The Foolish Quest for Stability

It is now the established consensus that the 2007-2009 financial upheaval was the fault of the self-destructive propensity of unregulated markets. The minority view, which the writer of this column has also argued, is that the system was a hybrid between freedom and regulation and each element undermined the possible virtues of the other. There is no telling what the outcome would have been with a system of more, less or no regulation. The issue may be decided by a future generation of economic historians. Meanwhile, bygones are bygones and we are in for an ardent quest for more stability, more fixity of elements that are destined to move and change to adjust to a changing reality. The first batch of new regulations, the Volcker Rule and Basel III, is already with us. It may be claimed that it means to adapt the system to changed realities. In fact, it looks more like a rule book for fighting the last war, and the perverse effect of Basel III on banking and insurance are already becoming apparent.

The most fervent and excited of the current quests for fixity is in the eurozone. When twelve of the fifty American states are technically bankrupt, nobody is predicting that the dollar will become worthless and the United States will fall apart in fragments. Such a fate, though, is supposed to await the euro and the EU if some of its tottering sovereign debtors are forced into default. It is not really obvious why this is so readily accepted as gospel truth, except perhaps because the media unanimously trumpet that it is so. Accordingly, after some angry protests by the German taxpayer who is the ultimate EU paymaster, Greece and Ireland received emergency transfusion in 2010. Portugal may only just get by in the next two years without being bailed out, but at a high cost; it had to pay 6.7 per cent interest on new ten-year loans last month. The majority of eurozone countries are suspect, most notably Spain, Italy, Belgium and France (in that descending order). All have the same chronic ailment: their budget deficit is a higher percentage of their GDP than the rate of growth of the latter, so that their national debt is a steadily rising proportion of GDP. The London Economist calculates that by 2015 it will be 165 per cent for Greece, 135 per cent for Ireland, 100 per cent for Portugal and 85 per cent for Spain (this relatively sober Spanish number is thanks to the thrifty Aznar years, just as the high French figure is due to the spendthrift Mitterrand and Chirac regimes). Evidently, the annual interest charge on the debt pre-empts a growing share of GDP, making the burden ever harder to bear. Adding insult to injury, much of the debt is not “owed to ourselves”, but to foreigners. The corresponding percentages are 58 for Greece, 64 for Ireland, 66 for Portugal and 39 for Spain. The service of this foreign-held debt is a charge on the balance of payments which may be literally impossible to meet by generating a surplus.

Instead of giving it up as a bad job and meeting the oncoming defaults by what is politely called “restructuring,” the EU after much heart-searching has decided to throw good money after bad, redeem maturing private debt by loans from a new intergovernmental stability fund and preserve the status quo at least for the next few years. If, as it now looks likely, the arithmetic will get worse every year, such quest for stability will have proved to be a foolish one. The only realistic hope for a way out would be a rise in the inflation rate from 2 to 6-7 per cent—in itself a dreaded element of instability—that would shrink the debt in real terms. Even that would only work for countries whose debt was mainly medium or long term, for the service charge of short-term debt promptly moves up in parallel with the inflation rate. France, for instance, would get less debt relief from inflation than Britain.

In focusing its current agenda on the unwelcome variability of exchange rates and commodity prices, the G20 is also off to a quest for stability. As the quest will exhaust itself in 20 bored delegations listening to each other’s wishful thinking speeches in summit meetings and sending meaningless replies to each other’s dreary memos, one might be tempted to ignore this attempt at world economic government. However, it does deserve some wary attention, for the loud rhetoric of the G20 promotes in the public mind the kind of fantasy economics that could in future years well be reflected in foolish policies.

Mr. Sarkozy, president pro tempore of the G20, is calling for it to adopt a “new monetary system” to replace the present vacuum. In practice, this means the re-introduction of fixed exchange rates. At present, only China operates with a fixed rate, one result of which is the accumulation of $2,600 billion of currency reserves which is of no conceivable use, present or future, for China has little chance of swinging into a massive trade deficit, and the United States of America into a massive trade surplus, that would enable these reserves to be spent on something useful. However, despite the widespread nostalgia for fixed rates, there is no danger of a “new monetary system” where the burden of adjustments now borne by exchange rates would have to be borne by other variables, such as employment, the price level and taxes (all of which are also objects of the quest for stability). At worst, the G20 may resolve that the question “merits further study.”

The other major point of the G20’s agenda is the regulation of commodity prices. Nobody knows how this could achieve stability any more than how to make water flow upward, but everybody claims to knows that speculation is the culprit and must be brought under tight control.

If there were no speculation, i.e. no adjustment to what the future is likely to bring, commodity stocks would always be at the minimum needed to conduct ordinary trade, for carrying more than hand-to-mouth stocks would tie up capital. Minimum stocks provoke high volatility of the price in response to any change in supply or demand. How does speculation, accused of causing more volatility, affect this mechanism?

When a speculator anticipates a price rise, he will seek to buy the commodity as a “future”, i.e. for future delivery. If his demand is met by a “short seller” who promises future delivery, one ends up gaining, the other by losing, they settle and nothing happens to stocks. If, on the other hand, no short seller is there to meet the demand of the long buyer, the “futures” price rises above the current “spot” price, the difference (called the “contango”) making it worth while to buy the commodity for spot delivery now and selling it immediately for future delivery. If the speculation turns out to be profitable, there must have been a net speculative addition to stocks when the price of the commodity was low and a net reduction in stocks when the price was high. In other words, speculation, if successful, withdraws stocks from supply when the need for the commodity is at a low, and releases stocks to the trade when the need for the commodity is at a high. It is hard to see how regulation of commodity markets and the suppression of speculation could possibly do better than this. But then the problem no doubt “merits further study” to keep the foolish quest for stability chugging along.