysis, which is nonsense. The relevant monetary aggregate in the US compared with M3 in Europe is M2, which is still existent.
Second point, the monetary analysis and monetary pillar of the ECB’s strategy doesn’t just boil down to monitoring M3 and comparing it with the reference value. The approach is much broader. It was the broader from the beginning. It has been further extended. There’s a lot of continuing research. The ECB, although at my time and now later, in a number of articles for example in the monthly bulletin and quite a number of research papers, has made clear what monetary analysis means. It’s a much broader concept. It includes several monetary aggregates. It includes credits, the counterparts, so to say, of monetary developments. And on the basis of that, the monetary analysis is not just reduced to looking into M3. We see this especially in the time as we are in the present crisis when the multiplier, so to say, collapses. Base money is increasing and M3 is stagnating. Looking just into M3 and M3 alone would give you a wrong view, a very limited view, on the monetary sector.
David: It’s in chapter three of your book The Birth of the Euro that you describe the creation process and the things that you wanted to prioritize, looking at each of the monetary policy options and choosing, as you did, the course for the euro. It seems that there has been a greater sensitivity within Europe, perhaps with the European Central Bank, to inflation. Is that from the visceral experiences of the German hyperinflation, both instances in the last century, or perhaps you’d like to comment on that?
Otmar: I think it’s certainly true that the fact that in Germany money was totally destroyed, the currency twice in one generation, has left a deep imprint in the mind of people in Germany. Now this generation has more or less passed away, but nevertheless memories of hyperinflation in Germany—even in October 1923, for example, we had monthly inflation rate of 10,000% and more—this is something which people don’t forget.
But it would be too simple to reduce the inflation or anti-inflation bias of Europeans to the German experience. Also in times of more moderate inflation rates, still double digit in some countries, several banks in Europe, before entry into monetary union, have learned and have reached a consensus that even moderate inflation of, lets say, 5 or 6, 7% is too high, it’s not helping for any problems. It’s not the solution, but it’s a problem.
So, the consensus, which was also marked by the definition of price stability by the inflation rate of below 2% annual inflation rate to be maintained over the medium term, reflects this common conviction. Which is, I would claim, now a European conviction and not just one based on German historical experience.
David: You ask the question in your book, “Does one size fit all?” What began as a project with 11 countries has now expanded to well over 25, and there’s still a list of new potential entrants into the EU and the EMU, the monetary unit. Do you feel that there is the possibility of a shift towards a unified political system? Is that necessary for the success of the euro, or is it adequate to the have the monetary union, as we’ve already seen significant benefits since 1999 and it’s inception?
Otmar: This is a big story. I’ll try to make a few remarks on that first. It was clear from the beginning, and I wrote extensively on that in my book, that the 11 countries that formed the monetary union at the start in 1999 were anything but representing an optimal currency area. So, the introduction of the euro and having a single monetary policy for all, one size has to fit all, which creates different developments in some countries.
For countries like Spain, for example, the strong decline in the real estate would necessarily trigger a boom in housing, this was clear from the beginning. So, monetary policy could not do anything about that, there’s only one interest rate set by the European Central Bank, which now applies for, in the meantime, 16 countries which are members of the monetary union. So if there are divergent developments in some countries, let’s say in overheating in the construction sector, it is the duty of the national authorities to implement national measures.
Just take the example of Spain. I could refer also to other countries. We in the ECB have warned the Spanish government time and again that this boom would finally lead to a collapse. The Banco de España, the Spanish National Central Bank, was on our side. Almost there was a monthly warning. So, this is explaining what monetary union is what it is not. It’s not a political union. The decision on taxation in the housing sector et cetera is a national decision. But the rules for national policies have changed with entry into monetary union, and this was forgotten. So, the present crisis in which we are in, and the case of Greece is just the strongest example for that, it’s a development which started right from the beginning. One should have avoided that by implementing national measures. Now it’s not too late, but the consequences are huge.
David: The period of financial and economic turmoil— is there a way to avoid there being political conflict or even geopolitical crisis as people blame someone else for their own problems? At least at the level of rhetoric we’ve seen Greece want to say, focus on your own business and quit fixating on ours. This goes back to World War II and biases. It seems that they’ve wanted to draw in the past, and perhaps that is only rhetoric, and perhaps that is something that’s quite easy to dismiss. But is there the potential for what began as a financial crisis, and has morphed into an economic crisis, to become a political or geopolitical crisis? Do we have a political crisis in the euro?
Otmar: You are right, this was a geopolitical dimension. Consider the tensions between the US and the Chinese authorities on the exchange rate of Renminbi. It’s difficult to disentangle political and economic issues.
But concentrating on Europe, European Union, even on monetary union, I think what we see now had to be expected. Once the countries like Greece get advice from Europe from Brussels it’s easy to blame European authorities or national governments for their prescriptions, which people of course don’t like. They have to suffer from those measures, but they are needed.
The rhetoric you mentioned, it’s a very unfortunate accompanying aspect of the present crisis, and I think responsible politicians should not endanger what is the biggest achievement of post-war Europe, that not only has war disappeared as a threat in Europe, but also political tensions of this kind, which are now here and there emerging. I would not take it too serious, but one should warn on the first sight of these things emerging.
David: Has the team at the European Central Bank faced particular challenges incorporating command economies and integrating them into more of a free market framework?
Otmar: It’s not so much, if at all, a challenge for the European Central Bank. The European Central Bank has a clear and limited—an important, but limited—mandate: to conduct a monetary policy for the single currency, the euro, to maintain price stability. This of course is enshrined in a treaty. The ECB is made independent to be able to take the appropriate measures. Now countries which have joined the euro have to live with this regime, which they wanted to have. But the consequences are far reaching.
I think one of the big problems of monetary union is that politicians, not only politicians, but politicians signing the Maastricht Treaty and joining monetary union, just though that transferring the competence of conducting monetary policy from the national central bank to the European Central Bank is enough, that’s it. Of course this is the major element, but the consequences are far reaching. The wage policy, for example, is different from the past. The tool of devaluating one’s own currency has disappeared, which means that there’s not one single sentence in the treaty how to conduct wage policy in the monetary union.
But the economic consequences are such that you have to consider maintaining your competitiveness within monetary union, living in a regime without having the exit of devaluating one’s own currency, et cetera. So, I think this learning process—what participation in monetary union means now in the crisis—is obvious. Not all countries have already taken the lessons.
David: It seems there’s a number of features which would make the euro that much more attractive to the currency markets, the long term— there maybe short-term disruptions because you cannot devalue your currency as the British have done this last year by close to 30%. But long term it seems that that adds stability to the currency. That adds to the success story that you’ve put in motion back in 1998.
It seems also that having a gold component as a part of the reserves to the euro is an important component. Is that particularly relevant, having gold as part of the currency? That was always one of the attractive sub-notes or footnotes to the Swiss Franc during a period of economic crisis and inflation during the ’70s and early ’80s? Are those elements still relevant in the currency markets today?
Otmar: I am not a supporter of importance of gold in our times. Of course, we have seen that once it comes to a crisis, gold as a natural asset, as a rare physical asset, has its own value, but I think what is really relevant for the euro is the independence of the central bank and the mandate of the maintaining price stability. These are the fundaments on which the euro is based. If the currency in terms of reserves has the gold part or not in context is for me irrelevant.
David: Are those assets perhaps better used as the German Finance Minster Wolfgang Schäuble suggest as a part of emergency economic fund?
Otmar: I’m not sure if he suggested that, it was said he had suggested. I have not seen any comment by him supporting that view. But I think this is out of question, the Bundesbank would never agree to such a transfer. So, this is an idea which does fly.
David: You have such vast experience, both academically, up to 1990 you were professor a university professor, then also very practical experience with the Bundesbank and then as a member of the executive board of the European Central Bank. What are your reflections based on your experience of where we’re at today and where we’re going, perhaps more philosophical reflections?
Otmar: This is something which— thinking on that increases by age, so to say. Indeed, this is a long story, and perhaps one, in case I would write another book, let’s say in 10 years time—if—this would be my main interest.
But to cut it short, for the time being, I think we are at a turning point. Remember when the ’90s of the last century started? There was a lot of talk about the great moderation, the situation in which a kind of Goldilocks economy—high growth, low inflation—and many were already celebrating this as a new era.
I think what is now at stake is if it turns out that it was just an episode in the long waves of inflation in the past, changing with short episodes of price stability, or if we can really preserve this great achievement. I think this is what is at stake now. In fighting still against the consequences of the crisis, one must not lose sight of this long-term goal of maintaining low inflation. Because, in the end, societies, and especially the poorest people, suffer most from a surge in inflation. This is, so to say, the mantra for me. And of course it’s not easy for central banks to keep this course when they’re attacked—politicians, unions, et cetera—but this is their task. They have to deliver in the interest of their people.
David: I want to thank you for joining us. The book that you wrote in 2008, The Birth of the Euro, I would encourage any of our listeners to look at for historical background, to look at the foundations of the ECB, and the considerations that went into the monetary union that impact our world so greatly today. For a firsthand account, you cannot get a better look into the inner workings of the EMU. So, thank you very much for joining us and I very much look forward to that next book. I hope we don’t have to wait 10 years, perhaps we can have a discussion then about what your reflections are in total.
Otmar: Thank you, you are welcome.
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Kevin: David, today, Harold James. This is a person that you’ve wanted to have on a number of times in the past, but actually it ties right in with our comments that we talked about with Otmar Issing, the architect of the euro last week.
David: Harold James, we thank you for joining us on the line today. I want to start with reading a section from your book as an introduction to our conversation today. “Financial crises are the catalyst for turning the globalization cycle. In such crises, assessments of the future which form the basis of monetary evaluation change very quickly. An inability to put a correct price on assets leads to the breakdown of markets and the erosion of confidence. Banks, businesses, and even individuals no longer trust each other. The effect on social cohesion is devastating. Collapsing values also have a spillover effect which intensifies the process of disintegration. They fundamentally change immaterial values as well. Hence, the globalization collapse becomes a story of changing values in both the usual sense of the term, as monetary and ideal values are shaken.” I wanted to know if, getting started, you’ll just give a brief definition of globalization and an overview of what the end of globalization past and present looks like?
Harold James: It’s a great pleasure to be with you. I’ve obviously thought about globalization a lot over the last 20 or 30 years. I think of globalization really as involving the exchange of things across national boundaries, across large geographical oceans. It’s the exchange of money, it’s the exchange of goods, it’s the movement of people, it’s the movement of ideas, and all of those areas are interconnected with each other. When you start to chip away at one of those interconnecting aspects, all the other aspects of mobility, all the other aspects of interconnections then start to change.
David: Well again, going to your book, you say that, “In practice, a globalization of goods, capital, and people often leads to a globalization of violence.” And as I read Niall Ferguson’s book War of the World, this concept was clarified for me, where the violence of the last century is related to financial change, whether it’s positive or negative. You point out that, as almost every period of globalization came to an end, there was a war. Is this, in your opinion, a high-probability outcome?
Harold: I think it’s right historically that most previous phases of globalization collapsed with dramatic military conflict. I give that really quite a long wave. I think Niall Ferguson doesn’t. Think of something like the Roman Empire as an early experiment in globalization, or China in the 10th, 11th, 12th century as an experiment of globalization. Indeed, those stories did collapse with war. I think most recently a lot of historians now have paid attention to this—the 19th century, which holds out a kind of template or a model for our era of globalization, really was substantially shocked in 1914 when the big European countries of Europe went to war with each other.
I wonder which it is really that’s most destructive, war or financial crisis, though they’re connected with each other. In a sense, in the 19th century example, the First World War, was this dramatic shock. But in the 1920s, people tried to put the story together again. The dramatic collapse was followed by the contagious financial crisis in the early 1930s. So both war and financial crisis are very, very destructive.
David: When that globalization cycle rolls over and there’s a break in the trend, there’s a profound disorientation or disillusionment which occurs with people. Is this the making for political or social upheaval? That’s something that the Economist has pointed out and predicted as a global trend for 2010, would you agree with that?
Harold: Yes, I think people, when they see the world becoming more uncertain, want some sort of protection against that uncertainty and they look to much more local ways of protecting themselves. They look to existing states as a way of protecting themselves. They want to define themselves as citizens of one state, rather than as citizens of the world. Or they define themselves as citizens of one state opposed to citizens of another state. They are just looking for protection or certainty in the middle of the great upheaval. Hence, the values are shifting; we can’t really rely on all the things that we’ve taken for granted before. That is a very common cause, historically, of a demand for radical action.
David: So it seems there is a shift from internationalism to nationalism.
Harold: Yes, I think that is generally right. One of the things I think we’ve been seeing in the course of the economic crisis is, on the one hand, lots of statements about how important international cooperation is. But on the other hand, how difficult it is, really, to get that cooperation in practice. So, the declaration at the summit about the importance of resisting protection, but then the individual politicians go back and they do things to try to protect their domestic markets.
David: With the advancement of globalization, there has been a diminished role for both the right wing and left wing, in terms of the redistribution of wealth by government. Does the diminishment of globalization, and that trend, bring back that old difference into high relief, with the left wanting to take and redistribute, and the right wanting to keep as much as possible?
Harold: Yes, I think we are seeing, absolutely, that. We are much more worried now about the increased inequalities that globalization brought, and we are really prepared to act, politically, against those inequalities. You see that in country after country, and in part, also, I think this is a consequence of just dealing with enormous fiscal burdens that states have suddenly discovered that they are confronted with.
David: We look back, and you do this very well in the Creation and Destruction of Value, you have an entire chapter on 1929 to 1931, which historical analogy applies. We have the Depression, which turned into the Great Depression in 1931, as it affected institutions all over the globe, triggered trade protectionism and tariffs between formerly open trade partners. What, in your opinion, are the parallels to the Chinese, as the emergent industrial giant of our day, as we were in the 1920s and 1930s?
Harold: I think that is a fascinating issue. There is a wonderful book, and this, really, to my mind, is still the most influential book on the Great Depression, Charlie Kindleberger, World In Depression, and the analysis of Kindleberger was that the world financial system, the world economic system, or political system, required some kind of hegemon, and in the 19th century, that demand had been supplied by Britain as a hegemon, but in the 1920s and the 1930s, Britain was much weakened by the war, incapable of providing that kind of hegemonic role, and the United States built up an enormous position as the world’s leading creditor country.
But the United States was not willing to take the responsibilities that went with that creditor role, American politics were very inward-oriented, and very domestically oriented, and the United States actually contributed very little to solving any of the problems of the other countries during the Great Depression. It seems to me that the Kindleberger story is really very easily updated now. The United States still has a very international outlook, and in practice, it is like the Britain of the 19th century. It is no longer a big surplus country, it’s a big deficit country. It is reliant on the financing of its deficits by the surpluses that have built up rather surprisingly in relatively poor countries and emerging market countries, in China above all, but in other Asian countries, and in the Middle East, as well.
The question really is, whether those emerging countries are going to have the ability and the willingness to stabilize the world economy. Up to now, I have to say, I think China today has done much better than the United States did in the 1920s and 1930s, and the big Chinese fiscal counter-cyclical fiscal stimulus package, a 4-trillion renminbi package, was one of the things that really stopped the world slipping into something like the Great Depression in 2008 and 2009, and has really produced very substantial growth and maybe even the danger of a new bubble now, so I don’t think we are out of the danger. But the danger is actually of a bubble developing in the emerging markets, rather than a collapse in demand in the emerging markets, which would be the equivalent of the collapse of demand in the 1930s in the United States.
David: Speaking of bubbles and asset bubbles, it could be argued that loose monetary policy was largely responsible for the asset bubble of the late 1920s. Is it advisable to employ loose monetary policies as the cure for a bursting bubble? Intuitively, it seems, that sets you up for the next misallocation of capital, or the next major bubble. This is what we discussed last week with Otmar Issing, what he described as an asymmetrical banking policy, where you support on the one hand, but you let go on the other, and don’t really keep a cap on asset prices.
Harold: I think he is right on that. The danger is that we go from one big bubble to another bubble that is even bigger, and each time the bubble collapses, the more devastating it is, because it has a terrible effect on financial institutions. In the collapse of financial institutions, I think if it were just the question of some banks failing, on their own, nobody would be worried about it, but they really affect a lot of real activity, and they can do tremendous damage when they collapse. I think the advice of avoiding serial bubbles is very sound, and very important, advice.
But it is actually hard to implement it in practice, because when you get a crisis, everybody shouts, “Why don’t you do something about it?” And what they do, as in 2008, they inject enormous amounts of liquidity, all the world’s central banks did that, and quite a lot of really big countries have big fiscal action as well, so the stimulus coming from the monetary side is simply coming from the fiscal side, and it does, indeed, set the world up for the next asset bubble. As I say, you can see signs of that next asset bubble developing in the emerging markets at the moment, and what a collapse there would look like, would also be quite a frightening prospect.
David: We saw the structure of credit change in the 1930s, and you highlight this in your book. Do you think that the Fed is buying time, hoping the consumer shows up again en force? How long will, or can, the Fed and Treasury remain the spender of last resort? As in 1931, essentially, has the structure of credit changed, and with it, a lasting wealth effect?
Harold: I think one of the problems is that what we had in 2008, in the last quarter, in the aftermath of the AIG collapse, was a sort of world financial heart attack, and the result of that is still with us—that financial institutions, banks, are going to put the emphasis, in part, because regulators tell them to do that, but in part, also, because of their experiences, they’re going to put the emphasis on increasing their capitalization. The easiest, simplest way of doing that is, it is hard to raise new capital now, so they are going to cut back on their asset size, and they are going to reduce the amount of credit that they give.
So I think what has happened is that we’ve seen the central banks step in as creditors and dealers of last resort, stepping in where the banking system failed. In that sense, I don’t think this is so much an inflationary danger, but I think it is a problem that is going to be with us, really, for a very long time.
It has a sort of interesting distribution effect, as well, because the businesses that tend to be hit hardest by this are small and medium-sized enterprises. Big firms can easily use the capital market, can issue securities, and those markets are functioning again quite well. It is the small and medium-sized business that are having great difficulties, and where, I think also, some of the great anxieties are building up, and a sense of injustice, because they are going to say, “Why are we paying, really, very large amounts for bank credit, when the central banks are providing credit almost for free to the major financial institutions?” It looks very, very unjust, and that, to me, is characteristic of these credit crunches, where people get very, very anxious about credit, and they are right to get anxious about credit, and they are very angry about the consequences.
David: That’s particularly relevant here in the United States where jobs are dominated by that small and medium-sized enterprise category, 60-70% of jobs provided by small business owners.
Harold: It is relevant in the United States, and it is relevant in Europe, because in Europe bank credit plays a much bigger role in the financing of enterprises than it does in the United States. All the big industrial economies really suffer from this.
David: You discussed both the history of forced bank mergers, as well as those from just a short time ago, and looking back a little bit, reviewing history, you had the forced merger of Creditanstalt, and Bodencreditanstalt, which was orchestrated by the government. The primary issue ended up being, after the fact, that the balance sheet was in shambles.
Do we have a Creditanstalt in our midst today? We have the likes of Bank of America, City Group, Wells Fargo, which are now having to set aside an additional 30 billion in reserves for home equity losses. There are a lot of bad debts still in the banking system, and our concern is that there might be a similar kind of forced disclosure of balance sheet frailty as there was with Creditanstalt, if the FASB rules are resurrected, or if there are additional regulatory reforms where disclosures of off-balance sheet entities are required, and it looks as if derivative regulation is on the horizon.
So what does it look like for these banking entities, the forced mergers of the last year or two, to sort of give up the ghost on information relating to level 3 assets, and things that, just like Bodencreditanstalt, would be consider the bad debt category?
Harold: Yes, I see that parallel, as well. I am worried by exactly that. In a sense we have a kind of big irony in that we thought that oversized financial institutions that behaved irresponsibly because they thought that they were too big to fail, or too complex to fail, they were all part of the cause of the crisis. What we do in a crisis is to make financial institutions even bigger.
I’m not quite sure that I see the exact parallels with the Creditanstalt, at least for the moment, because what happened was that Austria was a very, very small country, and it was really completely overwhelmed by the debts of its banking system. The United States is much larger, and has a much greater borrowing capacity, even though with enormous fiscal deficits, and in crisis situations the United States is in a really quite unique position. It is the borrower of last resort. It is still the most stable country in the world.
So I think the United States is capable of handling these very big banks, but I believe the reactions to those sort of problems are going to be, in really a rather political sense, we are going to complain about the way that it is done, all kinds of political corruption in the way that these things are worked out and practiced, and injustices in terms of the way the credit is allocated by these mega institutions. The United States can rescue the banks in a way that I think Austria in 1931 really couldn’t. But on the other hand, it is going to produce the same sort of reaction, and that, again, is something that would worry me.
David: In the 1931 crisis, and today, as well, there is an important geopolitical component. Democracy makes navigating in an international crisis more difficult. Maybe you can explore this idea a bit. It’s the constituency-driven nature of democracy, and choices that leadership may make, which don’t always render an immediate solution, which may be an issue. Democratically elected politicians have a short time-slice in which to enact policies and achieve results or re-election is out of the question. How do you take a long view in implementing policies? Maybe you can explore the geopolitical dimensions of the current crisis.
Harold: Yes, I think this goes back to the earlier conversation that we were having about the analogies with the Great Depression and the analogies, in particular, between the role of the United States then and the role of China and other big emerging markets today. One of the big differences is, clearly, that China is not a democracy, and in some ways, this makes it easier for the Chinese leadership to take a longer-term view.
But on the other hand, it also means that the Chinese leadership is very, very worried about things that might threaten its legitimacy, because the fact that there aren’t elections in China doesn’t mean that the Chinese government isn’t sensible to what goes on in the streets and big cities and also in the villages in rural China, and there is a kind of terror of what might happen if there isn’t a constant rate of growth. So one of the things that pushed this big fiscal stimulus package was the sense that unless there was a big stimulus, there would be a rise in unemployment, and the unemployed would be very violent, and would threaten the stability of the regime.
I think, even in a non-democracy, you have a kind of way in which the regime is sensitive to the demands of people, and those are some things that I think enter into the current equation. When you come to the question of how democracies deal with it, there, I think, the pressure to be protectionist is really quite substantial, and it is a very classic answer of democracies in depressions, that is what they tend to do, and I do think we are seeing some of that happening at the moment.
David: Different than most of the crises of the 19th and 20th centuries, the starting point this time was in developed countries versus developing countries, some of the most powerful of the G8. You review the weekend meetings in your book, where the world’s central bankers and fiscal authorities were behind closed doors with the financial elite, “saving capitalism from itself.” Is their success enduring?
Harold: I think they really had a moment when it looked as if it was all going to fail, and you raise the question of the impact of democracy and the impact of elections. I think one of the reasons why the Lehman story was so severe and why it was really so mishandled, was the short space of time between September 2008 and the elections of November 2008, and it really produced a kind of paralysis in dealing with the situation.
It meant that, on the one hand, dealing with the Democrats and looking at this, they didn’t want to hand dice triumph over to the Republicans, and on the other hand, the Republicans wanted to involve the Democrats in the solving of the problems on the congressional level, and so it was really the congressional impasse that made for a lot of the confusion, and that was very, very damaging. I wonder whether, if you had something like the Lehman collapse a long way away from any election, there wouldn’t have been a better and more efficient solution of it.
David: Turning to Europe, what do you think about, in relation to capital requirements and leverage limits— will the shortness of memory, will the persistence of greed bring concentrated risk back into the financial markets, and in this environment, is Europe going to be able to improve their capital ratios with concerns persisting over Portugal, Italy, Greece, and Spain?
Harold: We’ve just seen really quite bad mishandling of the Greek situation, and clearly, there are more problems down the road in that direction because, as you say, it’s not just a problem with Greece, there are different sorts of problems in all the Mediterranean countries. There are questions of competitiveness, there are questions that existed long before the crisis.
I think the whole of the European story is something that was a fantastically interesting experiment in terms of getting the common currency, but some things were really badly neglected, and that neglect is having a very destabilizing effect—the neglect of fiscal rules, and the neglect to have a common European banking supervision and regulation system. Those two problems are ones that should have been addressed a long time ago, and it’s quite hard in the middle of a crisis to produce an answer for it.
In both areas, I think you will see an intensified debate about whether there should be more Europe or less Europe, in other words, more of a move to a conventional type of state, or a move back to nation states. In that sense I see, also, parallels with the United States in the Great Depression, in that one of the things the Great Depression did was to federalize a lot more. The federal government got a lot bigger as a result of the Great Depression, and that’s clearly one of the possible outcomes in Europe.
But if it doesn’t take place, I would see the pendulum swinging back, and I think that’s more likely, really, to nation states. We are seeing incredibly focused politics in Greece and Germany, that people talk about these European packages in very nationalistic terms. The Germans say, “Why should bail out the Greeks?” And the Greeks say, “The Germans have got all these advantages out of their export industries, they should really help in dealing with some of the problems that arise out of that.”
David: It seems that some of your large investors around the world, whether it’s the folks at PIMCO or Warren Buffet, are, at least in the United States, betting on the direction of planned capitalism, where perhaps we are in a new era where free-market capitalism takes on command economy characteristics and you can see, at least on this side of the pond, a reaffirmation of what we saw in the 1930s under the Roosevelt administration.
Harold: I think there is something in that. The investors see that; the academics see that. The National Intelligence Council produced a report a year or so ago of what the world would look like in 2025, and they took the theme of state capitalism as being one of the distinguishing features of this world that was going to emerge after the crisis, and I think that is the reality of countries like China, and countries like India.
You have to say, in the past, those state capitalist systems were not very successful, so if the world is really going to be like this, it may well be a world in which there is less economic growth, less freedom, and more of a potential for conflict, so all the bad things that we saw in deglobalization periods in the past coming back again to undermine and destabilize us. That is quite a frightening thought.
David: You allude to, in your book The Creation and Destruction of Value, an idea fascinating to me, which you called deep history. This is not just being aware of certain facts and figures within history, but having a deeper, more complex understanding of history. Would that be what is necessary to avoid entering into sort of a state capitalism, which admittedly, was not all that successful? Command economies, I think that was what was discredited with the end of the Cold War. How is it that we might take a step back in that direction, and what does a deeper history look like?
Harold: Yes, I think that, indeed, we really should look at the way in which our existing order is quite fragile, and that, to me, in the end, is the biggest sense that you get out of history, that you see such a number of radically different social universes that it is possible to inhabit—very different systems—and they are systems that appear to be quite solid, and then suddenly break up. Most political scientists thought, when they looked at the Soviet Union, that it was there forever, and then suddenly the whole picture started to fragment and fracture, and we got a very different world.
I think we really need the same observation of liberal market economies, that they, too, are vulnerable. It isn’t that they are uniquely resilient in a way that the planned economies were vulnerable. There are great weaknesses and great problems there. I think we should be aware, in that particular discussion, also, what it is that we might lose if they collapse.
David: The special drawing rights, a unique currency basket constructed by the IMF, seems to be taking on greater significance. The Chinese have moved tens of billions in reserves into the vehicle. There is a two-fold question here: One, what is the future of the euro as a dollar alternative for central bankers seeking greater currency diversification? And in your opinion, do these SDRs, the special drawing rights, play a greater role over the next decade?
Harold: I am quite skeptical, first of all, about the possibility for countries really managing their reserves through synthetic currencies or basket currencies like the SDR. There is also a nice precedent for this. In the 1980s, the Europeans were very impressed that more and more companies, and governments, as well, were doing bond issues and ECUs, what were then called ECUs, synthetic currencies, European currency units. It was very much based on the SDR concept. That looked absolutely fine, and then when the European monetary system went into a series of crises in the early 1990s, that ECU market just completely collapsed, and people wanted the certainty of a currency that was actually issued by a central bank that had a clear analog in the political realm, so they wanted to see a central bank and the government acting together. So in that sense, the dollar was always the currency that looked like the simplest currency, and in a crisis you want something that is simple and comprehensible. So I find the SDR proposal really deeply problematical.
In terms of other currencies replacing the dollar, or going alongside the dollar, that’s a much more plausible thought, and I think the euro will have some of that role. I think it is also quite conceivable that if the Chinese were to have some degree of liberalization—you can’t have this with the controlled currency that they have at the moment, but if they had some degree of liberalization, it is possible to think that the renminbi might be a reserve currency.
In the same way, in the 1960s, the Japanese yen and the German mark became major international currencies only 15 or 20 years after a devastating war in which those countries had been substantially destroyed, and the political systems had been destroyed, but they had good growth, good export performance. That was enough to be the basis of a stable currency. The Japanese could hold a model there for what China might do. But I think a number of individual currencies being reserve currencies is a plausible thought. The SDR being a reserve currency, I don’t find a plausible thought.
David: Looking at Michael Bordo’s Monetary Regimes in Transition, he, and a number of contributors to that book, explore the role of gold in the past as a stabilizing force as a part of the reserve mix for a currency. Is it such today, that there is a, perhaps, central banker bias against gold as a reserve asset, as an implausible reserve asset, to bring about stabilization of the currency markets, and a particular currency?
Harold: I think gold comes in sometimes as a hedge when people fear there is going to be a substantial inflationary development and we have seen part of that over the last 12 months or so. I really think it is very difficult, conceptually, to rebuild an international monetary system on the basis of gold. It was system that worked, as Michael Bordo has shown, very well in the 19th century, but it was under quite unique circumstances. One of the things I think people would worry about now is, for instance, just where is the gold? Where is gold produced? South Africa, Russia—this doesn’t seem to me to be the best way to make a new monetary order.
David: A couple of things you focus on in your book, perhaps lessons learned from 2008 and 2009—the limits of the financial revolution. Also being a university professor, do you think that universities will be teaching modern portfolio theory and the efficient market hypothesis as working models in future years?
Harold: That’s a very interesting question. I’ve just come back from a conference in Cambridge where a very large number of economists came together to discuss what might replace the efficient market hypothesis. There is a sense that the old model is broken, and people are really groping toward what might replace it.
David: The securitization innovation was both miraculous and something of a curse. We created a banking system in the shadows, where lending occurred outside the normal conduits of credit. The credit markets became accustomed to extraordinary growth with this new venue. How soon do you think the market will forget the perils that came with that innovation, and perhaps attempt a resurrection of the whole shadow banking system?
Harold: I think you have to distinguish between the shadow banking system and the phenomenon of securitization. I wouldn’t be as negative about securitization as most people are today. It does seem to me to have been a conceptual advance, and it sort of gets us out, in some ways, of this dependence on banks, which has been, historically, one of the great sources of instability in the financial system. The weak link was really the relationship between banks and the shadow banking world, and that, I think, is gone forever. I think regulators are not going to tolerate that anymore.
In my optimistic moments I think what is happening at the moment, trying to push the dealing of securities onto open markets, onto central clearing houses, away from the internal trading platforms of banks—that really is a great advance, and it is an advance toward what a market should actually be, in which there is a transparent price discovery process. If regulators take this path, maybe we will see a re-emergence of the securitization phenomenon, without the wilder and more destructive sides of it.
David: So, perhaps a return to Glass-Steagall, or some other form of meaningful regulation, stabilizes that part of the financial system?
Harold: Yes, although I think they are still going to be quite divided about this, because I think, as commentators have pointed out, that some universal banks have dealt with the crisis quite well, others have dealt with it very badly, and it may not be the concept of the universal bank, as such, but the problem associated with banks having these vast internal trading platforms in which they are offering services to customers, they are dealing in securities that are very, very hard to value, and that kind of service then suddenly fails in an event like September 2008. So my tendency is to think pushing securities dealings into the open, under open markets, is a more important sort of reform than actually separating banks out by function. In that sense, I’m not sure that I would want to think that a revival of Glass-Steagall would be the best way of preventing a crisis like 2008 in the future.
David: There is, as you mentioned, the difficulty in pricing assets, which brings me to one of the last issues you address in your book, in chapter 6 at the end—the importance of values. You discuss modern art, and how modern art reflects modern finance. Maybe you can explore that a bit.
Harold: This is one of the things that really fascinates me—why there was, at the same time as the bubble, this explosion of prices and valuation, not in the art market as a whole, but in contemporary art. This was an area where some of the people who were dealing in this, some of the people who were producing the contemporary art, were really openly contemptuous of the customers of the art market in general. Indeed, they were exactly, to me, the analog of these traders with over-complicated financial products, in that they know the customers can’t understand them, and they push them on the customers.
That was a world that collapsed. I wanted, in the book, in the end, to reflect a bit on why that was, because the art market is very inherently connected with financial markets, and I’m just sitting, looking out of my window in Florence, Italy, at the town where in the 15th, 16th century, there was very much a precedent for this, but it was a different kind of art then.
David: There are values which you discuss at the end of your book which are very important to the globalization cycle, and markets which rely on a degree of certainty—trust being integral to a market exchange and cooperation. In your opinion, in what are values grounded?
Harold: I think the basis of this sort of immaterial value that you are talking about, is the sense of responsibility, the sense of respecting the personality and the dignity of others, and where it arises, and where the interface with the financial markets occurs. I think the question of the buildup of debt—we have seen colossal buildups of personal debt and government debt. Those debt buildups, I think, are danger signs. This is living irresponsibly, whether you are a person or a government.
There is a calculation—I go through the steps of this in the book—that my desires must be better than somebody else’s, so everybody else better finance my debt, finance my ability to realize my desires. That is an unhealthy world, and I think one that has had a set-back in the course of the financial crisis.
David: As we wrap up, I just want to end with a quote from your book, and then perhaps a reflective question for you. You say on page 277, “The only way of dealing with a collapse in values is to rebuild values. Regaining trust is a long and arduous process. That is why, when globalization is broken, it’s not easy to put together again. We look for communities of virtue, but inevitably, we will not find them at once, and the globalization cycle will resume, but not immediately.”
You have been a student of modern history, taught at many universities. Your professional experience and intellectual rigor speaks for itself in the books that you have written. As you spend time in Europe, as you spend time here in the United States on occasion, as well, would you reflect with us on what you hope, and what you likely see, over the next 3-5 years? What is your most realistic view of where we are going?
Harold: I believe, as you think, of this medium-term horizon, not what is going to happen tomorrow, not what is going to happen in 20 or 50 years’ time, but the foreseeable future is, I think, going to be, actually, a rather bleak one. The sense of an imminent collapse pulling governments and politicians together in order to deal with it, is going to go away, that we are going to be just dealing with the aftermath of the crisis with poor economic growth for some time, and really, an increase in distrust, an increase in anger, resentment, alienation. So the short-term, medium-term, for me, is really, on the whole, not a very happy one just at the moment.
David: We would love to have you join our conversation again. Our attempt to understand what is happening in the world, and what we should do in light of that, is one that is a process added to, and complimented well, by discussions with you and other guests. Thank you so much for joining us today, and we will look forward to having you as a part of the conversation again.
Harold: Thank you, it has been an enormous pleasure talking to you. Thank you so much.
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Kevin: Dave, here we’re back in 2021, the marvels of technology, but gosh we need to do this more often. We need to go back and listen to the critical interviews, whether it’s Carmen Reinhart, Harold James, Otmar Issing. There’s so many treasures from the past that will help us understand what’s coming in the future.
David: You know, on an occasional Sunday I’ll get together with one of my kids and we’ll have a book conversation. Go to breakfast, just the two of us, and certainly we’re interested in the books, we’re interested in really the time spent and the conversation that emerges from the ideas that are stimulated from either a book that I’ve read or a book that they’ve read. It’s the conversation which is rich.
So The War of Words coming up in September is a conversation I’m looking forward to. The book is an excuse to get back on the line with Harold James and engage with him and take a look at the world as it is today, and to see what’s on his mind. What should we be paying attention to? In what ways is the landscape similar or different from the last time we had a conversation? How constructively should we be seeing things? I love the fact that his area of expertise is political economy. It’s stretches from the economic into the political, public policies are certainly on the table, but so are so many of the facts and statistics that are driving economic growth or shrinkage. And the interrelationships between companies and people and nations. It’s a very rich and robust way of looking at things.
So, for him to join us now as we look at, again, whether you consider the asymmetrical policies that Otmar Issing talked about, or the inflation concerns and the way that impacts the poor. And how in fact public policies and taxation and in fact public policies are in many ways shaped by what people are experiencing and demand of their leaders. It would be a conversation with Harold James and as you suggested wouldn’t it be great to have Otmar Issing back on the program as well?
Kevin: You’ve been listening to the McALvany weekly commentary. I’m Kevin Orrick along with David McAlvany. You can find us at McAlvany.com M–C–A–L–V–A–N–Y.com and you can call us 800–525–9556.
This has been the McAlvany Weekly Commentary, the views expressed should not be considered to be a solicitation or a recommendation for your investment portfolio. You should consult a professional, financial advisor, to assess your suitable for risk and investment. Join us again next week for a new edition of the McAlvany Weekly Commentary.