The Daily Capitalist is pleased to welcome John L. Chapman, Ph.D., an Austrian economic theory economist, as a regular contributor to our growing site. Dr. Chapman will publish articles on the economy and markets. He is Chief Economist with Alhambra Investment Partners, an investment advisory firm in Florida. He is also a researcher affiliated with Hill & Cutler Co., an economic consulting firm promoting sound money and low-tax rates as the cornerstone of a stable, high-growth economy. John was a research fellow at the American Enterprise Institute. John holds a B.A. with high honors in Economics from Wake Forest University, an M.B.A. from Harvard Business School, and a Ph.D. in Economics from the University of Georgia.
Recent data from Europe suggest the economy there is already in recession with, regrettably, the political class seemingly in denial over its potential severity. Depending on the fate of bank recapitalizations there, a Eurozone recession may or may not pull the U.S. down with it in 2012, but it will bear close watch. In any case, brief highlights of causes and consequences of this are discussed below, but we start our analysis of the present global economy by recalling the similar-seeming gloom and denial of the early 1970s here.
When the great Austrian economist Ludwig von Mises died in New York on October 10, 1973, he was a broken man. Mises had devoted his life to the cause of unrestricted laissez faire — or as he called it, the unhampered market economy. He understood better than any man who lived in the 20th century what redistributive interventionism would generate: for the individual, lower living standards that bred frustration and broken dreams. And, at a macro level, slower growth, a breakdown in social cooperation due to declining investment, and in the extreme, the unraveling of civilization itself are the inevitable results of socialist policies.
As a captain in the field artillery of the Austro-Hungarian army in the Carpathian Mountains during World War I, he had witnessed the destruction of a century of peace and progress in Europe in a war that could only have happened in collectivist madness. Then came the interwar disintegration in Germany. Later, with the rise of Hitler, he felt compelled to leave Vienna for the relative safety of Geneva in 1934, and eventually hurried across France in a bus bound for Lisbon — his gateway to America — just ahead of advancing German armies in 1940, having left behind and lost everything.
For Mises the repeated denial of reality by the major powers both throughout World War I and then about Germany during the interwar period, were a depressing commentary on the inability of the political class to act in ways that benefited the populace. But this was not to be the worst of it: following the post-war rise of collectivism, in 1971 he was horrified to see the final and total decoupling of the world’s currencies from gold, the first time in at least 2,700 years that the yellow metal was not money anywhere in the world.
Mises knew — and predicted — that a regime of fiat currencies everywhere in the world would not end well. He asserted at the time that this would lead to an era of unprecedented monetary instability, fiscal profligacy that guaranteed retrograde government policies, depressions, and inevitably, social conflict. Without a sound monetary system to facilitate trade and harmonious cooperation between countries, peaceful and progressive economic order disintegrates. And ultimately, Mises knew, this leads to the kind of catastrophe we lived through in 2008, and whose reverberations will now long be felt, even as we may yet live through it all again.
Mises’ heroic life and vision — and the depth of despair he felt at the end over the Orwellian denial all round him alongside retrograde policies — were recalled to us this week for two reasons: first, the fairly unprecedented intervention by the Federal Reserve and other central banks’ easing to support initiatives undertaken by the European Central Bank (ECB) to prop up asset values and maintain interbank credit flows in the Eurozone.
And secondly, the calendar has turned inside one month until the first votes are cast in the 2012 election for the U.S. Presidency. This election, like those of 1896, 1932, and 1980 before it, is dominated by the lingering effects of a recessionary downturn borne of monetary instability. And like those others, it is an inflection point that will either ratify existing policies put into place in the wake of the recession, or bring someone new in to change the direction of policy (as an aside, in all three of those prior inflection point elections, the candidate from the challenging party beat the incumbent or his party; in 1896 the Republican challenger McKinley defended the incumbent Democrat Cleveland’s monetary policy against radical change sought by William Jennings Bryan, but in 1932 and 1980 the White House switched party hands and policy regimes).
The United States thus has two very different futures in store based on competing visions that will be discussed next year — one in which government-run health care and 25% federal spending-to-GDP levels are permanently cemented into America’s welfare state apparatus, or the other in which much policy in recent years is dismantled and the U.S. economy retreats back toward <20% spending-to-GDP.
Mises had long recognized the inescapability of such a clash to the death of the competing ideologies – between socialism and the market economy – that is now in store for us in 2012. And as such, he would understand the primal importance of vigorous engagement with the other side in the months prior to the vote. As he wrote in 1922,
Everyone carries a part of society on his shoulders; no one is relieved of his share of responsibility by others. And no one can find a safe way out for himself if society is sweeping toward destruction. Therefore everyone, in his own interest, must thrust himself vigorously into the intellectual battle. None can stand aside with unconcern; the interest of everyone hangs on the result. Whether he chooses or not, every man is drawn into the great historical struggle, the decisive battle into which our epoch has plunged us.
This sentiment resonates as one reviews the situation in the Eurozone this week in the run-up to the meeting that may yield greater fiscal coordination there in exchange for German acquiescence to a quasi-bailout of periphery debtors. And indeed this is a great historical struggle, though too many on both sides of the Atlantic seem not to realize it. The wrangling over first Belgian, then more acutely Greek, and now Italian, debt has consumed the better part of two years, with little resolution alongside growing investor risk and pervasive gloom about the Eurozone’s prospects. And here in the United States, concerns about the Eurozone have taken on an outsized proportion, with wild stock market swings on every bought rumor and sold fact. As gloomy as Mises was at his end, he nonetheless also never failed to think clearly.
And so the first thing to note is that indeed, Europe is likely headed into recession in 2012. Data on Eurozone manufacturing out this week were stark in their universal trend in the last four months (>50 = expansion; <50 signals contraction):
These data are alarming for their trend uniformity; while the manufacturing sector is now down to roughly 20% of the total Eurozone economy, like everywhere else in the world, it correlates very closely with changes in GDP growth. Capital goods equipment production is tailing off at an alarming 2% rate on a quarterly basis, partly due to rising rates in Europe, but mainly due to perceived drop in primary demand. The Eurozone PMI Index was in fact down to a 28-month low, and there were job layoffs in every country except Austria and Germany. New orders have fallen for the fifth month in a row, and at the steepest rate in 30 months, due to both the lack of demand in Europe and for exports.
And why is demand everywhere falling pari passu with rising cash positions? Clearly the Europeans themselves feel the extraordinary volatility borne of the uncertain outcome attendant with a likely Greek default, bank insolvencies, and other fairly major restructurings. But what Mises would not fail to point out to Mr. Draghi and anyone else who would listen is that, far from acting as a force for stability, the ECB and officials in Brussels are themselves fanning the fear. Speaking this week during a release of information on its Financial Stability Report, the Bank of England’s Mervyn King had this to say about the Eurozone’s present torpor:
Many European governments are seeing the price of their bonds fall, undermining banks’ balance sheets. In response, banks, especially in the euro area, are selling assets and deleveraging. An erosion of confidence, lower asset prices and tighter credit conditions are further damaging the prospects for economic activity and will affect the ability of companies, households and governments to repay their debts. That, in turn, will weaken banks’ balance sheets further. This spiral is characteristic of a systemic crisis.
Tackling the symptoms of the crisis without resolving the underlying causes, by measures such as providing liquidity to banks or sovereigns offers only short-term relief. Ultimately, governments will have to confront the underlying causes. … The problems in the euro area are part of the wider imbalances in the world economy. The end result of such imbalances is a refusal by the private sector to continue financing deficits, as the ability of borrowers to repay is called into question.
The crisis in the euro area is one of solvency and not liquidity. And the interconnectedness of major banks means that banking systems, and hence economies, around the world are all affected. Only the governments directly involved can find a way out of the crisis. …
Governor King is precisely correct. The problems in Europe, Mises would say, stem from a lack of capital, which begets solvency — they are not problems relating to temporary liquidity issues, in the main. Many European banks are, collectively, more or less insolvent, as the case may be, as the value of their sovereign holdings and other debt instruments has fallen. What to do about this?
Mises never tired of explaining that most all economic problems would be solved through market-led growth (viz., strong dollar, low tax rates on capital and income, free trade, unleashed entrepreneurship via regulatory relief). But growth does not happen through Keynes’ usual exhortation to increase government spending. Indeed, this is a solution in answer to the wrong problem. For in fact more government spending is tantamount to less capital accumulation, which alas IS the answer to the Eurozone’s core problem right now.
And secondly, central bank coordination this week leaves many investors cold with the prospect of a fairly broad round of quantitative easing in coming months including the likely participation by the Federal Reserve. Mises would again protest the folly of general fiat inflation. Swap lines from the Fed, guaranteed by good collateral, are one thing, and may indeed be appropriate to solving short term liquidity constraints in the Eurodollar market there.
But weak and vacillating global currencies have long been the core problem and cause of this deep recession, particularly the Federal Reserve, which fueled the 2008 crisis through years of ”QE”. Denizens of the Eurozone are manifestly not being told the truth about the state of their banks there, or the massive capital malinvestment that fiat monies have caused. Nor were they adequately advised of the fiscal profligacy of their socialist governments (which a fiat currency abets) – particularly in cases like Greece that involved outright fraud.
So why all the coordinating moves this week and accompanying market euphoria? Again, as Mises would say, this is merely a postponement of the day of reckoning. With respect to sovereign debt issues, as George Mason University’s Lawrence White puts it:
The Eurozone has a choice for dealing with its unrepayable sovereign debts: explicit partial defaults by a few governments’ bonds OR implicit partial defaults on all bonds by debauching the euro. The first sticks it to bondholders who voluntarily bought those bonds. The second sticks it to everyone who holds euros. So why does the second option seem to be more popular everywhere but Germany?
And Professor White, following Mises’ logic, might well say something similar with respect to the banks themselves, many of whom hold this debt: let them fail.
We have entered a strange new phase in the Eurozone saga. Truly, Rome is burning while fiddlers are playing. Months of wrangling have produced no fix to bank insolvency, and the manifest internal contradictions of the welfare state model, wrought from decades of borrowing tomorrow’s wealth to pay for today’s consumption, have, like proverbial chickens, come home to roost. Facing the truth of the situation, that failures and defaults are not only an option but vastly preferred over more bail-outs and currency debauchery, is the first of those in the 12-step program to follow.
The second step is for Europe’s business leaders to step up and fight any monetary easing that does not involve liquidity needs. Inflating away Greek debt, say, makes no sense even if the alternative is a sovereign default. Eurozone business leaders, indeed, now need to come forward as well and understand they are indeed in an “historical struggle”, just as in the United States. The only way out for them is to cast off the burdens of welfare state Keynesianism, and for the first time in a long time, point Europe toward the unhampered market economy.
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