Illustration by Louise Rouse
Central planning has increased in “popularity” ever since the financial crisis of 2008. Remember when former President George W. Bush infamously declared that “I’ve abandoned free-market principles in order to save the free-market system”? He uttered those mind-numbing words shortly after pushing the Troubled Asset Relief Program (TARP) legislation through Congress with the help of Fed Chairman Ben Bernanke and former-Treasury Secretary Henry Paulson. At the time this was necessary – central planners needed to “come to the rescue” because the free market had supposedly failed.
It was from the day when Troubled Asset Relief Program (TARP) passed into law that the world as we know it changed. It was from that day that government involvement in the economy was allowed to reach new highs. True, the trend was in that direction for the previous 100 years, but President Bush accelerated the trend. Most important, however, is the fact that since that day the US stands exposed on the global stage as no longer fully credible as a clear-cut champion and steadfast advocator of free-market capitalism.
Europe always stood in contrast to America. Europe is the birthplace of the modern Social Welfare State, i.e. modern day democratic socialism. This requires central planning and, yes, this is expensive. The financing of a centrally planned social welfare state is burdensome. Those who are productive and engaged in profit-generating activities are forced, by law, to pay for “transfers” to those who otherwise would not be compensated in a voluntary (free-market) exchange. This tension is the very basis of all politics in any country on this earth.
When social welfare states were established in the late 19th and early 20th century, the means of financing were also established. There are two principle ways to finance the government: taxation and borrowing. Taxation is relatively easy to understand – we all have to fill out the forms. Borrowing is much less understood. Most of us never buy government debt directly, yet we have somehow learned that sometimes the good faith of the country is broken. Why can a government borrow one day, but not the next? And what is the connection between the central bank – part of the government – and the central planners?
The most pure form of central banking is fixing the currency to gold. Under a gold standard, the amount a government can borrow is severely limited because there is no “buyer of last (or first) resort” for that debt. That is, there is no central bank that can arbitrarily print money and buy government bonds. The IOUs the state can issue are fixed by the amount of gold it holds. Only if the country’s “productivity” rises, can the government buy more gold, and finance whatever new services the central planners deem necessary.
Jesper Koll is a Managing Director and Head of Research at JP Morgan Japan Securities Inc. He has been analyzing and investing in Japan since becoming a resident in 1986.
Under a true gold standard, debt monetization is simply not possible – the central bank does not have the assets to do so. This does mean that the market for government debt is limited. No productivity, no new gold. No new gold, no new programs. Make no mistake – this very constraint is the reason why the classical gold standard was eliminated in the early- 20th century. It stood in the way of the financing of the newly-formed social welfare states and its central planners.
In fact, central banks were established with the explicit intention of financing the respective governments, with Europe leading the way. Central banks are not part of free-market capitalism, but the exact opposite.
Here is what former-Fed Chairman Paul Volcker had to say about this topic in a 1990 interview: “Central banks are not exactly the harbingers of free market economies… central banks were looked upon and created as a means of financing the government.”
Where Europe led the way, the US followed quickly. In the US, the establishment of both the national income tax and the Federal Reserve in 1913 coincided with the founding of the modern-day social welfare state. If you want a big government, then you need the two big guns to finance it. Sometimes you need to finance wars, sometimes a new unemployment support system, sometimes new schools. Apologies for sounding somewhat cold-blooded here – I’m just trying to explain the economics, not judging which centrally planned program should or should not be funded.
The ongoing crisis in Europe is due to the fact that the basis of Europe’s economic management is a glaring contradiction: seventeen politically independent social welfare states are operating without captive central banks. The European Central Bank ECB is not answerable to any individual country. Its “mandate” is inflation.
This was made perfectly clear by former ECB President Jean-Claude Trichet when he said on October 14, 2011 that “the ECB will not act as a lender of last resort.” The ECB’s mandate – operating instructions created by law – is not to finance any particular government.
That, in effect, is the glaring contradiction in Europe.
The seventeen countries are massive social welfare states in which government spending as a percentage of GDP is around 50%. Fully half of all economic activity is at some point funneled through the government. The financing requirements are huge.
However, none of the seventeen countries has a central bank that acts as a lender of either first or last resort, which effectively limits the amount of money that can be borrowed. Without central banks standing ready to monetize debt, the bonds of respective countries in Europe necessarily carry credit risk. Countries like Greece – and now Spain and Portugal, with France not that far off – are finding out the hard way what it means to have a political structure (i.e. democratic socialism) without the necessary tools of finance (i.e. a captive central bank).
In the early-20th century, the gold standard stood in the way of the establishment and expansion of the modern-day social welfare state. As a result, the gold standard was summarily eliminated. Today, the Eurozone effectively is operating under a psuedo-”gold standard.” The ECB’s only mandate is to control inflation. This has exposed the weak links in government finance around the continent.
Because there are seventeen distinct nations involved, the politics of the situation in Europe today is quite different than what it was in the early-20th century. Back then, it was within the power of individual governments to eliminate a monetary system that stood in the way of political objectives. Today, there are independent nation states whose objectives would be undermined by the elimination of the pseudo-gold standard in Europe.
In today’s Europe, what this really comes down to is that countries in the north do not want to bail out countries in the south. There are compelling reasons why Germany, for example, is resisting the debasement of the ECB. Personally, I highly doubt that the Europeans are willing to give up their way of life – democratic socialism. If so, the real adjustment will not come through reduced spending, or reduced central planning. Therefore it follows that the real adjustment will come through monetary reform. Personally, I wonder what the ECB will look like by the end of the year.
And what about Japan?
Clearly, Japan has no inherent contradiction – the country does have a defacto social democratic set-up, with strong emphasis on the desire for a functioning social welfare state. At the same time, the central bank is capable of funding government central planners. Indeed, on most analysts’ calculations, the Bank of Japan is monetizing well in excess of half the national debt issued. So the system is stable and, in my view, in no danger of experiencing a sovereign crisis.
Where Japan is interesting is on the other side of the debate: local governments are now more and more outspoken about the misallocation of funds imposed upon them by the central government. Osaka mayor Toru Hashimoto, for example, wants less money from the central government, but wants more local independence on deciding how the money should be used. It’s the local central planners up in revolt against the national central planners, with the local planners arguing that they can use the funds more efficiently and productively. From my limited study of the exact projects, it nevertheless looks like the locals do have strong cases. Can you imagine anywhere else in the world (never mind Greece) coming up with requests for less money, but all they want is more say in how to spend it? You got to love Japan – still very much pushing the frontier and ready to create new solutions in economic management.
Can you imagine a Japan Inc with strong local power, yet combined with a national central bank? Here is a concrete path towards bright future, me thinks.
Go, Osaka, go!
