IN AN earlier article I said that I was disheartened by the chain of disappointments that are perpetuating the crisis of the Eurozone. Many analysts, and I among them, believe that the European Central Bank has the ability to change history, or is destined to repeat it. To quote the world renowned economist and Nobel Prize recipient, Milton Friedman, “Governments never learn. Only people learn”. On this point, one can only hope that he is wrong.
LEARNING FROM THE DEPRESSION
The Eurozone crisis has been drawing a great many parallels to the Great Depression, though some economists feel that that is unjustified. However, quite a few believe that some of the blame for the Great Depression must be placed squarely at the feet of the central bankers, which steadfastly supported the gold standard. Back in the late 1920s and early 1930s, the majority of the worlds’ developed economies were all tied to the gold standard, which meant that they pegged their circulating currency to the actual amount of gold bullion they held in store. That limited their ability to increase the money supply, which in turn prevented them from lowering interest rates. A liquidity crunch ensued, and the banking system – such as it was—essentially collapsed.
Finally, in 1933, President Franklin D. Roosevelt took the US off the gold standard, which gave the Federal Reserve leave to print money, as and when needed. A few years after, as their economy worsened, the UK would similarly abandon the gold standard. Even now, Federal Reserve Chairman Ben Bernanke acknowledges that it was a mistake for the US government to have waited that long to abandon the gold standard and to ignore the demand to increase the money supply. He is among many who believe that that was a major policy misstep.
And that is where the European Central Bank finds itself right now – in a similar place to the Federal Reserve Bank of the twentieth century’s Great Depression, on the verge of a major policy misstep that could result in the twenty-first century’s Great Depression. Yes, it is a different century, but the mistakes being made are unchanged. The US, no longer tied to the gold standard, through the Federal Reserve’s monetary policy, can print money as and when needed. As it is now, the ECB is standing idly by, watching the Eurozone economy rapidly deteriorate for want of additional capital, and using the excuse that it is bound by the tenets of its mandate.
CENTRAL BANK ACTION
The recent actions by the world’s major central bank went some way to appeasing the market, but the euphoria was fleeting. Markets need quick and decisive action; they are hopeful that the rescue of Italy and perhaps Spain, as well, will be sufficient to avert a crisis. If that is what they are hoping, they are making a fatal mistake.
Take the revised yield curve on Italian sovereign debt as evidence of how worried investors really are. Two-year bonds were trading at a higher yield than the 10-year benchmark notes; that means investors are already pricing in a default. Even a successful rescue doesn’t provide assurance that Italy will never go bankrupt at some point in the future. The government is in the process of instituting various reforms, many of which will be wildly unpopular with the Italian people, but are absolutely necessary. But Italy won’t be the only Eurozone member facing austerity; hardships will be prevalent throughout, and liquidity will be sharply squeezed. Just like in the 1930s.
It’s quite possible that, without quick ECB intervention, the liquidity squeeze could hit the major indices incredibly and protractedly hard. Historical data suggests that investors could see a decline in global indices by as much as 50 per cent, and which could last as long as three to four years.
It can all be averted. Milton Friedman, considered one of the great thinkers of our time, said this, “The Great Depression, like most other periods of severe unemployment, was produced by government mismanagement rather than by any inherent instability of the private economy.” Certainly, Ben Bernanke, who once offered an apology on behalf of the Federal Reserve for the needlessly enduring Great Depression, would agree.