The Monetary Causes of the Debt Crisis

On February 22, 2012, in economic theory, monetary policy, by Jon Lewis

Philip Coggan. Paper Promises: Debt, Money, and the New World Order. Public Affairs, 2012, pp. 294, $27.99 What is money? At first, it sounds like a simple question. But, as this thoughtful new book makes abundantly clear, the definitions of what money is, and what it should be in the future, are far more complex [...]

Philip Coggan. Paper Promises: Debt, Money, and the New World Order. Public Affairs, 2012, pp. 294, $27.99

What is money? At first, it sounds like a simple question. But, as this thoughtful new book makes abundantly clear, the definitions of what money is, and what it should be in the future, are far more complex than one might initially realize. In Paper Promises, Philip Coggan of The Economist forces the reader to think differently both about the nature of money and the concept of debt. “Modern money,” writes Coggan, “is debt and debt is money.” Throughout this engaging work, he successfully demonstrates how, throughout history, societal attitudes toward money and debt have changed and that they may be about to change once again.

The author contends that one can view all of economic history through the prism of a perennial contest between creditors and debtors, between those who lend money and those who borrow it. Anyone reading a newspaper these days knows all-too-well that much of the West is in debt. The battle between creditors and debtors aptly described by Coggan is being played out in front of our very eyes. Although some countries, like Greece, are in far more perilous shape than others, both the European Union and the United States face the looming prospects of increased sovereign debt and the possibility of default.

“As these debts become due,” writes the author, “rich creditors will be pitted against poor debtors; private-sector taxpayers against public-sector workers, young workers against the retired, domestic voters against foreign bondholders. It is impossible to forecast who will win each of these battles but one thing seems certain: not all these debts will be paid in full.” One of the book’s myriad takeaway lessons is that creditors will be disappointed. The breaking of these paper promises, as Coggan describes them, will result in economic turmoil akin to the end of the gold standard in the 1930s and of fixed exchange rates in the 1970s.

The book’s first chapter, entitled, “The Nature of Money” is a thought-provoking introduction to the concept of money. “For thousands of years,” writes Coggan, “the nature of money has been subject to change at the whim of those in power.” Indeed, the relationship between state power and money is nothing new. Coggan suggests, however, that something new did occur in eighteenth-century France, when John Law, a Scottish economist advising Louis XV, fathered modern monetary economics and attempted to redefine money. Law advised the French king that the way out of the country’s fiscal mess was to create a bank with the right to issue paper money, even if it were not backed by gold. This, recounts the author, led to an asset bubble in the form of land speculation in the Mississippi basin.

In a more theoretical section of the same chapter, the author delineates three uses of money. As a medium of exchange, money allows people to buy and sell goods and services without having to barter or ship bullion across great distances. He rightly notes that, with regard to the “media of exchange, paper and electronic money are much more useful than precious metals.” Money is also a unit of account, meaning that it expresses “the price of goods and services with relation to one denominator.” Finally, as a store of value, money allows one to save and not spend what one earns immediately. This facilitates investment. Coggan posits that, “the means of exchange and the store of value . . . lie at the heart of the struggle between creditors and debtors.” For the last forty years, he argues, the pendulum has swung toward loose money and money’s medium of exchange function. In other words, credit and money have expanded, benefitting debtors.

In Coggan’s estimation, our troubles began with the breakdown of the Bretton Woods system in the early 1970s, when the formal link between money and gold disappeared. “Paper money prevailed. Without a gold anchor, and without full capital controls, fixed exchange rates were not really feasible. Governments preferred the freedom to govern their own economies as they saw fit, using both monetary and fiscal policies to support demand.” According to Coggan, these governments and their central banks “overdid it, a process that culminated in the debt crisis of 2007 and 2008.” As he writes in the book’s introduction, the developed world financed their economies through debt.

Although Coggan tells a compelling story of how we got into our current debt crisis, it need not have ended up this way. The author certainly makes a strong case for the argument that the breakdown of the Bretton Woods system likely contributed to the vast increase of debt in the western world. Demography, fiscal policy, globalization, housing policy, and technology, however, also played dispositive roles in destabilizing the world economy. In my opinion, if voters throughout the past decade were more demanding that politicians in Washington adhere to a balanced budget and not engage in excessive spending, many of our current problems could have been avoided.

While Coggan accurately notes that the Clinton administration ran “a fairly conservative fiscal policy,” he seems to imply that the 1990s boom and budget surpluses were an anomaly in the post-Bretton Woods era, rather than part of a natural ebb and flow cycle in which politicians and bureaucrats alternatively acted fiscally responsibly and irresponsibly. After all, governments throughout history have made financial decisions that would prove, in retrospect, to have been significantly flawed.

One should not underestimate China’s potential to make financial, or political, mistakes that will inadvertently benefit the United States. Given the infeasibility of returning to a gold standard in an age of electronic money and instantaneous transfers, western countries are going to have to find a way to create a more stable fiscal and monetary system. If they do not, and the United States experiences a lost decade of anemic growth, then the world’s new monetary system may very well, as Coggan suggests, be made in China.

Due to his willingness to acknowledge readily that, “there are no easy answers in economics,” Coggan’s work stands apart. Paper Promises certainly doesn’t have all the answers; it, however, does force the reader to think differently about the nature of money and of debt. One need not agree with Coggan’s analysis of fiat money to appreciate that Paper Promises is an extremely thoughtful contribution to the ongoing debate about the financial crisis and our current debt problems.

Jon Lewis (c) 2012

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A Plan to Restore American Prosperity

On February 8, 2012, in economic theory, Federal Reserve, monetary policy, by Jon Lewis

First Principles: Five Keys to Restoring America’s Prosperity. John B. Taylor. W.W. Norton & Company 2012, pp. 235, $24.95 Unless something dramatic happens in the Persian Gulf, this year’s presidential election could very well hinge on the unemployment rate in November 2012. While January’s unemployment numbers had to have been somewhat encouraging for the White [...]

First Principles: Five Keys to Restoring America’s Prosperity. John B. Taylor. W.W. Norton & Company 2012, pp. 235, $24.95

Unless something dramatic happens in the Persian Gulf, this year’s presidential election could very well hinge on the unemployment rate in November 2012. While January’s unemployment numbers had to have been somewhat encouraging for the White House, a recent poll nevertheless revealed that only a mere thirty-six percent of Americans say President Obama is doing a good or an excellent job handling the economy. Many Americans, particularly those who understand the extent of our debt crisis, continue to be wary about this country’s economic outlook.

In First Principles: Five Keys to Restoring America’s Prosperity, John B. Taylor (Stanford University) presents his strategy to restore American economic greatness. According to the author, our current economic problems stem from its getting away from the basics of what made America great. “The premise of [First Principles],” writes Taylor, “is that the best way to understand the problems confronting the American economy is to go back to the first principles of economic freedom upon which the country was founded.” The author defines economic freedom as meaning the freedom to decide what to produce, consume, buy and sell, and how to help others. He enumerates what he considers to be the defining principles of economic freedom as: a predictable policy framework; the rule of law; strong incentives; a reliance on markets; and a clearly limited role for government.

Influenced by libertarian economists Milton Friedman and F.A. Hayek, Taylor emphasizes the importance of policy predictability and the rule of law. “Government’s adherence to known rules,” Taylor contends, “allows people to have a clearer sense of what is coming, and therefore to make more informed decisions about long-range plans.” Indeed, many of President Obama’s critics have complained that the current administration has created an uncertain business climate, making it very difficult for businesses and industry to plan for the future. When one hears echoes of capital sitting on the sidelines, this almost certainly is what is being referenced.

America’s adherence to the principles of economic freedom, suggests Taylor, has been stronger and weaker at different moments in our nation’s history. Policy shifts back and forth between interventionism and an appreciation for limited government. This occurs, “remarkably” according to Taylor, “nearly simultaneously for fiscal policy, regulatory policy, and tax policy.” Whereas the latter half of the 1960s into the 1970s was a time of increased interventionism, the Reagan-Bush-Clinton years were a more an era of economic freedom. This period is generally known as the Great Moderation. The George W. Bush-Obama era, on the other hand, has been a bipartisan era of increased interventionism. Following the financial crisis of 2008, the federal government has been increasingly interventionist with quantitative easing, health care regulations, and the Dodd-Frank financial reform legislation.

Taylor, who most recently served in the George W. Bush Administration, rightly acknowledges that members of both parties have veered away from an adherence to economic freedom. His assessment of how differing chairmen of the Federal Reserve performed deserves particular attention. Paul Volcker, best known for quelling rising inflation during the early years of the Reagan Administration, is presented as someone who intuitively understood the importance of economic freedom. Volcker’s near-singular focus on combatting inflation stands in stark contrast to Ben Bernanke’s monetary activism. With regard to the best-known Fed chairman, Taylor presents Alan Greenspan as someone who, in 2003-2005, purposefully moved away from the previous decades’ predictable rules-based monetary policy.

The author devotes individual chapters to the looming debt crisis, crony capitalism, and entitlement reform. Given his expertise in monetary policy, Taylor’s chapter on the Federal Reserve merits particular attention. In 1992, the author proposed the eponymous Taylor rule, a policy benchmark designed to aid the Federal Reserve in setting interest rates to achieve price stability. Unlike those who want to ‘end the Fed,’ Taylor wants to reform the nation’s central bank. He advocates that the Federal Reserve “focus on long-run price stability within a clear framework of economic stability,” and that it report its strategy and be accountable for deviating from it. Indeed, Taylor suggests that the Federal Reserve’s sole focus should be price stability, rather than its current dual mandate of price stability and maximum employment. He has at least one supporter in Congress. In late 2011, Representative Paul Ryan (R-WI) proposed a similar course of action in a Wall Street Journal op-ed.

In terms of policy, Taylor is largely correct. In my opinion, interventionism has largely not worked in the ways in which its advocates have intended. A commitment to predictability and the rule of law are extremely important for sustaining a democratic polity with a free market system. Where Taylor is less correct, however, is in his analysis of American economic history. Although the United States was partially founded on the principle of limited government, the nation at the time of the founding was largely agrarian and not as committed to economic freedom as we might initially imagine. Fearing the power of finance on our political system, many debated the wisdom of a central bank. Most significantly, slavery, an economic system in which people were considered property, would continue to grow and thrive until the Civil War and Reconstruction. It was not until after the largely industrial North defeated the Confederacy that free market capitalism and a commitment to the rule of law for all people became the country’s dominant economic and political ideologies.

In conclusion, First Principles is a thought-provoking work that deserves a wide audience. Even those readers who will disagree with the author’s analysis will find much to appreciate in this recent contribution to the ongoing debate about America’s economic woes.

Jon Lewis (c) 2012

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