Rethinking Bretton Woods | Thu, Sep 13, 2012
This article draws on Minsky's "two price" theory to come to some conclusions on the positive and negative aspects of ECB Chief Mr Mario Draghi's recent announcements to support indebted countries in the eurozone.
(The following article appeared on South -North Development Monitor SUNS, a publication of Third World Network, Issue 7436, September 12 2012, from where it is reproduced.)
Washington DC, 12 Sep (Aldo Caliari*) -- Two types of responses were elicited
by the European Central Bank (ECB) chief, Mr Draghi's widely-quoted remarks
that the ECB stood ready to do "whatever it takes" to save the euro.
In one school there are those who decried yet another European Bank intervention
as pointless. They offered as grounds the evidence that the previous interventions
failed to produce anything but short-lived results and postponed inevitable
structural reforms by target countries.
In another are those who think the ECB was finally stepping up to the plate. If
anything, they claim, Mr Draghi should withdraw his statement of a week later
when he conditioned Central Bank's action on Eurozone members requesting
assistance from the bailout funds, which would presumably require their adoption
of tightening fiscal measures.
Both of these accounts have some truth. Those skeptical got this right: further
intervention by the European Central Bank to stabilize credit markets, other things
staying equal, will be a waste. The second school also got something right: the
ECB should step up to the plate and take forceful action.
Is this stating a contradiction? Not really, if one looks at them through the lens of
Minsky's "two price theory."
In his theory, Minsky referred to the existence of two systems of prices in a
capitalist economy: one price for current output and one for capital assets. When
prices for current output are stable at a level above prices for capital assets,
conditions for investment are favourable, and vice-versa. So, to assess the
likelihood of investment (and thus growth), one should look at the relationship
between those two prices, their relative position to each other, and not the
particular level of any one of them considered in isolation. As a corollary, there is
no point in stabilizing capital asset prices unless current output prices (the
expectation of firms' profit flows) would be at a higher level, thus leading to a
demand for loans for investment.
Applying the "two price theory" framework to the question at hand, it is easy to see
what is right and wrong in each of the reactions mentioned above. The ECB's
willingness to do "whatever it takes", as long as it can influence only one of those
two prices, that of capital assets - perhaps rightly so given its mandate - will not be
enough. What matters for the economy to resume growth is not that price alone,
but how that price relates to the price of current output.
What is happening with this second price? With the European region entering
recession, everything seems to indicate that it will continue to fall, in the face of
lower demand. Such expectations are only reinforced by the austerity programs
that European governments are taking. This also explains why the monetary
stimulus provided through banks has ended fattening those banks' reserves rather
than increasing business lending. Businesses cannot credibly commit to repay
loans in an environment where their profits are expected to fall.
This is why, if all things stay equal - without a turning around of expectations for
demand and thus current prices of output - there is no point to further ECB
intervention. Such intervention needs to be accompanied by strong fiscal stimuli.
Minsky understood this and that is why he was also a forceful advocate of
offsetting expectations of profit falls through increased government spending.
Critics say that, since the problem is excessive debt, throwing more debt at it will
only worsen matters. They feel their views are validated when the markets react
negatively to governments' unwillingness to cut spending. What they fail to
observe is that the commitment to fiscal cuts also leads to negative market
reactions as soon as markets realize that cuts will bring further contraction making
an exit from the debt crisis not credible. When creditors look at debt-to-GDP or
debt-to-revenue ratios, they are not just concerned with obstacles to growing the
denominator but also with obstacles to lowering the numerator.
In the long-term, increased fiscal spending is a more credible alternative with
which to accompany ECB further interventions. It could be implemented in a
variety of forms, from joint "Eurobonds" to programs for private household debt
restructuring or haircuts for bank bondholders to reduce the need for bank
capitalization commitments from the public purse. What matters is that they
increase demand and the prices of current output stabilizing them at higher level
than the price of capital assets. Only then, lending for investment will be restarted,
multiplying the effectiveness of ECB actions and eventually allowing that they be
gradually unwound. When genuine recovery is underway, debt reduction will be
much easier to achieve.
Of course, it is outside of Mr Draghi's domain to take action on the fiscal front.
But if he is willing to condition ECB action on fiscal pledges, he should make sure
they are the right ones: pledges of a concerted fiscal stimulus effort in the
(* Aldo Caliari, who contributed this article, is Director, Rethinking Bretton
Woods Project, Center of Concern, Washington DC.)