Stephen King: A lesson in public finances history

Governments cannot increase borrowings indefinitely. Someone has to take the pain
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The Independent Online

Before the First World War, the Gold Standard had worked reasonably well. There had been occasional ups and downs in the world economy, but countries had learnt how to cope. Currencies were mostly backed by gold. Each central bank promised to swap notes and coins for gold at a fixed rate.

That promise kept the international monetary system alive. If a country was borrowing too much from abroad and thus living beyond its means, it would typically experience a run on its gold reserves. The central bank would then have to raise interest rates, reduce money supply and deflate the domestic economy. Growth would falter and prices would fall, reducing demand for imports and increasing the competitiveness of exports. The amount of borrowing from abroad would be lowered. The Gold Standard therefore prevented nations from living excessively. It faltered at the start of the First World War as countries rushed to print money in support of military follies.

The huge costs of that war were seen not only in the horrific loss of life. There were also incredible economic costs. Some nations ended up enormously in debt. Germany suffered the most. Like others, it had borrowed heavily to fund the costs of its military endeavours. But it also ended up with a massive reparations bill, a consequence of the short-sighted decisions reached at the Treaty of Versailles.

Others, however, also experienced tremendous economic pain. The war had left much of Western Europe completely impoverished and increasingly beholden to American creditors. Yet, coming out of the First World War, no one could imagine a peacetime monetary system based on anything other than gold. Hard currency mattered and it wasn't long before political leaders were working out how to get back to the Gold Standard. There was, however, a big problem. Because currencies had lost so much of their value during the war, what was the appropriate rate for currencies rejoining the Standard?

For Britain, the then Chancellor Winston Churchill made a fatal error, one he came to regret. His decision to rejoin the Gold Standard in 1925 at an inappropriate rate left sterling overvalued and British exports uncompetitive. He had hoped to burnish his "hard currency" credentials, but Churchill only succeeded in exposing the soft underbelly of the economy.

For membership to work, the UK economy would have to go through years of painful deflation. Not surprisingly, there was popular resistance. In 1926, the country was brought to a standstill through a general strike. The French authorities, who had built up huge sterling reserves earlier in the decade, decided it was time to swap their sterling for gold, thereby reducing Britain's gold reserves. The decision was sensible – the French rightly recognised that Britain had returned to the Standard at too high a rate – but the system's logic triggered more deflation in the UK.

Fearing that the UK was about to leave the Gold Standard, and fearing also that the move could be a disaster for the international monetary system, the Federal Reserve Board loosened US monetary policy in 1927, hoping that the exodus of gold from Britain – and from Europe more generally – to the US would ease. In doing so, the Fed stoked up the biggest financial bubble in modern history, a bubble which ultimately led to the Wall Street Crash and the Great Depression which followed. As the Depression took hold and each country fended for itself, the Gold Standard completely crumbled. The world descended into economic, financial and political anarchy.

Now, you might be wondering why I have chosen to set out in so much detail events from another era. There are two reasons. First, if one of the key causes of the inter-war crises was too much public sector debt, we should now be very worried because, once again, public sectors are awash with the stuff. Second, when a public sector holds too much debt, a conservative monetary regime designed to balance the interests of both creditors and debtors can all too easily be thrown out of the window.

Few governments in the Western world have yet adopted a serious plan designed to get their public finances in order. The Irish are doing well and the Greeks are slowly being forced to adopt more than a smidgen of austerity. The Germans are intent on reducing their budget deficit as fast as they possibly can, consistent with the rules governing the eurozone. As for the rest, it seems as though the public finances have been taken over by a group of Dickensian Mr Micawbers, always thinking that "something will turn up". Unfortunately, finance ministers have mostly forgotten Micawber's other maxim, namely: "Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery."

Governments cannot increase their borrowing indefinitely. They will ultimately be faced with hard choices. Someone will have to take the pain. Will it be taxpayers, recipients of public sector provision and workers? Or, instead, will a country's creditor lose out? When austerity hits, it can hit in more than one way. The Gold Standard was designed to ensure that the domestic economy always did the adjusting and that the creditors' interests were mostly looked after. But as popular resistance to wage deflation began to build, partly through the growing strength of unionised labour, it proved increasingly difficult for economies to deliver the necessary internal adjustment. Eventually, domestic social and political pressures toppled the Gold Standard, leaving many creditors licking their wounds as nations either devalued or defaulted.

The dangers today are obvious. Within the eurozone, there is an obvious inconsistency. The Germans want a domestic inflation rate no higher than 2 per cent and thus refuse to countenance any form of fiscal reflation. If other eurozone nations are to improve their competitiveness against Germany, they will have to deliver inflation rates of zero or, even worse, outright deflation, leaving eurozone inflation well below the European Central Bank's target. Put another way, it seems impossible in current circumstances for both Germany and the eurozone as a whole to achieve price stability. The strains between national and collective interest are precisely those which led to the inter-war crisis.

Outside the eurozone, life seems easier. Whereas in the 1920s, economic rebalancing in the UK had to be achieved via domestic deflation, today it can be achieved by opting for persistent exchange-rate depreciation. This, however, is no more than a default to the UK's foreign creditors. Over the years, they have happily bought sterling assets believing that Britain was committed to a hard currency via its inflation target. They may now be worrying about that commitment, not because the Bank of England is about to do something silly, but because the political parties have yet to prove they have the ability to deliver major spending cuts.

Promising cuts is easy; delivering them is an entirely different matter. Monetary stability is ultimately grounded in fiscal stability. If, after the general election, it simply proves impossible to deliver the necessary budgetary cuts, what then happens? Does sterling collapse? Does the new government raise the inflation target? Will the printing presses be turned back on? Will Britain see its credit rating downgraded, thereby increasing the cost of international borrowing? I don't have the answer, but I know it's time to dust off the history books.

stephen.king@hsbcib.com

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