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A Response to de Soto's 'Defense of the Euro'

Excerpted from an issue of The Dollar Vigilante dated July 11, 2012


Spain's Leading Austrian School Economist Hails Euro as Next Best Thing to Gold

A Response to de Soto's 'Defense of the Euro'

As I mentioned above, one of the factors weighing on the hard assets theme (and gold bull market) is the debate in Europe between the factions promoting a reduction in government spending or deficits (or austerity) and those promoting "growth" in government spending (or in inflation) as a way to stimulate economic growth and higher tax revenues, thereby bypassing the need for cuts. It is weighing on gold demand because there is some hope that Germany will continue to press for fiscal discipline and resist improvements to the EU's transfer schemes.

The stalemate has even inspired Spain's leading Austrian School economist, Jesus Huerta de Soto, to write a Blockean treatise in June, which he aptly titled: "An Austrian Defense of the Euro".

It was bold to name it an "Austrian" defense. His raison d'être appears to be a reliance on arguments provided by Hayek and Mises back in the early days of the Mont Pèlerin Society (1960's) when they argued against freely floating (flexible) exchange rates and in favor of fixed exchange rates ("fixity"). The position of the school then was that a fixed exchange rate regime forced governments and central banks to remain prudent. Under such a system of fixity, Hayek and Mises argued, if a government inflated persistently and could not fund imports by its own production it would be forced to settle its payments deficit in gold (i.e. there would be an outflow of gold).

The basic argument here is that the objective of fixed exchange rates (under a gold standard) between nations tends to check the inflation tendencies of each state while flexible exchange rates tend to encourage them.

Hayek wrote a book about this in which he argued that flexible exchange rates amounted to a sort of "monetary nationalism" - implying that with each nation state in control of its own monetary policy there would exist competitive pressures between mercantilist interests wishing to "combat imports by devaluation."

On the other hand, Hayek wrote,

"So long as the preservation of the external value of the national currency is regarded as an indisputable necessity, as it is with fixed exchange rates, politicians can resist the constant demands for cheaper credits, for avoidance of a rise in interest rates, for more expenditure on "public works," and so on"

Flexible exchange rates would "preclude an efficient allocation of resources on an international level, as they immediately hinder and distort real flows of consumption and investment", writes professor de Soto. Mises also saw that since flexible exchange rates were able to hide the effects of inflation better, governments could grow.

Solidifying the concept of "fixity" as an inherently Austrian School position, de Soto cites Hayek once more,

I do not believe we shall regain a system of international stability without returning to a system of fixed exchange rates, which imposes on the national central banks the restraint essential for successfully resisting the pressure of the advocates of inflation in their countries -- usually including ministers of finance. (Hayek 1979 [1975], pp. 9-10)

Because the individual nation states in the eurosystem today do not control their own monetary policies, the professor likens it to a system of fixed exchange rates...a kind of fixity. He argues that the system is the next best thing to a gold standard, clearly preferable to the previous pre euro system of exchange rates in Europe.

This is where the controversy really starts.

For professor de Soto says,

"The introduction of the euro in 1999 and its culmination beginning in 2002 meant the disappearance of monetary nationalism and flexible exchange rates in most of continental Europe. Later we will consider the errors committed by the European Central Bank (ECB). Now what interests us is to note that the different member states of the monetary union completely relinquished and lost their monetary autonomy, that is, the possibility of manipulating their local currency by placing it at the service of the political needs of the moment. In this sense, at least with respect to the countries in the eurozone, the euro began to act and continues to act very much like the gold standard did in its day. Thus, we must view the euro as a clear, true, even if imperfect, step toward the gold standard."

In fact, he says, in one way, the euro even "surpasses the gold standard."!!

"We must note that abandoning the euro is much more difficult than going off the gold standard was in its day. In fact, the currencies linked with gold kept their local denomination (the franc, the pound, etc.), and thus it was relatively easy, throughout the 1930s, to unanchor them from gold..."

He then lists the empirical evidence: the austerity measures taken in his own country, Spain, for example, where the government has altered its constitution, suspended programs, cut salaries, raised the retirement age, and so on; and he notes that "significant liberalization has occurred in the labor market, business hours, and in general, the tangle of economic regulation." Furthermore, this is happening in all of the peripheral eurozone countries.

To be fair, the good professor sees these results as "insufficient", and obviously, he'd like to see much more.

Nevertheless, de Soto's position is by no means an "Austrian" defense as I have set out to prove.

My Critique of de Soto's Defense

First, we absolutely cannot share his enthusiasm about the difficulty of abandoning the euro as a reason to hail it as better than gold. Why can't the same argument be applied to the United States for example? Generally my criticism of his arguments, which is not really the main objective of this analysis, can be summed up as follows.

The crisis of the euro was caused by an inherent inflationary bias in the eurosystem. These include the incentive for national central banks to buy high yielding government debt, like say Greek debt, and use it as collateral to draw a low interest rate loan from the ECB - i.e. a process by which the ECB monetizes the debts of eurozone governments and encourages those with high time preference to borrow and spend even more.

As Austrian economist Phillip Bagus notes in a separate essay,

"Several independent governments can use one central-banking system to finance their deficits and externalize the costs in the form of a loss of purchasing power of the Euro onto all users of the currency. The incentive is to have higher deficits than other eurozone governments in order to profit from the monetary redistribution...During the early 2000s an expansionary monetary policy lowered interest rates artificially. Entrepreneurs financed investment projects that only looked profitable due to the low interest rates but were not sustained by real savings. Housing bubbles and consumption booms developed in the periphery." Bagus

In fact, this bias has always been known, which is the reason the stability and growth pact exists. It was supposed to restrain this tendency. Most everyone knew it wouldn't. And it's the reason that the crisis exists.

Moreover, as Bagus and others have revealed about the eurosystem's payments system (target2), this eurosystem is precisely nothing like a gold standard. It encourages money creation at the periphery and underwrites the carrying of increasing balances that under a gold standard would be forced into settlement.

"While in a gold standard, the payment of imports (if not financed by private loans) is limited to the outflow of gold, there is no limit for TARGET2 credits, i.e., the import surpluses may be financed without any limit by the creation of Euro claims" http://www.mises.org/daily/6067/Passing-the-Bailout-Buck

So Professor de Soto, in our opinion, seriously discounts the inflationary bias in the eurosystem that brought about the crisis to begin with. Needless, he likely also overestimates the extent of austerity undertaken in Europe to date; as well as the political commitment to this aspect of the eurosystem by the rest of Europe.

What's more, he seems to ignore that, as we saw last week, the ECB still has a price stability mandate and has to ease if it perceives a threat to aggregate demand in its neo-keynesian framework of analysis.

Finally, and perhaps most fundamentally, his analysis of the eurosystem as analogous to a fixed exchange rate regime may be flawed. We are not talking about different currencies under an international gold standard, after all. Would it be any less valid to argue that the US dollar system similarly can be compared to a system of fixed exchange rates (between the member states), and that for the same reasons there is no way out of the dollar - so therefore the states are forced into austerity? Perhaps, but the centralization of such a union produces the largess at the federal level - a level that is just now being created in the eurosystem, unbeknownst to de Soto?

In order to emphasize this point I only need to defer to Hans Herman Hoppe - America's leading Austrian School economist - in an unrelated lecture on the advantages of small states and the dangers of centralization.

The lecture was given in 2005 and describes the euro more in the way you understand it from our own narrative - as a step towards greater inflation...a step further away from sound money...not toward it as de Soto argues.

Advantages of Small States and the Dangers of Centralization | Hans-Hermann Hoppe

In his lecture, at about the 30-minute mark, Hoppe discusses the euro not as a system of fixed exchange rates between the various euro nations within the eurozone as professor de Soto does, but rather as a step towards greater centralization of monetary policy that is more inflationary than the former system of flexible exchange rates between independent states. Hoppe's argument is twofold. On the centralization side, he points out that the more and smaller the states are, the harder it is for them to tax and bully their citizens on account that they can just get up and move to a competing state. This is one of the incentives of the drive toward centralization, he notes. Thus as political power over a given region consolidates and centralizes, he sees a reduction of this competitiveness between the former smaller states that kept them from plucking too many feathers, if you will.

In other words, many of the checks against government expansionism, including against inflationism, will have disappeared. Applying this to the subject of money, Hoppe pointed out how historically centralization played a part in abolishing gold/silver. He said that in "every" case in history, sometimes earlier, sometimes later, but all states have destroyed the free market money standard and replaced it with its paper money in three steps:

1) they first monopolized the minting of gold,

2) then they tend to monopolize the issue of money substitutes (claims to money), and

3) finally, they cancel redeemability.

In my view, there is one more step: the state's attempt to regulate the value of money, as in the case of the gold-silver ratio historically. I think that is a pretty early step too. At any rate, Hoppe's point is that centralization is a tool in the state's toolbox that facilitates its expansion. Thus, he sees the euro as more inflationary than the least inflationary currency of the previous system, say, the German Mark. Specifically, he thinks the more centralized euro, which de Soto likens to a system of monetary fixity, is more inflationary than the former system of floating exchange rates. This seems to confirm experience. After all, the reason for the euro crisis is no mystery as I said earlier. It was driven by the inherently inflationary mechanisms built into it that encouraged governments like Greece and Spain to borrow and spend too much. But even in terms of money supply: the ECB expanded money supply by 113% over the last ten years, hardly that different from the 135% increase in US money supply over the same period, or the 115% increase in UK money from 2001-2011. Indeed, it is empirically more inflationary than euro area money supply in the 1980's and 1990's according to Mike Pollaro's work on Euro area money supply going back to 1980 here: http://blogs.forbes.com/michaelpollaro/files/2012/07/RTMSEuro-6-30.pdf (See page 7 of the pdf - red line in the graph for yoy% changes)

Indeed I don't see how anyone can call the eurosystem a step towards gold, especially after listening to Hoppe.

The second part of Hoppe's argument on flexible exchange rates relies on the shame factor. In his lecture he explains the lesser inflation of the former regime in Europe (pre euro), and ties it to the built in incentives of a system of flexible exchange rates between many small (and independent) countries. Specifically, he points out that since currencies float, those currencies that fell the least would gain a prestige and increased marketability in the region like the German Mark did in its day (post WWII). Now this again contrasts with de Soto's argument, in which he argues, based on Hayek-Mises, that the mercantilists would engage in competitive devaluations.

Conclusions, and the Outlook for the Euro

The reason we have brought up this debate is because it is directly influencing the trade in gold. The dollar has been given a vacation by media these days. And whether de Soto is right and the eurosystem forces the nation states into greater austerity and sounder monetary policies or whether Hoppe is right and the euro is now seeing a fall from grace is important for our gold market outlook. And since we are not talking about simple minds, like Paul Krugman, it is an important debate. On Hoppe vs de Soto we could point out that de Soto follows the Mises-Hayek tradition whereas Hoppe breaks from it. But then, so did Rothbard. Mises's views on the state and democracy were undeveloped. But that is another essay. What is important with respect to the Hoppe position is his point on centralization, and how it liberates the natural checks against the state's expansiveness.

Hoppe's second point stands on less solid footing. It is true that some nations have discovered the prestige that is associated with having a "relatively" sounder monetary policy (and hence a stronger currency).

On the other hand, the vast majority is content with accumulating those currencies, and subjecting their own to a policy of mercantilist debasement in order to, as Mises put it, "combat imports..."

Nevertheless, Hoppe's analysis of the euro is in our view generally the more correct view.

On the outlook for all this for the Euro, Phillip Bagus puts it this way,

"The future of the euro and the EU depends on who will finally win. If France and the periphery get their way, there will be a fiscal union and more centralization. The euro will be a political and weak currency. If Germany wins and there is a reformed SGP, the euro will be a strong currency in the long run. Yet, there exists also the possibility that the losing side will be so unhappy that the eurozone disintegrates. In the case of a German victory, more austerity measures and a reduction of the living standard may lead to unsustainable social unrest in Greece. Greece may then leave the eurozone and devalue its new currency to continue its spending spree. This could trigger a chain reaction with other countries exiting the eurozone and cause a banking crisis. In the case of a Germany defeat, there will be more centralization in Europe and possibly double-digit inflation rates in the future. Then a German "tea party" opposed to the wealth transfer into the periphery may arise. Germany may then leave the euro, also triggering a disintegration of the eurozone and a banking crisis."

If you accept the Hoppean analysis, as we do, then it is only a matter of time before the euro politicians find new ways to fix the constitution and centralize the "transfer union" further, which will lead away from austerity and sounder policies. Nevertheless, so long as the Germans continue to fight, it could continue to weigh on gold.


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