Posted by Kevin Villani on October 17th, 2014 (All posts by Kevin Villani)
This year marks a century since the outbreak of WW I and coincidently the initiation of US Federal Reserve System operations. Prior to these events, politics were democratizing, economic growth was booming, economies were liberalizing and global trade and finance were growing, all at a pace not seen again for almost another century. Recognizing that achieving these mutual benefits required an externally imposed political discipline, all of the countries participating in this happy situation voluntarily followed a set of rules governing domestic and international trade and finance for automatic and continuous adjustment to changing economic reality, then provided by the gold standard.
It was during this enlightened period that philosopher George Santayana wrote: “those who cannot remember the past are condemned to repeat it.” Hedge fund manager and Brookings Director Liaquat Ahamed set out to remind us why countries failed to recapture this economic dynamism after the Great War with the publication of the Pulitzer Prize winning Lords of Finance: The Bankers Who Broke the World in 2009. This book took on greater significance when in 2010 Federal Reserve Board Chairman Ben Bernanke recommended only this historical account in response to the Financial Crisis Inquiry Commission’s request for a book reference explaining the 2008 financial crisis. What history had this most recent financial crisis already repeated and what was Chairman Bernanke determined to avoid repeating in the aftermath?
Beyond the 16 million dead, the economic consequences of the “Great War” were orders of magnitude greater than any other war in human history over a condensed time period. The warring parties had suspended the gold standard but the famous British economist John Maynard Keynes can be credited with doubling the length – and hence cost – of this war as the British treasury official who provided the innovative financing needed to keep the war going, basically by relying on the historic credibility of the British pound sterling to borrow for both Britain and its allies. Most of the funds were provided by private American banks, implicitly protected by the newly created Fed.
Virtually all central bankers, politicians and economists of that time including Keynes supported a return to the gold standard as soon as possible to restore pre-war economic dynamism, but this required that each participating country recognize their share of past economic losses in order to establish a new exchange rate reflecting their new post war economic reality. Continuous renegotiation of war debts and reparations attempting to shift the burden made this problematic.
Britain and France – against American wishes – imposed sufficiently high reparations that German politicians rightly argued would impoverish its citizens for generations to come, a burden that could not be imposed in a market economy by a democratically elected government. That the British and French public simultaneously supported a default on their war debt owed to Americans for, as The Economist put it “saving Kansas from the German hordes” made a universal negotiated settlement of debts and reparations virtually impossible.
The leading British advocate of reducing or eliminating German reparations while defaulting on American debt was Keynes, who ironically had negotiated the debt during the war. Against Keynes’s advice Britain early on agreed to pay 80 cents on the dollar, whereas after a decade of protracted negotiations the French and Italians agreed to pay less than half that.
Fifteen years of political negotiations didn’t resolve the issue, so countries found ways to default. Having hyper-inflated away its domestic debts Germany was then able to return to the gold standard with the others. This allowed it to borrow internationally not just for “public works” – some of dubious merit – but even to finance the current budget deficit ballooned by unemployment benefits as well as reparations. Over-indebted and under-employed, with another monetary default on debt and reparations by going off gold unworkable after the prior hyperinflation, explicit default on reparations became a major part of the political platform that brought Adolph Hitler to power.
Having supported a return to the gold standard, Keynes now railed against the unfair discipline imposed by the “barbarous metal” at the pre-war exchange rate chosen by British politicians in 1925 to restore the pre-war primacy of Sterling. Britain ultimately defaulted by going off the gold standard in 1931. This “beggar thy neighbor” devaluation policy produced the intended salutary economic benefits for Britain in the short run but started a currency war as virtually all Britain’s trading partners followed suit, including America after the election of Franklin Roosevelt.
In the end the Germans defaulted on their renegotiated reparations, paying only about an eighth of the original imposition. European default on American loans was the same order of magnitude, amounting to about 17% of US GDP. Ironically, in spite of their default the French hated the Americans more for its failure to forgive the debt outright early on than they did their German war enemies who defaulted on reparations. The inability of politicians to face up to the Great War’s economic cost and the ensuing two decade battle to shift the incidence undermined European growth and recovery, adding greatly to the War’s total economic cost, which created the political conditions for the next war.
The four highly regarded central bankers of the time – Benjamin Strong at the Fed, Montagu Norman at the Bank of England, Hjalmar Schacht at the Reichsbank and Emile Moreau at the Banque de France – all sought a quick return to the gold standard at realistic exchange rates specifically to avoid the destructive politics of revenge and redistribution by restoring economic growth. While each was proactive in his own way, they all recognized the limits of central bank power. They could print money but could not create real income or wealth. They could manipulate exchange rates to gain a temporary domestic advantage at the expense of foreign competitors, but only to the ultimate detriment of all. They could temporarily maintain confidence in the financial system by lying about the solvency of one financial institution while redistributing income and wealth from others, but could not fill a systemic solvency hole with liquidity measures. They could buy time for politicians to implement mutually beneficial economic policies to recoup past losses, but they recognized the moral hazard of enabling politicians to do the opposite.
In recommending only Lords of Finance while rejecting all of the dozens of books specifically on the 2008 financial crisis Chairman Bernanke was obviously attempting to justify his unprecedented actions taken during the aftermath as necessary to avoid a repeat of the post war past, including the Great Depression. But Santayana’s admonition is problematic in several ways: historical narratives may reflect a preconceived ideology; readers may infer lessons from history selectively, colored by their own preconceptions and biases; and, forgetting the past may make a repeat more likely, but not inevitable.
Ahamed’s judgment that these central bankers – considered among the greatest leaders of their time – were The Bankers Who Broke the World would seem a bit harsh. The initial problem, massive war costs, was entirely political: central bankers could be criticized for indirectly being too accommodative. Similarly, the post war turmoil was due to the political failure to settle the distribution of these costs, again entirely political, with the same criticism of the bankers who as Ahamed puts it “spent much of the decade struggling to mitigate some of the worst political blunders behind reparations and war debts” (pp. 501-502).
Ahamed nevertheless puts the burden for the interwar failures on the central bankers for two reasons. First, he accuses their leadership of being hidebound in clinging to the ideology of the past by advocating a return to the gold standard. The post WW I monetary problems he describes did not relate to the gold standard mechanism per se or its objective, but rather to the political distortions the standard was intended to avoid, e.g.: the French hoarding gold to dominate Britain politically; the British going back to the old exchange rate to restore the international prominence of Sterling (almost succeeding with 50% deflation in six months); and the Americans sterilizing gold inflows to keep interest rates low.
His second criticism is on the mark. Low US interest rates during the post war years undermined the gold standard, causing a stock market and housing bubble in the US that led investors to stretch for yield, e.g., by lending excessively to Germany. This caused continual international financial market instability, culminating in the US stock market crash of 1929 followed by global depression. But this criticism is somewhat inconsistent with the first: had they followed the requirements of the gold standard the US would have been precluded from fueling the “roaring twenties” with cheap credit.
Ahamed doesn’t draw parallels to the sub-prime lending debacle of 2005 through 2007 and the financial crash of 2008, just before his publication date, but he may well have. Politicians used their regulatory authority to opaquely subsidize weak home mortgage borrowers by facilitating extreme leverage by government backed agencies and regulated and protected too-big-to-fail commercial banks, shifting the cost to consumers and taxpayers. The result was an example of Hyman Minsky’s 1992 financial instability hypothesis that attributes systemic financial crises to excessively leveraged investments in assets of insufficient productivity to provide repayment. Home mortgage credit losses spread among financial institutions globally were several trillion dollars, with additional homeowner equity losses of a similar order of magnitude.
Chairman Bernanke is arguably doubly implicated in the sub-prime lending debacle, by supporting such risky lending while Fed Chairman in spite of the systemic risk to the financial system and by providing the excessively cheap credit that fueled a house price bubble in the US. Hence he had substantial motivation to provide an opaque bailout in the aftermath of the 2008 financial crash.
He essentially doubled down on the very same post WW I central bank policies that Ahamed concludes Broke the World. To “maintain confidence” in the financial system he denied the solvency crisis, treating it as a “liquidity crisis” to buy time for an opaque central bank bailout– thereby redistributing income and wealth to “Wall Street” while politicians were simultaneously blaming the big banks for the crisis. The subsequent legal extortion of rescued banks of hundreds of billions of dollars partially reversed these bailout subsidies, but arguably at the expense of the rule of law. The ultimate irony was the passage of the Dodd-Frank financial reform bill in 2010 named after the two politicians most responsible for the subprime lending debacle. This bill granting the Fed Chairman even greater powers and responsibilities may ultimately prove more costly than the initial mortgage credit losses.
But the centerpiece of Chairman Bernanke’s policy was ZIRP – zero interest rates in the US for the more than 5 years of his post crash tenure and planned for several years beyond. This policy re-inflated mortgage security and house prices in the US and in addition contributed to what many analysts believe is an unsustainable stock market bubble. The Fed’s balance sheet now bears a closer resemblance to that of a mortgage hedge fund than a central bank, i.e., doomed to fail should interest rates ever rise.
As they did during the post WW I period central bankers have struggled to contain political blunders, but six years after the systemic financial crash of 2008 western economies still remain stagnant. The US has had virtually no growth per capita in spite of massive fiscal and monetary stimulus and while technically in its sixth year of recovery two thirds of the public still don’t believe the recession ever ended, likely reflecting the continued weakness in labor markets partially obscured by government statistics, as labor force participation has plummeted and productivity has stagnated. Conditions in Western Europe are worse, as Italy is slipping into its third recession since 2008.
Bernanke’s choice of only Lords of Finance in 2010 is curious in the context of his strategies then and since, which closely resemble the policies that Ahamed concludes “Broke the World.” Perhaps the explanation lies not within Ahamed’s historical narrative but in his concluding paragraph, which begins: “More than anything else, therefore, the Great Depression was caused by the failure of intellectual will, a lack of understanding about how the economy operated.” His concluding sentence is a testament to Keynes: “There is no greater testament to his legacy to that trusteeship (“the possibility of civilization”) than that …armed with his insights, the world has avoided an economic catastrophe such as over-took it in the years from 1929-33.”
Putting aside the economic catastrophe of WW II, Ahamed’s interpretation of Keynes’s legacy, that a single individual of sufficient “intellectual will” could save the world regardless of the magnitude of political blunders and depth of the economic hole they had already dug, may well have appealed to Chairman Bernanke, who certainly operated without ideological (and, current court testimony alleges, legal) constraints independently of other central bankers.
Keynes was undoubtedly a genius, but however appealing the notion of an economist as world savior Ahamed’s historical discussion doesn’t come close to justifying this tribute. In addition to the funding of WW I Keynes’s major impact during his lifetime, which ended shortly after the end of WW II, was the political flexibility of the Bretton Woods post-WW II monetary mechanism. This system avoided The Economic Consequences of the Peace (Keynes’s first widely recognized publication) but lasted only a quarter century, brought down by America’s exploitation of the adjustment mechanism leading to its default on gold convertibility (for the second time) in 1971. A long period of “beggar thy neighbor” exchange rate policies that amplified subsequent economic cycles and systemic financial crises (once again) followed.
Keynes wrote The General Theory to provide an explanation of high US unemployment when massive US gold holdings implied the opposite under the gold standard. Others have since questioned whether FDR’s anti-business policies weren’t the source of Keynes’s “animal spirits” and the US was in any event already on the rebound when he published. Keynes was in a major dispute before his death with the disciples who shaped his legacy, particularly communist collaborator Joan Robinson.
The most important legacy of the Great War is the social welfare state. Unprecedented losses, compounded by policies in the interwar years focused on redistribution rather than growth provided fertile ground for political upheaval and the response of social democrats in both the US and Europe for the central government to address severe economic distress, more widely implemented after the devastating economic losses of WW II. Not surprisingly given the economic costs of the wars and depressions and hence weak state of government finances, this response began as extremely limited pay-as-you-go welfare systems.
Public finances arguably haven’t yet recovered from the Great War. The current $18 trillion outstanding US debt owes much more to these entitlement systems than to the sub-prime lending debacle. This debt is 50% greater per capita than the $2.4 trillion (in current dollars) reparations Germany owed in 1921 and current Western European debt burdens are similarly onerous.
The US and Western Europe are in many ways better able to afford this debt than during the post WW I years, but the population is much older now and the entitlement burden is just beginning as baby boomers retire. These unfunded welfare systems eventually crowded out private funded retirement and health insurance systems. The secular decline in household savings rates and increase in government debt over the past four decades has resulted in an approximately $60 trillion shortfall in US wealth relative to the predictions of the life cycle savings hypothesis, not coincidently the approximate present value of Social Security and Medicare unfunded liabilities. States and localities face a similar underfunding of their retirement obligations and most EU countries face comparable per capita underfunding.
The US could hypothetically remove the contingent liability of past underfunding making the opaque obligation transparent by borrowing this $60 trillion to fund these systems. This is equivalent to the “pension bonds” issued by state and local governments, which do not improve government finances, but the debt covenants do reallocate income, and in the case of local government bankruptcy, assets, to retirees and away from e.g., current police protection. The federal equivalent is to recognize the SS and Medicare Trust Fund assets as a US Treasury liability, removing the illusion that the “Trust Fund” doesn’t run out of money for decades when in fact these systems have operated at a cash deficit for years.
As in the interwar years, chronic government deficits are a source of economic instability, and the continuous application of “temporary Keynesian” monetary and fiscal stimulus – government deficit spending – has likely exacerbated the secular decline in savings and build-up of debt.
Negotiations among the warring political parties in the US and Europe over income redistribution and debt forgiveness so far show no sign of being more fruitful than the interwar negotiations over debt and reparations. As with post WW I Germany, the (shrinking) productive working class will not voluntarily accept this burden, further undermining work incentives. The extremely high youth unemployment in Europe and black youth unemployment in the US is already culminating in political unrest
Just as Germany borrowed internationally to finance reparations and even unemployment benefits, the US borrowed money from the demographically younger and economically much poorer China and India during the first half of the last decade to help finance these intergenerational transfers (as well as sub-prime mortgage loans). But the availability of such funds was similarly limited and short term, contributing to economic instability when the debt comes due. Countries within the EU such as Greece are attempting to shift the burden to other EU members, particularly Germany, with only limited success.
Financial crises and central bankers’ responses have ricocheted across the Atlantic over the last decade just as they did in the interwar years. Central bankers have been even more accommodating this time around, rationalizing printing the money to fund these systems as “short run” stimulus. They have allowed politicians to postpone the day of reckoning, but like their inter war predecessors have no tools to avoid it. Economic costs continue to mount with significant compound interest in spite of the ZIRP illusion.
The alternative interpretation of the interwar years is that meretricious and counterproductive income redistribution policies are politically more appealing than policies that emphasizing hard work and thrift to foster economic growth, and overly accommodative central bank policies allowed politicians to dig an economic hole from which their economies could not escape. In the US income distribution has continually worsened during the Obama Administration, a direct reflection of Bernanke’s accommodative monetary policies that enabled fiscal and regulatory policies that discourage work, savings and investment – hence growth.
Chairman Bernanke promised that we could crawl out of this hole with modest inflation, a stable exchange rate and negative real interest rates on the ballooning fiscal debt, fueled by a return to the real per-capita growth rates of prior generations. This is reminiscent of France and Italy believing that the path to prosperity during the interwar years was to collect full reparations from Germany while defaulting on their American debt. Other countries, especially those facing similar distress, will have something to say about the extent of US implicit default and burden shifting.
Whether Chairman Bernanke’s unprecedented market interventions “saved” or “broke the world” has yet to be determined and will be open to differing interpretations in any event depending on one’s ideological interpretation of history, but he can hardly be accused of having been insufficiently politically accommodating. Carmen M. Reinhart and Kenneth S. Rogoff capture the current political response to the pending funding crisis in their satirical title to their book (also published in 2009) This Time Is Different: Eight Centuries of Financial Folly, attributing all financial crises over this much longer period to political fiscal profligacy, implicating central bankers only to the extent of their political accommodation.
In the words of baseball player Yogi Berra this is: “de ja vu all over again”.
University of San Diego