The history of finance is partly the history of a struggle for a stable, secure way to measure value. And, like any quest for certainty in our unpredictable world, it was doomed to failure.
The latest financial crisis powerfully highlights this vulnerability, as it destroys any sense that we can put an accurate price on assets. Most people are now convinced that this shortcoming is inherent in the financial system. But uncertainties about value also expose deep problems in the political order.
In the past, metallic money provided an inconvenient and unsatisfactory solution to the question of value. It was inconvenient because gold was awkward for everyday transactions, and silver had too little value for major transfers. Moreover, metallic money was prone to unpredictable shifts in value with the discovery of new supplies. The arrival of silver from the New World in the 16th century triggered sustained inflation. The discovery of gold in California in the middle of the 19th century and in Alaska, South Africa and Australia 50 years later also produced mild inflation, while the absence of such new discoveries in the 1870s and 1880s led to mild deflation.
PAPER MONEY
Consequently, many economists and politicians concluded that paper money could be more easily controlled and more stable. This innovation, which was dependent on high-security papermaking and printing techniques, transformed the 20th century. But it initially produced a much less stable outcome, because of the strong temptation of political abuse. Instead of moderate inflation, most of the 20th century was wildly inflationary, as governments over-issued currency.
In the last two decades of the 20th century, however, an intellectual revolution occurred. Entrusting monetary policy to an independent central bank promised to be a perfect way to counter the political pressure to print money. When Paul Volcker took over as chairman of the US Federal Reserve in 1979, he began engineering a sustained and successful process of disinflation. Europe learned the same lesson with the move to monetary union and the creation of the European Central Bank to manage its new currency, the euro.
As a result, people assumed that the problem of monetary stability had been solved and that they could pile up assets and then use them as collateral to borrow ever-larger sums. But the large-scale destruction of financial assets because of underlying uncertainty about the extent of losses in the wake of the subprime crisis, and especially after the bankruptcy of Lehman Brothers, shook that assumption.
Deflation that emanates from the financial sector is lethal. It is more difficult to deal with than inflation, in part for the technical reason that interest rates can be reduced only to zero. The closer to zero they fall, the more problematic monetary policy becomes. The policy instruments no longer work. Central banks have expanding balance sheets, but prices continue to fall and uncertainty rises.
There is a further reason why deflation is such a threat, and why policymakers setting out to eliminate it have a much tougher task than inflation fighters: All prices do not move down; in particular debts do not adjust because they are fixed in nominal terms. Inflation and deflation of debts produce very different outcomes. Inflation reduces the value of debt, which for many people and companies feels like slowly sipping champagne, producing a nice buzz of light-headed excitement as they are unburdened.
Deflation, on the other hand, increases debt and feels like being smothered by a lead blanket. In the interwar Great Depression, the economist Irving Fisher accurately described the process of debt deflation, in which lenders, worried by the deterioration of their asset quality, called in their loans, pushing borrowers to liquidate assets. That, in turn, merely drove down prices further, leading to more credit rationing, bankruptcies and bank failures.
CALLING FOR MORE
The political response to deflation is to call for a stronger state. Dealing with deflation is impossible within the bounds of normal market operations. Only the state is reliable enough to take on all debt, which private institutions are too risk-intolerant to hold. But economists’ abstract description of the resulting state intervention as an expansion of “aggregate demand” conceals the fact that the government conducts specific expenditures and makes political decisions that rescue specific businesses and individuals.
In the climate of scarcity that characterizes debt deflations, the specificity of bailout operations inevitably leads to intense political debate. We see this in the current discussion about the distributional effects of rescuing the automobile industry; or the worry that hedge funds, which are widely blamed for today’s financial malaise, should have access to the Fed’s emergency credit lines.
Currently, parallels are being drawn to Japan’s experience in the 1990s — a “lost decade” in economic terms that also undermined the legitimacy of the ruling Liberal Democratic Party. The Great Depression produced more alarming outcomes, as the political response to deflation throughout central Europe and Latin America destroyed the prevailing order, including several democracies.
Statism has been a characteristically 20th century response to new uncertainty. Its inadequacy may lead to the formulation of a much older answer: revulsion against the market economy, accompanied by indiscriminate condemnation of debt and debt instruments. Indeed, as governments scramble to respond to the current crisis, we should remember that deflation tends to produce not only radical anti-capitalism, but also a profound hostility to any kind of economic or political organization.
Harold James is professor of history at Princeton University in the US and the European University Institute in Florence, Italy.
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