POLITICIANS NOW FACING PROBLEMS NOT CONTEMLATED SINCE THE THIRTIES

The current economic situation is challenging because it is bringing up issues that are outside the range of experience of either the present, or the most recent previous,  generation of politicians.

One would have to back to the 1930s to find politicians who actually had real life experience of the sort of problems we  face today

In the 1930s, there was

1.) a collapse of confidence, in and between, banks, which paralysed the economy.

2.) There was a gold standard (currencies had a fixed exchange rate with gold and the supply of gold was limited) which, like the euro, precluded  countries using the standard from devaluing or printing money as  ways on inflating debts away  and thus  making savers pay for  the mistakes of debtors.

3.) There was also a slowdown in the rate at which people spent money (“velocity” is the economic  term for this),  and that meant  there was less bang for each  buck  that was  printed.

All these things are happening today, 80 years later.

NO RELIABLE  MEASURE OF VALUE ON WHICH TO BASE BANKING DECISIONS

The advantage of the gold standard was that it provided a fixed measure of value. And a banking system needs a fixed measure of value, which each bank can hold, and which provides it with a guide as to how much it can lend.

Since 1971, when the US ceased to exchange dollars for gold at a fixed rate of exchange, the world has lacked  a fixed measure of value on which to found its banking systems.  It has had to improvise.

In the  absence of  gold, sovereign debts of Governments were pushed into assuming  gold’s  role  as  a fixed measure of  value , on the assumption that Governments always repaid their debts at face value, and if a bank held enough Government bonds ,  it was thus , by definition,  a sound bank.

GOVERNMENT  DEBT A POOR SUBSTITUTE

The difficulty was that , unlike gold, there is  no natural limit on the  amount of  Government debt.  Indeed the United States, and other Governments, issued large amounts of debt to people, like the Japanese and Chinese , who wanted to save for the rainy day and were prepared to buy the debt at ridiculously favourable prices to the borrower.  That, in turn,  led to an over expansion of the US and other western economies on the basis of credit fuelled by an oversupply of Government bonds.

Now the very clever people in the bond markets have discovered, to their amazement, that Government bonds are not as good as gold after  all. If you have too much of a good thing, it is not good any more.   Here is how their eyes were opened.

THE THINGS THAT SPOOKED THE TRADERS, WHO HAD NO SENSE OF HISTORY

 Political parties threatened to, deliberately and unnecessarily , default on  Government debts to make a political point. This happened in the US recently.

 Some Governments produced deceptive public accounts to allow them to issue more debt than they can afford to service.  This happened in Greece.  Governments  generally, and many businesses, simply  borrowed too much,   at artificially low interest  rates .

The fact that none of the highly educated people in the rating agencies, banks, and accounting firms did not see the risk that  such  errors might be made , and  price the  risk such errors into the interest rate they charged on Government bonds,   was a result of  the  “tunnel visioned”  specialisation,  that passes for education in many our leading universities nowadays.

 We paid a price for the  fact that economics courses focussed insufficiently  on economic  history and  finance was  taught  as if it was  a branch of mathematical engineering,  rather than  something inherently under the influence of  psychology and politics

All this critique is fine as far as it goes.  But is there a solution?

HOW A EURO BOND MIGHT  SOLVE THE PROBLEM

I think we will only get our economies going again, if we can restore belief in a fixed measure of value ,that can perform the role that gold performed in the past, and  which sovereign bonds  performed until recently.

That is where the proposal for a euro bond could be helpful.  It could be a lot more than a short term fix.

Suppose all the euro area Governments could agree that they would all mutually guarantee the repayment of a  new  collective euro bond,  and that in addition  it  would have first call on (say) a fixed share of all VAT receipts.  Suppose then that this guaranteed  euro bond  could only  be issued by a euro area Government  in limited circumstances eg.

1,) that their budget law , and five year projections,  had been approved in advance by the European Commission and 

2.) the euro  bond  could only be issued  cover a limited  proportion of their total borrowing, as long as their overall debt/GDP ratio was more than (say) 40%.

This would have a number of advantages.

It would guarantee a minimum borrowing capacity to all euro area states.

It would, however, penalize countries who had debt /GDP ratios over 40%, because they would be forced  to borrow commercially  and pay higher rates of interest on the  extra borrowing, which would be a strong incentive to them to  get their debt level down as quickly as possible to  40% or below.

Because it would be guaranteed by all euro area Governments, and have a prior call on VAT receipts,  the new euro bond would have real credibility globally, as well as within the EU.

Banks who held such new euro bonds would now have something of real and certain  value, on the basis of  which they could confidently base  their lending  decisions. In that way, credit would start flowing again, jobs would be created and permanent structural damage to our economies avoided.

If this happened, Europe, rather than being the world’s economic problem, could be the provider of part of the world’s economic  solution.