Bondage and Discipline

When inflation rates in most countries soared during the 1970s, economists reacted by developing ad hoc theories about why this was inevitable with discretionary monetary regimes and governments that had a short term focus.  The ink was hardly dry on all these acclaimed “time-inconsistency” theories when they were decisively refuted by events.  Inflation fell sharply all over the world, in good countries and also in countries lacking “discipline.”

But economists hold on to clever theories even after they’ve been refuted; after all, the world should work that way.  Thus the theories are still taught in textbooks.

And I believe this way of thinking may have helped to create the current euromess.  Consider the following two systems:

1. The current eurosystem.
2. A fixed exchange rate regime where all countries have their own national euros, which trade at exchange rates of one.  For instance, imagine the US, Canada, and Australia all fixed their dollars to each other at an exchange rate of 1.0.  (We’re actually pretty close right now.)

If I’m not mistaken, the Europeans do have something similar in the coinage area, where each country has its own distinctive coins.  Why not do that for bills as well?  In that case the adoption of the euro would have still involved the same sort of “currency reform” (say 1500 lira for one Italian euro) but Italy would have preserved its own national currency.

Now lets think about the advantages and disadvantages of my alternative.

1. Advantage:  Italy could devalue in a crisis.  It could avoid a macroeconomic disaster.
2. Disadvantage:  Italy could devalue in a crisis, delaying needed fiscal reforms.

I don’t see the disadvantage as being all that important.  Even with your own currency, markets will still impose “discipline” in the form of higher interest rates.  There is no free lunch for deficit countries in a world of rational expectations.  Thinking you can continually fool markets with inflationary policies is not a strategy, it’s a delusion.  In addition, the peripheral countries were arguably better behaved in the pre-1999 EMS (when they’d better behave or they’d face higher rates) then in the post-1999 eurozone, when they could borrow at German interest rates and throw a wild party.  Indeed the system I am proposing (similar to the old EMS) was one where the peripheral countries were behaving in an increasingly responsible fashion, sharply reducing their inflation rates.  And before anyone jumps in and says “they were only doing that because they needed to in order to join the eurozone,” consider that the vast majority of non-European countries were also reducing their inflation rates during the 1990s.  Even countries with much worse fiscal traditions than Italy and Greece.

So why wasn’t my proposal adopted, if it was as clearly superior as I claim?  If you are a non-economist you are going to find the following hard to comprehend, but trust me, it’s true.  Even though the time-inconsistency theory was totally discredited by events, it still holds a powerful sway over the minds of the world’s macroeconomists.  Discipline is the key.  If you allow just a bit of inflation, it’s like giving a drunk a sip of whiskey.  All hell will break lose.

The Aussies showed that 6% to 7% trend NGDP growth keeps nominal interest rates above zero, allowing them to avoid liquidity traps.  Also allowing Australia to avoid recessions, and without inflation shooting up to double digits.   Yet the theory says this policy can’t work.  So we’ll just close our eyes to reality and pretend Australia doesn’t exist.  We’ll set up a regime that you can check into, but you can’t check out of.  Because we don’t trust democracy.  People might at some future date come to the realization that the system is not optimal, indeed it is a disaster.  And we can’t allow them to change their minds in that case.  It’s all about the time inconsistency problem.  Discipline and more discipline.

By the way, bondage disasters know no cultural boundaries.  In the early 1930s the discipline imposed by the gold standard destroyed the German economy–ushering the Nazis into power.  During 1998-2001 discipline wrecked the Argentine economy.  Now it’s damaging other economies.  There’s no telling where it will hit next.

Countries really do need self-control.  All the success stories exhibit that cultural trait.  But you don’t get there by putting your monetary system into a straight-jacket and throwing away the key.  Only by changing your culture.