French Fried Politics

Very interesting, and long, article examining the political dysfunction across the western democracies under rapid globalization. Published by City Journal.

The French, Coming Apart

But it’s not just the French, we’re all fried.

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Politics, Economics, and the State of Our World

QE paradox

This is an interesting graphic that not only illustrates the futility of current monetary stimulus (the QE-ZIRP Paradox), but also the larger contradiction we’ve created in the relationship between politics and economics. I’ll explicate how this contradiction also explains Europe’s predicament with Greece and the other periphery countries in Eurozone, and also applies to emerging countries, especially China.

We can envision economics as a boundary of constraints or possibilities on the choices we can make in life. We might call these budgetary constraints, but it also pertains to constraints on growth and expansion. Relate this to personal finance:  economics constrains the choices we have on what kind of house we buy or rent, what cars we drive, what vacations we can take, what schools we attend, etc., etc. Within those constraints we often have many choices and possibilities for trade-offs. We can decide to buy a small house to afford a big car, or a tuition-free school in favor of more exotic vacations. We make these decisions everyday throughout our lifetimes.

The personal choices we make within the constraints of economics are analogous to the social choices we make through democratic politics. So, economics is like the box within which politics can allocate resources by democratic consensus. We can decide on more social welfare, or more national defense, or more leisure time. The irrationality is believing that we can somehow make choices that lie far outside the constraints of economics. Fantasies like we can all fly to the moon, all have a heart transplant, or perhaps live high on the hog without working to produce the necessary prosperity.

Economic constraints and political choices interact, an important dynamic since both are malleable over time. We can make choices that expand the constraints of economics, which would mean an expansion of possibilities through growth. Or we can make choices that shrink the boundaries of the economically possible, reducing our choices in the future. The interesting point to make at this stage of our exposition is that, like the boundaries we set for our children, economic constraints are a disciplinary factor that helps to keep our political choices honest.  In other words, economics disciplines our political choices by penalizing bad choices and rewarding good choices.

This has profound implications for how society works.

One can imagine that one of the major economic constraints on our personal set of choices is the amount of money we have. In other words, the fungible value of our assets and savings. Rich people have fewer economic constraints than poor people. But this supply of money is not fixed and can be augmented by borrowing through the issuance of credit and assumption of debt obligations. So, one can buy a more expensive house by borrowing the necessary funds from a mortgage lender and then paying it back over time. We soon figured out that when the supply of money is too strict, economic constraints are unnecessarily tight, so money supply should adapt to the needs of the political economy.

Thus, we can expand the economic constraints facing society by expanding the supply of money through credit. One might think, “Wow, that was easy. Now we have lots more choices!” And the next thought should be, “Well, what’s the limit on how much money we can create?”

First, we should remember that money is not wealth, it merely represents wealth. When money was backed by gold reserves, the supply of gold limited the amount of money in the system. If  Country A adopted bad policies relative to its trading partner Country B, gold reserves would flow out, threatening the underlying value of Country A’s currency. This would force Country A to correct its policies or risk impoverishment. The exchange rates between currency A and B did not reflect these changes because both were fixed to gold; but the underlying values had obviously changed demanding a revaluation of both currencies relative to gold. While workable, this was a herky-jerky way of adapting to changing economic conditions and resulted in many financial,  economic, and political crises along the way. It took WWI and WWII to finally break away from a gold standard as an economic constraint.

In 1948, the western powers that had been victorious in WWII established an international currency regime (called Bretton Woods) backed by the US$ fixed to gold and a host of institutions to help manage international relations, such as the IMF, the World Bank and the United Nations. Unfortunately, this regime depended on US policy to defend the monetary regime, even when it contradicted US domestic economic interests. With Vietnam war spending and Great Society social spending (guns and butter), too many dollars were created, causing a run on US gold redemptions by countries like France. In 1971, the Bretton Woods system finally broke down as Nixon closed the gold window to redemptions and all currencies began to float in value relative to other currencies. There was now no fixed relationship of the currency to anything of tangible value – its value was established by government fiat. The initial effect was a stagnating economy plus inflation, a decade-long slog in the 1970s that gave birth to the term stagflation.

At the time, it was thought that exchange rate movements would signal necessary policy changes to keep each countries’ political priorities aligned with economic constraints. It turns out this assumption did not hold up to political realities because volatile exchange rates do not necessarily affect domestic economic interests to the point where politicians feel the need to respond. How many of us know or care how the US$ is performing relative to the other currencies of the world? The result was that politically favorable (more for everybody!), but economically detrimental, policies could be pursued, while exchange rate volatility could be largely ignored. Thus, the economic discipline to guide political choices was lost, permitting bad policies to persist. We have seen this in the explosion of credit and debt around the world and the volatility in exchange rates and asset markets.

Now we can see the problem illustrated in the graphic above. Instead of forcing necessary fiscal reform, we end up throwing more monetary stimulus at the problem. The results have been rising inequality, asset booms and busts, and massive resource misallocations that will cost society economically for a long time. On the global stage, China is the poster child of excess. It will all end when we finally hit the wall and throwing more money at the problem no longer works.

Europe, the EU, and Greece.

We can consider another case in Europe where volatile exchange rates after 1971 inhibited trade with unnecessary currency risks and conversion costs. The idea was that a currency union under the euro would greatly expand intra-European trade by eliminating these costs. But a currency union requires consistent monetary and fiscal policy and a re-balancing mechanism. In the US this is achieved through a Federal government that taxes and redistributes resources. In the European view, economic discipline would by imposed by a set of consistent policy rules established under the European Union and Parliament. Once, again, the result was that individual country governments found ways to skirt the rules or outright deceive the EU on its government budgets. Sometimes this was necessary given the varying needs of uneven development among countries. We see the result in Greece, when it was soon discovered that Greece had borrowed and spent public funds far in excess of the 3% boundary established by the EU.

So, a currency union also has failed to discipline politics, and the result has been a catastrophe for the Greek people and a severe blow to the concept and credibility of the European Union and the euro.

————

The bottom line is that democratic politics needs a firm disciplinary constraint, or else a financially manipulated economy will give society just enough rope to hang itself with. Unfortunately, this has happened quite frequently in history.

Somebody Loan Me a Dime…

Loan me a dime

…as Boz Scaggs sang (as Duane Allman burned on guitar).

Debt as a Share of GDP

This graph (compiled by McKinsey) shows the levels of debt by sector across several significant countries as a percentage of their GDP. This is the relevant measure because it tells us how much bang countries are getting for their borrowed ‘buck’  (in their home currency).

An analogy would be if you were borrowing money on your household account that did not increase your income over time, but instead increased the burden of interest you had to pay on the debt, which would reduce the share of your income for other purchases, like vacations or retirement savings. It makes sense to borrow to earn a degree that will increase your earning potential; it makes less sense to borrow money to take a vacation or buy a car you can’t afford.

A rising debt to GDP ratio means the excessive borrowing is not paying off with increased income (national GDP). We can compare countries on the chart below and see that the US has greatly increased government debt, which according to the effects of our monetary policies, has been used to retire private debt. In other words, we’ve shifted private debt, much of it from the financial sector, to taxpayers. Japan is not included, but would show that just government debt as a share of GDP is well over 200%. All this debt has not bought Japanese citizens much in terms of real wealth. One could argue it has just prevented the Japanese economy from imploding.

Another risk factor not displayed here is the effect of financial repression on the service of this debt. US debt is being financed at historically low interest rates that do not reflect the time value of money or the risk premium of lending. When interest rates rise, as they must eventually, all this debt will need to be rolled over at higher rates, meaning the service on the debt will explode, driving out other spending priorities while driving balance sheets toward insolvency. (If we can’t pay, we won’t pay.)

All in all, this is not a pretty picture. Be afraid.

World debt

What, Me Worry?

M policyUnfortunately, this is not an April Fool’s joke.

Central bank strategy, and what we refer to now as “forward guidance” is a never-ending puzzle. In divining future Fed policy we may also need to consider the international ramifications. The three major currency blocs in the free world today are the Japanese yen, the Euro and the US dollar.

For reasons of historical experience, both the Bank of Japanese (BoJ) and European Central Bank (ECB) have been far more reticent to lower interest rates and provide excess liquidity relative to the Fed in the wake of the world-wide financial crisis. But the US has pushed hard for coordination among the central banks to prevent wide exchange rate fluctuations through competitive depreciation of currencies. In the last year, the Fed’s argument has persuaded both the BoJ and now the ECB to provide more credit to their banking systems to stimulate their economies.

One can perceive a general strategic vision here: coordinated devaluation of currencies to reduce debt liabilities and forestall rising unemployment. This makes debt less burdensome while devaluing the real value of assets priced in those currencies. In other words, the bad debts of the financial crisis get absorbed by all the citizens of the world’s most productive economies, hopefully without them noticing. It’s the hidden inflation tax through gradual currency devaluation.

But one wonders who is going to blink first when it comes to tightening up monetary policy in the face of rising prices? The virtue of a stealth devaluation is that the inflation rates are obscured. How many people notice when their dollar  buys fewer European or Asian goods? Of course, financial markets will notice as liquidity flies to the protection of real assets, something that has been occurring  for the past several years (that’s where rising prices in select real estate, farm land, and luxury goods are coming from).

Will the Fed risk rising unemployment to stop perceived inflation? I doubt that will be politically feasible. The BoJ has engineered a swift depreciation of the yen, but one wonders what yen holders have to show for it. And will the ECB tolerate higher inflation or will dollar holders begin to abandon their large dollar reserves in the face of persistent depreciation? Trying to stimulate the real economy by manipulating currency values is a very tricky balancing act.

From the WSJ:

The Fed’s Missing Guidance

Janet Yellen should make clear what the central bank will do if inflation exceeds the 2% target rate.

Janet Yellen, like Ben Bernanke before her, believes that the Federal Reserve should communicate the reasons for its current policies and the strategy of its future policy actions. And so we have been told the basic plans are for gradually reducing the volume of large-scale asset purchases, and for keeping short-term interest rates low—”for some time,” as she said in her speech on Monday—in order to stimulate employment and raise the inflation rate toward 2%.

But the Fed’s leaders should also be telling the public and financial markets what they think about the risk that future inflation could rise substantially above the Fed’s 2% target—and what the Fed would do to prevent such inflation or reverse it if that occurs.

Experience shows that inflation can rise very rapidly. The current consumer-price-index inflation rate of 1.1% is similar to the 1.2% average inflation rate in the first half of the 1960s. Inflation then rose quickly to 5.5% at the end of that decade and to 9% five years later. That surge was not due to oil prices, which remained under $3 per barrel until 1973.

Although history teaches that a rapid expansion of the money supply leads eventually to rising inflation, the current inflation risk is not, as many people assume, that the Fed’s policy of quantitative easing has greatly expanded the money supply. Although the commercial banks received trillions of dollars of reserves in exchange for the assets that they sold to the Fed, these reserves were not converted into money balances but were deposited at the Federal Reserve, which now pays interest on such excess reserves. The broad money supply (M2) increased only about 6% in the past year.

The real source of the inflation risk is that the commercial banks can use their enormous deposits at the Fed to start lending when corporate borrowers with good credit ratings are prepared to borrow. That increase in lending to businesses will be welcomed until the economy is back at full employment.

The big question is how the Fed will respond when the lending is excessive and leads to inflationary increases in demand? The Federal Open Market Committee (the central bank’s policy-making body) and Chairwoman Yellen should reassure the public that the Fed will not tolerate high inflation and will take steps to prevent such a recurrence of rising inflation even if that requires allowing the unemployment rate to rise. To be credible they also should tell the public and the financial markets what policies they will use to limit that inflationary lending.

The Fed’s traditional anti-inflation strategy—raising the federal funds rate at which banks lend to each other—won’t work. Commercial banks have so much in excess reserves that they don’t need to borrow from each other.

As an alternative, the Fed could increase the interest rate paid on excess reserves. This would give commercial banks an incentive to keep their excess reserves on deposit at the Fed.

But this policy would create two problems. It would be politically awkward for the Fed to pay large amounts of interest to commercial banks as a way of discouraging them from lending to businesses and households. It would also be a political problem to pay more interest on the $2.5 trillion of excess reserves than the Fed itself earns on its current portfolio of bonds and mortgage-backed securities.

So paying higher interest rates on excess reserves is not a viable strategy for limiting commercial bank lending, especially if the interest rate has to be raised substantially to limit inflationary pressures.

The Fed has been experimenting with repurchase agreements (known as repos) to manage short-term market interest rates. Repos are essentially short-term sales of securities by the Fed—which suck money out of the financial system—with a promise to buy them back at a price that implies the Fed’s desired interest rate. This allows the Fed to deal with a wide range of financial institutions, not just banks but also primary dealers, money-market mutual funds, etc., and to do so in a way that obscures the interest rate that it is paying.

Repos may obscure the implied interest rate, but the repo strategy will not stop the Fed from losing money when it pays more than it earns on its bond portfolio. To be effective in preventing inflation, the Fed will have to push short-term market rates to a high enough level to deter excessive commercial borrowing. And with higher market rates, the banks still will want to lend to commercial borrowers unless the interest rate on excess reserves also rises substantially.

The alternative to interest-rate strategies is quantitative restrictions on bank lending. One way would be to increase required reserves, making it impossible for the commercial banks to use all of their current excess reserves to make loans. The Fed could pay a moderate rate of interest on such newly required reserves, reducing the pain felt by banks on their lost earnings. A different form of quantitative restriction would be to increase substantially the capital requirements imposed on the banks, particularly an increase in the leverage ratio that relates bank capital to all of the bank’s assets rather than a risk-weighted measure of assets.

I am not advocating either of these quantitative restrictions. But I think it is important for the Fed to explain now how it will prevent the banks from using their current short-term reserve assets to finance inflationary commercial lending in the future. If the public is convinced that the Fed is really committed to price stability, it will be less costly in unemployment to prevent or reverse future increases in inflation.

merk-yellen-snowboard-olympics

End the Insanity

Printing money

Again, a Zero Interest Rate Policy (ZIRP) is a signal of a very sick economy where the time value of money is zero and savings income is driven to zero. It should be temporary. With their policy choices, the central banks are essentially telling us this is a semi-permanent state of affairs. In other words, they have no other tools to jump-start the economy and create jobs.

No kidding. Can’t make it better, but they sure can make it worse.

Economist Ronald McKinnon quoted from the WSJ:

If presidential nominee Janet Yellen succeeds Ben Bernanke as Federal Reserve chairman when his term ends Jan. 31 (and I see no reason she won’t), she will inherit a vexing dilemma: To taper or not to taper.

The major objection to this kind of policy change is that the “recovery” from the subprime mortgage crisis and economic slump of 2008 is so weak that the economy can’t withstand any increase in interest rates. This general concern with economic weakness is what pushed the Federal Reserve into its near-zero interest-rate trap to begin with—followed by the Bank of England, the European Central Bank and the Bank of Japan. All four central banks have fallen into similar traps and their economies remain sluggish.

What is at fault here is conventional macroeconomic theory. First, although reducing high interest rates to more moderate levels is stimulating for aggregate demand, going from moderate rates to near-zero rates has proved far less effective. Second, fine-tuning monetary policy to target a nonmonetary variable, such as the level of unemployment, has become an ill-advised fetish. What Milton Friedman taught us in his famous 1967 address to the American Economic Association, “The Role of Monetary Policy,” is that central banks cannot (and should not) persistently target a nonmonetary objective—such as the level of unemployment, which is determined by too many other factors.

The most straightforward approach now is for the leading central banks—the Federal Reserve (perhaps with Ms. Yellen at the helm), the Bank of England, the Bank of Japan and the European Central Bank—to admit that they were wrong in driving interest rates too low in the pursuit of a nonmonetary objective such as the unemployment level.

They could then begin slowly increasing short-term interest rates in a coordinated way to some common, modest target level, such as the 2% suggested here. Coordination is crucial to minimize disruptions in exchange rates. Then our economic gang of four should, in a measured and transparent manner, phase out quantitative easing so that long-term interest rates once again can be determined by markets.

Honey, I Shrunk the Money

gold-fools

Here we go, or should we say it’s time to open our eyes to where we have been going for some time. The unelected heads of the world’s central banks now explicitly control our economic fates. But as I mentioned in a previous post, they have little experience or power to influence politics and so central bankers risk serious political fallout from their currency machinations. In the meantime, anyone holding dollars, or yen, or euros, or renminbi, or promises to be paid in any such paper, can watch the real value of their wealth slowly dissipate. This should have wonderful consequences.

From the WSJ:

‘Loose Talk’ and Loose Money

The G-20 concedes that central banks rule the world economy.

The main message out of the Group of 20 nations meeting in Moscow on the weekend boils down to this: Countries can continue to devalue their currencies so long as they don’t explicitly say they want to devalue their currencies. Markets got the message and promptly sold off the yen on Monday in anticipation of further monetary easing by the Bank of Japan.

This contradiction between economic word and deed shows the degree to which policy makers have defaulted to easy money as the engine of growth. The rest is commentary.

The days before the Moscow meeting were dominated by blustery fears about the “currency war” consequences of money printing in the service of devaluation. Lael Brainard, the U.S. Treasury under secretary for international affairs, gave a speech in Moscow warning against “loose talk about currencies.” She seemed to have in mind Japan, whose new prime minister Shinzo Abe has made a weaker yen the explicit centerpiece of his economic policy.

In the diplomatic event, all of that angst went by the wayside. The G-20 communique bowed toward a vow to “refrain from competitive devaluation.” But the text also repeated its familiar promise “to move more rapidly toward more market-determined exchange rate systems”—words that essentially mean a hands-off policy on currency values. So Japan can do what it wants on the yen as long as it doesn’t cop to it publicly.

That message was also underscored by Federal Reserve Chairman Ben Bernanke, who implicitly endorsed Japan’s monetary easing and declared that the U.S. would continue to use “domestic policy tools to advance domestic objectives.” When the chief central banker of the world’s reserve currency nation announces that he is practicing monetary nationalism, it’s hard to blame anyone else for doing the same.

The upshot is that this period of extraordinary monetary easing will continue. Economist Ed Hyman of the ISI Group counts dozens of actions in recent months in what he calls a “huge global easing cycle.” The political pressure will now build on the European Central Bank to ease in turn to weaken the euro. South Korea and other countries that are on the receiving end of “hot money” inflows may feel obliged to ease as well to prevent their currencies from rising or to experiment with exchange controls.

This default to monetary policy reflects the overall failure of most of the world’s leading economies to pass fiscal and other pro-growth reforms. Japan refuses to join the trans-Pacific trade talks that might make its domestic economy more competitive. The U.S. has imposed a huge tax increase and won’t address its fiscal excesses or uncompetitive corporate tax regime. Europe—well, suffice it to say that Silvio Berlusconi is again playing a role in Italian politics and the Socialists are trying to resurrect the ghost of early Mitterrand in France.

So the central bankers are running the world economy, with the encouragement of politicians who are happy to see stock markets and other asset prices continue to rise. Here and there someone will point out the danger of asset bubbles if this continues—ECB President Mario Draghi did it on Monday—but no one wants to be the first to take away the punchbowl. It’s still every central bank, and every currency, for itself.

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Prof. John H. Cochrane, writing in the Jan. 25 issue of the Hoover Digest:

Momentous changes are under way in what central banks are and what they do. We’re accustomed to thinking that central banks’ main task is to guide the economy by setting interest rates. Their main tools used to be “open market” operations, that is, purchasing short-term Treasury debt, and short-term lending to banks.

Since the 2008 financial crisis, however, the Federal Reserve . . . has crossed a bright line. Open-market operations do not have direct fiscal consequences, or directly allocate credit. That was the price of the Fed’s independence, allowing it to do one thing—conduct monetary policy—without short-term political pressure. But an agency that allocates credit to specific markets and institutions, or buys assets that expose taxpayers to risks, cannot stay independent of elected, and accountable, officials.

In addition, the Fed is now a gargantuan financial regulator. Its inspectors examine too-big-to-fail banks, come up with creative “stress tests” for them to pass, and haggle over thousands of pages of regulation. When we imagine the Fed of ten years from now, we’re likely to think first of a financial czar, with monetary policy the agency’s boring backwater.

The Anti-Bernanke

What do I want for Christmas? How about Leszek for our Fed Chairman? This is an excellent interview filled with common sense and economic truths (probably the best I’ve read in the past 3-4 years; this is worth ten Greenspan speeches ).

Over the past 12 years Bush and Obama don’t even matter. These failed policies are what matters. From the WSJ:

Leszek Balcerowicz, the man who saved Poland’s economy, on America’s mistakes and the better way to heal from a financial crisis.

The markets didn’t “fail” but were distorted by bad policies. He mentions “too big to fail,” the Fed’s easy money, Fannie Mae and the housing boom. Those are the hard explanations. “Many people like cheap moralizing,” he says. “What a pleasant feeling to condemn greed. It’s popular.”

By MATTHEW KAMINSKI

Warsaw

As an economic crisis manager, Leszek Balcerowicz has few peers. When communism fell in Europe, he pioneered “shock therapy” to slay hyperinflation and build a free market. In the late 1990s, he jammed a debt ceiling into his country’s constitution, handcuffing future free spenders. When he was central-bank governor from 2001 to 2007, his hard-money policies avoided a credit boom and likely bust.

Poland was the only country in the European Union to avoid recession in 2009 and has been the fastest-growing EU economy since. Mr. Balcerowicz dwells little on this achievement. He sounds too busy in “battle”—his word—against bad policy.

“Most problems are the result of bad politics,” he says. “In a democracy, you have lots of pressure groups to expand the state for reasons of money, ideology, etc. Even if they are angels in the government, which is not the case, if there is not a counterbalance in the form of proponents of limited government, then there will be a shift toward more statism and ultimately into stagnation and crisis.”

Looking around the world, there is no shortage of questionable policies. A series of bailouts for Greece and others has saved the euro, but who knows for how long. EU leaders closed their summit in Brussels on Friday by deferring hard decisions on entrenching fiscal discipline and pro-growth policies. Across the Atlantic, Washington looks no closer to a “fiscal cliff” deal. And the Federal Reserve on Wednesday made a fourth foray into “quantitative easing” to keep real interest rates low by buying bonds and printing money.

As a former central banker, Mr. Balcerowicz struggles to find the appropriate word for Fed Chairman Ben Bernanke’s latest invention: “Unprecedented,” “a complete anathema,” “more uncharted waters.” He says such “unconventional” measures trap economies in an unvirtuous cycle. Bankers expect lower interest rates to spur growth. When that fails, as in Japan, they have no choice but to stick with easing.

“While the benefits of non-conventional [monetary] policies are short lived, the costs grow with time,” he says. “The longer you practice these sorts of policies, the more difficult it is to exit it. Japan is trapped.” Anemic Japan is the prime example, but now the U.S., Britain and potentially the European Central Bank are on the same road.

If he were in Mr. Bernanke’s shoes, Mr. Balcerowicz says he’d rethink the link between easy money and economic growth. Over time, he says, lower interest rates and money printing presses harm the economy—though not necessarily or primarily through higher inflation.

First, Bernanke-style policies “weaken incentives for politicians to pursue structural reforms, including fiscal reforms,” he says. “They can maintain large deficits at low current rates.” It indulges the preference of many Western politicians for stimulus spending. It means they don’t have to grapple as seriously with difficult choices, say, on Medicare.

Another unappreciated consequence of easy money, according to Mr. Balcerowicz, is the easing of pressure on the private economy to restructure. With low interest rates, large companies “can just refinance their loans,” he says. Banks are happy to go along. Adjustments are delayed, markets distorted.

By his reading, the increasingly politicized Fed has in turn warped America’s political discourse. The Lehman collapse did help clean up the financial sector, but not the government. Mr. Balcerowicz marvels that federal spending is still much higher than before the crisis, which isn’t the case in Europe. “The greatest neglect in the U.S. is fiscal,” he says. The dollar lets the U.S. “get a lot of cheap financing to finance bad policies,” which is “dangerous to the world and perhaps dangerous to the U.S.”

The Fed model is spreading. Earlier this fall, the European Central Bank announced an equally unprecedented plan to buy the bonds of distressed euro-zone countries. The bank, in essence, said it was willing to print any amount of euros to save the single currency.

Mr. Balcerowicz sides with the head of Germany’s Bundesbank, the sole dissenter on the ECB board to the bond-buying scheme. He says it violates EU treaties. “And second, when the Fed is printing money, it is not buying bonds of distressed states like California—it’s more general, it’s spreading it,” he says. “The ECB is engaging in regional policy. I don’t think you can justify this.”

“So they know better,” says Mr. Balcerowicz, about the latest fads in central banking. “Risk premiums are too high—according to them! They are above the judgments of the markets. I remember this from socialism: ‘We know better!'”

Mr. Balcerowicz, who is 65, was raised in a state-planned Poland. He got a doctorate in economics, worked briefly at the Communist Party’s Institute of Marxism-Leninism, and advised the Solidarity trade union before the imposition of martial law in 1981. He came to prominence in 1989 as the father of the “Balcerowicz Plan.” Overnight, prices were freed, subsidies were slashed and the zloty currency was made convertible. It was harsh medicine, but the Polish economy recovered faster than more gradual reformers in the old Soviet bloc.

Shock or no, Mr. Balcerowicz remains adamant that fixes are best implemented as quickly as possible. Europe’s PIGS—Portugal, Italy, Greece, Spain—moved slowly. By contrast, Mr. Balcerowicz offers the BELLs: Bulgaria, Estonia, Latvia and Lithuania.

These EU countries went through a credit boom-bust after 2009. Their economies tanked, Latvia’s alone by nearly 20% that year. Denied EU bailouts, these governments were forced to adopt harsher measures than Greece. Public spending was slashed, including for government salaries. The adjustment hurt but recovery came by 2010. The BELL GDP growth curves are V-shaped. The PIGS decline was less steep, but prolonged and worse over time.

The systemic changes in the BELLs took a while to work, yet Mr. Balcerowicz says the radical approach has another, short-run benefit. He calls it the “confidence effect.” When markets saw governments implement the reforms, their borrowing costs dropped fast, while the yields for the PIGS kept rising.

Greece focused on raising taxes, putting off expenditure cuts. They got it backward, says Mr. Balcerowicz. “If you reduce through reform current spending, which is too excessive, you are far more likely to be successful with fiscal consolidation than if you increase taxes, which are already too high.”

He adds: “Somehow the impression for many people is that increasing taxes is correct and reducing spending is incorrect. It is ideologically loaded.” This applies in Greece, most of Europe and the current debate in the U.S.

During his various stints in government in Poland, the name Balcerowicz was often a curse word. In the 1990s, he was twice deputy prime minister and led the Freedom Union party. As a pol, his cool and abrasive style won him little love and cost him votes, even as his policies worked. At the central bank, he took lots of political heat for his tight monetary policy and wasn’t asked to stay on after his term ended in 2007.

Mr. Balcerowicz admits he was an easy scapegoat. “People tend to personalize reforms. I don’t mind. I take responsibility for the reforms I launched.” He says he “understands politicians when they give in [on reform], but I do not accept it.” It’s up to the proponents of the free market to fight for their ideas and make politicians aware of the electoral cost of not reforming.

On bailouts, Mr. Balcerowicz strikes an agnostic note. They can mitigate a crisis—as long as they don’t reduce the pressure to reform. The BELL vs. PIGS comparison suggests the bailouts have slowed reform, but he notes recent movement in southern Europe to deregulate labor markets, privatize and cut spending—in other words, serious steps to spur growth.

“Once the euro has been created,” Mr. Balcerowicz says, “it’s worth keeping it.” The single currency is no different than the gold standard, “which worked pretty well,” he says. In both cases, member countries have to keep their budget deficits in check and labor markets flexible to stay competitive. Which makes him cautiously optimistic on the euro.

“It’s important to remember that six, eight, 10 years ago Germany was like Italy, and it reformed,” he says. Before Berlin pushed through an overhaul of the welfare state, Germany was called the “sick man of Europe.” “There are no European solutions for the Italians’ problem. But there are Italian solutions. Not bailouts, but better policies.”

Why do some countries change for the better in a crisis and others don’t? Mr. Balcerowicz puts the “popular interpretation of the root causes” of the crisis high on the list.

“There is a lot of intellectual confusion,” he says. “For example, the financial crisis has happened in the financial sector. Therefore the reason for the crisis must be something in the financial sector. Sounds logical, but it’s not. It’s like saying the reason you sneeze through your nose is your nose.”

The markets didn’t “fail” but were distorted by bad policies. He mentions “too big to fail,” the Fed’s easy money, Fannie Mae and the housing boom. Those are the hard explanations. “Many people like cheap moralizing,” he says. “What a pleasant feeling to condemn greed. It’s popular.”

“Generally in the West, intellectuals like to blame the markets,” he says. “There is a widespread belief that crises occur in capitalism mostly. The word crisis is associated with the word capitalism. While if you look in a comparative way, you see that the largest economic and also human catastrophes happen in non-market systems, when there’s a heavy concentration of political power—Stalin, Mao, the Khmer Rouge, many other cases.”

Going back to the 19th century, industrializing economies recovered best after a crisis with no or limited intervention. Yet Keynesians continue to insist that only the state can compensate for the flaws of the market, he says.

“This idea that markets tend to fall into self-perpetuating crises and only wise government can extract the country out of this crisis implicitly assumes that you have two kinds of people. Normal people who are operating in the markets, and better people who work for the state. They deny human nature.”

Gathering the essays for his new collection, “Discovering Freedom,” Mr. Balcerowicz realized that “you don’t need to read modern economists” to understand what’s happening today. Hume, Smith, Hayek and Tocqueville are all there. He loves Madison’s “angels” quote: “If men were angels, no government would be necessary. If angels were to govern men, neither external nor internal controls on government would be necessary.”

This Polish academic sounds like he might not feel out of place at a U.S. tea party rally. He takes to the idea.

“Their essence is very good. Liberal media try to demonize them, but their instincts are good. Limited government. This is classic. This is James Madison. This is ultra-American! Absolutely.”

They call this stimulus?

From the WSJ:

Les Moody Blues

If deficit spending were stimulus, France would be king.

Moody’s stripped France of its triple-A rating last week, citing “deteriorating economic prospects,” the “long-standing rigidities of its labor, goods and services markets” and “exposure to peripheral Europe.” And it could get worse: “We would downgrade the rating further in the event of an additional material deterioration in France’s economic prospects,” says Dietmar Hornung, Moody’s lead analyst for France.

Don’t think, however, that the French government is unduly alarmed. Finance Minister Pierre Moscovici insisted that the downgrade did not “call into question the economic fundamentals of our country.” We’ve never made a fetish of the opinions of the ratings agencies, which tend to be lagging indicators. Nonetheless, the “fundamentals” Mr. Moscovici points to are worth a closer look.

In 1981, when the Socialist government of Francois Mitterrand took office, France’s national debt amounted to 22% of GDP. In the intervening years France’s economy has grown by an inflation-adjusted 73%, while the national debt—now at 90% of GDP—grew by 609% in real terms. In raw numbers, that comes to about €1.7 trillion in additional debt. At no time in those 31 years did any French government balance a budget, much less run a surplus.

All this amounts to one of the free world’s longest-running experiments in the real-world effects of stimulus spending. If the fabled Keynesian multiplier really existed, all that spending should have translated into robust economic growth for France. Instead, the only thing that’s been multiplied is France’s debt.

President Francois Hollande is now bemoaning the supposed growth-killing effects of the spending cuts being demanded of him by the European Union. Yet if deficit spending could stimulate an economy, France would not be looking over the border with envy at Germany’s growth, debt and unemployment figures. Nor would it again be trying to explain away another debt downgrade.

Take on Wall St titans if you want reform

It’s more than just Wall Street – it’s central banks that seek to massage headline economic statistics like unemployment, inflation, and GDP with boundless liquidity. (Bernanke just doubled down again!) But the result has been to increase asset price volatility, creating endless gambles for traders, while providing a taxpayer safety-net for their gambles. It’s “heads we win, tails you lose!” It’s the current politics of finance. We either stop it or destroys our free market system. Our politicians prefer to let it ride.

From the Financial Times:

How can we expect stability when volatility increases the value of the instruments owned by the people who make or influence all important decisions?

 By John Kay

When the global worldwide banking system went into meltdown in 2007-8, the short-term response – the appropriate one – was to use public money to prevent a sequence of collapses of financial institutions. But the right long-term response is not to try to stop future bank failures, but to construct a global financial and economic system that is robust to individual bank failures. That is a fundamentally different objective.

Full Article.

On the Casino Floor, It’s a Crapshoot

This is what Casino Capitalism looks like. A damned-if-you-do, damned-if-you-don’t trading bonanza…

Quote from Barron’s market analysis this week:

Many investors, especially the so-called macro-hedge funds, are positioning for that damned-if-you-do, damned-if-you-don’t outcome to Greece’s election by buying bearish put spreads that will increase in value should global market indexes slump post-vote. Out-of-the-money puts that would increase in value if stock indexes fell 10% or more are extremely expensive. So cautious investors are selling others much further below market levels to defray the high cost of hedging.

Yet, many investors and traders are just as afraid of missing a rally, as they are afraid of a sharp decline. They believe that any negative economic development will be met by a government policy response. The Federal Open Market Committee meets Tuesday and Wednesday, and some investors believe that the U.S. central bank will unveil another iteration of quantitative easing that will spark a massive stock rally. It’s a vicious cycle.

However, some investors believe that the financial market’s performance, or lack thereof, is a leading indicator of government countermeasures. The more troubling the economic data—and recent statistics have been less than stellar—the greater the potential policy response.

We can keep this up until it all blows up in our face. Thank you, Mr. Bernanke…