Money illusion as a solution to the eurocrisis?
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Many macroeconomists uphold that a higher inflation rate in the eurozone in the range of 5-6% constitutes a large part of the remedy to the ongoing crisis. It is those people who were happy with the LTRO among others, while they remain the most vociferous critics of the “stingy” monetary policy of the ECB, arguing that more money should be printed. They argue that a higher inflation rate in the eurozone will be beneficial since it will have the twofold effect of first reducing the real value of debts, thus easing the broader deleverage of the European economy; and second of creating “money illusion” or “spending illusion” that will lead people down the garden path of spending their money instead of “hoarding” it, either because they will think that they have more money or due to negative expectations about the future value of their cash. Though it is correct that inflation diminishes the real value of nominal debts while it is also true that high inflation makes saving money more costly than actually spending it, since the future value of the money will be less than the present–inflation is like a negative interest rate on cash–the assumptions underpinning this rationale are inherently flawed and fallacious.
The underlying principle of this argument, is that the economy suffers from a shortage of “aggregate demand” and therefore it does not operate at its “general equilibrium” as the tidy models of the neoclassical macroeconomists show — yes those same models and theorems that spectacularly failed to predict or prevent the Great Recession; those that glorified the financial engineering of Wall Street together with the perverse regulations of governments which further fueled speculation and malinvestments. The reason we lack sufficient “aggregate demand”, they argue, is because people are hoarding money instead of spending it, due to the fear they have about the general conditions in the market, dominated by the uncertainty of the economic crisis. They maintain that if everybody saves and no one is actually spending, we enter into a “cyclical crisis”, a “downward spiral” where more saving leads to deeper recession. The only way to stop this alleged calamity is by means of inflating the economy through relaxed monetary policy and/or expansionary fiscal policy (“digging ditches” if necessary).
There is much that is wrong with this view, yet it is not without its historical precedent, since it was first developed by the gambler and speculator John Law in the 18th century and has been dominating economic thinking ever since, especially after it was mainstreamed by Lord Keynes through his theory of the “paradox of thrift”. The reasons this hypothesis is dead wrong are two: (1) they treat the previous level of spending as the normal rate, which is inherently misleading since it can consider bubble spending as “normal”, (2) it suffers from the main flaws, errors and misunderstandings of macroeconomics in general that fail to make classification between the various types of “spending”, “investing” etc and thus can overstate or misunderstand the real effects of certain phenomena, such as the fact that they could not treat “investments” in Greek bonds as “malinvestments” –if they could there would be no bubbles and crises.
The supposed hoarding in the eurozone comes from the fact that the GIIPS currently spend much less than they used to spend prior to the crisis. Someone looking at numbers, without any critical intention whatsoever, will identify an indubitable fall, which is reflected, in diminishing GDP, among others. To cling on to the figures themselves is misleading for one needs to question the sustainability of the pre-crisis levels of spending. In other words did we have a massive bubble in the eurozone’s periphery prior to 2008? “Yes absolutely” is the only correct answer, something which is shown in the consumption bubble in Greece or the housing and financial bubbles in Ireland, Spain etc. Thus the pre-crisis spending is “bubble spending”. Using it as a benchmark is understandably a false method.
The plain fact is that the eurozone’s periphery experienced an erratic capital inflow bonanza over the last years ever since the euro was conceived and finally launched in 2001. The interest rates between the German benchmark and the periphery converged, due to the perverse Basel Accords and the creation of the euro; both of which had the effect, inter alia, of practically treating all sovereign bonds of the eurozone as risk-free. As such Greece suddenly appeared as “Germany” in the bond markets, despite the absence of any real convergence in productive capacities. This process of nominal convergence, or artificial convergence to be more precise, is perfectly depicted in the following chart.
|Eurozone interest rate convergence. Source: BBC|
With the crisis putting an abrupt end to these abnormal, unsustainable capital flows, the countries that once enjoyed cheap and abundant credit inevitably suffer from a credit contraction and from a consequent downfall in economic activity, which is depicted on the national accounts as stagnant or negative GDP growth.
Claiming that these countries now “spend less” implies that the benchmark is the pre-crisis spending level. But if we were to argue along these lines we would completely obliterate the distinction between normal economic activity and a bubble. The neoclassical inflationists, anxious about the lack of aggregate demand, are in fact trapped in this egregious fallacy, where they see the bubble spending as if it were normal spending and hence they compound one mistake on top of another.
The cheap credit policies that were the single most important cause of the Great Recession in the first place are thought to be the panacea to the effects of the crisis. It is like suggesting that the remedy to a hangover is more alcohol. This is absurd.
Yes, countries like Greece, Portugal etc. suffer immensely, but not from some general “fall in spending”, from a vague lack of “aggregate demand” which will be cured by a money printing press. These countries lack essential productive capacities and require massive spending in particular areas of their economy, not excluding of course the political reforms necessary.
It is not cheap inflationary money that will solve their problem, but real readjustments and real investments in projects that can yield real benefits, open up real employment positions and profit opportunities and produce real savings. Inflation and its unrealistic macroeconomics are nothing more than a justification to the inane theories of certain academics and of the speculative mania of those who trade money via supercomputers, detached from the conditions in the real economy.
The “money illusion” which is propounded as the remedy to the crisis is nothing more than the manifestation of the delusions and grave fallacies that plague mainstream economic thinking.
Update July 14, 2012: Also consider reading “Is higher inflation in Germany a way to help Greece?”