Growth in 2012

Which economies will grow and shrink the fastest in 2012?

By The Economist

LIBYA’S economy will grow faster than any other in 2012, according to the Economist Intelligence Unit’s forecasts, boosted by reconstruction following the fall of Muammar Qaddafi’s regime. The surge is a bounce-back from an even more precipitous slump while war raged. In Iraq, post-conflict chaos has delayed recovery but performance in 2012 may mark the start of something new. Mongolia is enjoying a mining boom and will benefit from investment in that sector; Angola and Niger will gain from relatively high commodity prices. China will continue to experience robust growth; this is fortunate since demand generated by the world’s second-largest economy will counteract some of the drag from the rich world. As for the fastest shrinkers, Europe’s economies feature prominently, as they remain embroiled in the Euro crisis. But Sudan will suffer the heaviest economic contraction, having lost three quarters of its oil reserves to South Sudan when that country seceded in July.

The Culture of Violence in the American West

The Not-So-Wild, Wild West

By Thomas J. DiLorenzo 

In a thorough review of the “West was violent” literature, Bruce Benson (1998) discovered that many historians simply assume that violence was pervasive—even more so than in modern-day America—and then theorize about its likely causes. In addition, some authors assume that the West was very violent and then assert, as Joe Franz does, that “American violence today reflects our frontier heritage” (Franz 1969, qtd. in Benson 1998, 98). Thus, an allegedly violent and stateless society of the nineteenth century is blamed for at least some of the violence in the United States today.

In a book-length survey of the “West was violent” literature, historian Roger McGrath echoes Benson’s skepticism about this theory when he writes that “the frontier-was-violent authors are not, for the most part, attempting to prove that the frontier was violent. Rather, they assume that it was violent and then proffer explanations for that alleged violence” (1984, 270).

In contrast, an alternative literature based on actual history concludes that the civil society of the American West in the nineteenth century was not very violent. Eugene Hollon writes that the western frontier “was a far more civilized, more peaceful and safer place than American society today” (1974, x). Terry Anderson and P. J. Hill affirm that although “[t]he West . . . is perceived as a place of great chaos, with little respect for property or life,” their research “indicates that this was not the case; property rights were protected and civil order prevailed. Private agencies provided the necessary basis for an orderly society in which property was protected and conflicts were resolved” (1979, 10).

What were these private protective agencies? They were not governments because they did not have a legal monopoly on keeping order. Instead, they included such organizations as land clubs, cattlemen’s associations, mining camps, and wagon trains.

So-called land clubs were organizations established by settlers before the U.S. government even surveyed the land, let alone started to sell it or give it away. Because disputes over land titles are inevitable, the land clubs adopted their own constitutions, laying out the “laws” that would define and protect property rights in land (Anderson and Hill 1979, 15). They administered land claims, protected them from outsiders, and arbitrated disputes. Social ostracism was used effectively against those who violated the rules. Establishing property rights in this way minimized disputes—and violence.

The wagon trains that transported thousands of people to the California gold fields and other parts of the West usually established their own constitutions before setting out. These constitutions often included detailed judicial systems. As a consequence, writes Benson, “[t]here were few instances of violence on the wagon trains even when food became extremely scarce and starvation threatened. When crimes against persons or their property were committed, the judicial system . . . would take effect” (1998, 102). Ostracism and threats of banishment from the group, instead of threats of violence, were usually sufficient to correct rule breakers’ behavior.

Dozens of movies have portrayed the nineteenth-century mining camps in the West as hot beds of anarchy and violence, but John Umbeck discovered that, beginning in 1848, the miners began forming contracts with one another to restrain their own behavior (1981, 51). There was no government authority in California at the time, apart from a few military posts. The miners’ contracts established property rights in land (and in any gold found on the land) that the miners themselves enforced. Miners who did not accept the rules the majority adopted were free to mine elsewhere or to set up their own contractual arrangements with other miners. The rules that were adopted were often consequently established with unanimous consent (Anderson and Hill 1979, 19). As long as a miner abided by the rules, the other miners defended his rights under the community contract. If he did not abide by the agreed-on rules, his claim would be regarded as “open to any [claim] jumpers” (Umbeck 1981, 53).

The mining camps hired “enforcement specialists”—justices of the peace and arbitrators—and developed an extensive body of property and criminal law. As a result, there was very little violence and theft. The fact that the miners were usually armed also helps to explain why crime was relatively infrequent. Benson concludes, “The contractual system of law effectively generated cooperation rather than conflict, and on those occasions when conflict arose it was, by and large, effectively quelled through nonviolent means” (1998, 105).

When government bureaucrats failed to police cattle rustling effectively, ranchers established cattlemen’s associations that drew up their own constitutions and hired private “protection agencies” that were often staffed by expert gunmen. This action deterred cattle rustling. Some of these “gunmen” did “drift in and out of a life of crime,” write Anderson and Hill (1979, 18), but they were usually dealt with by the cattlemen’s associations and never created any kind of large-scale criminal organization, as some have predicted would occur under a regime of private law enforcement.

In sum, this work by Benson, Anderson and Hill, Umbeck, and others challenges with solid historical research the claims made by the “West was violent” authors. The civil society of the American West in the nineteenth century was much more peaceful than American cities are today, and the evidence suggests that in fact the Old West was not a very violent place at all. History also reveals that the expanded presence of the U.S. government was the real cause of a culture of violence in the American West. If there is anything to the idea that a nineteenth-century culture of violence on the American frontier is the genesis of much of the violence in the United States today, the main source of that culture is therefore government, not civil society.

The Real Cause of Violence in the American West

The real culture of violence in the American West of the latter half of the nineteenth century sprang from the U.S. government’s policies toward the Plains Indians. It is untrue that white European settlers were always at war with Indians, as popular folklore contends. After all, Indians assisted the Pilgrims and celebrated the first Thanksgiving with them; John Smith married Pocahontas; a white man (mostly Scots, with some Cherokee), John Ross, was the chief of the Cherokees of Tennessee and North Carolina; and there was always a great deal of trade with Indians, as opposed to violence. As Jennifer Roback has written, “Europeans generally acknowledged that the Indians retained possessory rights to their lands. More important, the English recognized the advantage of being on friendly terms with the Indians. Trade with the Indians, especially the fur trade, was profitable. War was costly” (1992, 9). Trade and cooperation with the Indians were much more common than conflict and violence during the first half of the nineteenth century.

One Market, One Money, One Government for All?

The French Don’t Get It

By Martin Feldstein

The French government just doesn’t seem to understand the real implications of the euro, the single currency that France shares with 16 other European Union countries.

French officials have now reacted to the prospect of a credit rating downgrade by lashing out at Britain. The head of the central bank, Christian Noyer, has argued that the rating agencies should begin by downgrading Britain. The finance minister, Francois Baroin, recently declared that, “You’d rather be French than British in economic terms.” And even the French Prime minister, Francois Fillar, noted that Britain had higher debt and larger deficits than France.

French officials apparently don’t recognize the importance of the fact that Britain is outside the eurozone, and therefore has its own currency, which means that there is no risk that Britain will default on its debt. When interest and principal on British government debt come due, the British government can always create additional pounds to meet those obligations. By contrast, the French government and the French central bank cannot create euros.

If investors are unwilling to finance the French budget deficit – that is, if France cannot borrow to finance that deficit – France will be forced to default. That is why the market treats French bonds as riskier and demands a higher interest rate, even though France’s budget deficit is 5.8% of its GDP, whereas Britain’s budget deficit is 8.8% of GDP.

There is a second reason why the British situation is less risky than that of France. Britain can reduce its current-account deficit by causing the British pound to weaken relative to the dollar and the euro, which the French, again, cannot do without their own currency. Indeed, that is precisely what Britain has been doing with its monetary policy: bringing the sterling-euro and sterling-dollar exchange rates down to more competitive levels.

The eurozone fiscal deficits and current-account deficits are now the most obvious symptoms of the euro’s failure. But the credit crisis in Europe, and the weakness of eurozone banks, may be even more important. The persistent unemployment differentials within the eurozone are yet another reflection of the adverse effect of imposing a single currency and a single monetary policy on a heterogeneous group of countries.

President Nicolas Sarkozy and other French politicians are no doubt unhappy that the recent European summit failed to advance the cause of further EU political integration. It was French officials Jean Monnet and Robert Schuman who launched the initiative for European political union just after World War II with the call for a United States of Europe. The French regarded the creation of the euro as an important symbol of progress toward that goal. In the 1960’s, Jacques Delors, then the French finance minister, pressed for a single currency with a report, “One Market, One Money,” which implied that the European free-trade agreement would work only if its members used a single currency.

For the French, achieving a European political union is a way to increase Europe’s role in the world and France’s role within Europe. But that goal looks harder to reach now than it did before the beginning of the European crisis. By attacking Britain and seeking to increase British borrowing costs, France is only creating more conflict between itself and Britain, while creating more tensions within Europe as a whole.

Looking ahead, stopping the eurozone financial crisis does not require political union or a commitment of German financial support. It depends on individual eurozone countries – especially Italy, Spain, and France – making the changes in their domestic spending and taxation that will convince global financial investors that they are moving toward budget surpluses and putting their debt-to-GDP ratios on a downward path.

France should focus its attention on its domestic fiscal problems and the dire situation of its commercial banks, rather than lashing out at Britain or calling for political changes that are not going to occur.

Not with a bang ...

The Decline and Fall of the Euro?

By Daniel Gros

Great empires rarely succumb to outside attacks. But they often crumble under the weight of internal dissent. This vulnerability seems to apply to the eurozone as well.

Key macroeconomic indicators do not suggest any problem for the eurozone as a whole. On the contrary, it has a balanced current account, which means that it has enough resources to solve its own public-finance problems. In this respect, the eurozone compares favorably with other large currency areas, such as the United States or, closer to home, the United Kingdom, which run external deficits and thus depend on continuing inflows of capital. 

In terms of fiscal policy, too, the eurozone average is comparatively strong. It has a much lower fiscal deficit than the US (4% of GDP for the eurozone, compared to almost 10% for the US).

Debasement of the currency is another sign of weakness that often precedes decline and breakup. But, again, this is not the case for the eurozone, where the inflation rate remains low – and below that of the US and the UK. Moreover, there is no significant danger of an increase, as wage demands remain depressed and the European Central Bank will face little pressure to finance deficits, which are low and projected to disappear over the next few years. Refinancing government debt is not inflationary, as it creates no new purchasing power. The ECB is merely a “central counterparty” between risk-averse German savers and the Italian government.

Much has been written about Europe’s sluggish growth, but the record is actually not so bad. Over the last decade, per capita growth in the US and the eurozone has been almost exactly the same.

Given this relative strength in the eurozone’s fundamentals, it is far too early to write off the euro. But the crisis has been going from bad to worse, as Europe’s policymakers seem boundlessly capable of making a mess out of the situation.

The problem is the internal distribution of savings and financial investments: although the eurozone has enough savings to finance all of the deficits, some countries struggle, because savings no longer flow across borders. There is an excess of savings north of the Alps, but northern European savers do not want to finance southern countries like Italy, Spain, and Greece.

That is why the risk premia on Italian and other southern European debt remain at 450-500 basis points, and why, at the same time, the German government can issue short-term securities at essentially zero rates. The reluctance of Northern European savers to invest in the euro periphery is the root of the problem.

So, how will northern Europe’s “investors’ strike” end?

The German position seems to be that financial markets will finance Italy at acceptable rates if and when its policies are credible. If Italy’s borrowing costs remain stubbornly high, the only solution is to try harder.

The Italian position could be characterized as follows: “We are trying as hard as humanly possible to eliminate our deficit, but we have a debt-rollover problem.”

The German government could, of course, take care of the problem if it were willing to guarantee all Italian, Spanish, and other debt. But it is understandably reluctant to take such an enormous risk – even though it is, of course, taking a big risk by not guaranteeing southern European governments’ debt.

The ECB could solve the problem by acting as buyer of last resort for all of the debt shunned by financial markets. But it, too, is understandably reluctant to assume the risk – and it is this standoff that has unnerved markets and endangered the euro’s viability.

Managing a debt overhang has always been one of the toughest challenges for policymakers. In antiquity, the conflicts between creditors and debtors often turned violent, as the alternative to debt relief was slavery. In today’s Europe, the conflict between creditors and debtors takes a more civilized form, seen only in European Council resolutions and internal ECB discussions.

But it remains an unresolved conflict. If the euro fails as a result, it will not be because no solution was possible, but because policymakers would not do what was necessary.

The euro’s long-run survival requires the correct mix of adjustment by debtors, debt forgiveness where this is not enough, and bridge financing to convince nervous financial markets that the debtors will have the time needed for adjustment to work. The resources are there. Europe needs the political will to mobilize them.

Suddenly, the world turned upside down

The New International Economic Disorder

By Mohamed A. El-Erian

A new economic order is taking shape before our eyes, and it is one that includes accelerated convergence between the old Western powers and the emerging world’s major new players. But the forces driving this convergence have little to do with what generations of economists envisaged when they pointed out the inadequacy of the old order; and these forces’ implications may be equally unsettling.

For decades, many people lamented the extent to which the West dominated the global economic system. From the governance of multilateral organizations to the design of financial services, the global infrastructure was seen as favoring Western interests. While there was much talk of reform, Western countries repeatedly countered serious efforts that would result in meaningful erosion of their entitlements.

On the few occasions that such resistance was seemingly overcome, the outcome was gradual and timid change. Consequently, many emerging-market economies lost confidence in the “pooled insurance” that the global system supposedly put at their disposal, especially at times of great need.

This change in sentiment was catalyzed by the financial crises in Asia, Eastern Europe, and Latin America in the late 1990’s and early 2000’s, and by what many in these regions regarded as the West’s inadequate and poorly designed responses. With their trust in bilateral assistance and multilateral institutions such as the International Monetary Fund shaken, emerging-market economies – led by those in Asia – embarked on a sustained drive toward greater financial self-reliance.

Once they succeeded in overcoming a painful crisis-management phase, many of these countries accumulated previously unthinkable levels of international reserves as precautionary cushions. They extinguished billions in external indebtedness by generating and sustaining large current-account surpluses. And they increased the scale and scope of domestic financial intermediation in order to reduce their vulnerability to external storms.

These developments stood in stark contrast to what was happening in the West. There, unprecedented leverage, massive debt creation, and a seemingly infinite sense of credit entitlement prevailed. Financial excesses become the rule rather than the exception, facilitated by financial innovation and the erosion of lending standards and prudential regulation.

Suddenly, the world turned upside down: “rich” countries were running large deficits and, in some cases, tipping from net creditor status to net indebtedness, while “poor” countries were running surpluses and accumulating large stocks of external assets, including financial claims on Western economies.

Little did these countries know that their divergent paths would end up fueling large global imbalances, and eventually trigger a financial crisis that has shaken the prevailing international economic order to its foundations.

There is no restoring fully that order. Rather than recovering strongly, sluggish Western growth is periodically flirting with recession at a time of high unemployment and multiplying debt concerns, particularly in Europe. In an amazing turn of events, virtually every Western country must now worry about its credit ratings, while quite a few emerging economies continue to climb the ratings ladder. We can now consider the image of Western delegations heading to emerging countries to plead, cap in hand, for financial support, both direct and through the IMF.

At first blush, this unusual convergence between Western and emerging countries seems to reflect what advocates of a new international economic order had in mind. But appearances can be misleading, and, in this case, they are misleading in a significant way.

Advocates envisaged an orderly process in which economic convergence accompanied and facilitated global economic growth. They foresaw a collaborative process guided by enlightened policymaking. But what is occurring is far different and more unpredictable.

Rather than exhibiting enlightened leadership, Western policymakers have consistently lagged realities on the ground, with a bewildering mixture of denial, misdiagnosis, and bickering undermining their responses. Rather than proceeding in an orderly manner, today's global changes are being driven by the disorderly forces of de-leveraging emanating from a Europe in deep financial crisis and an America seemingly unable to restore sustained high rates of GDP growth and job creation.

Multilateral institutions, particularly the IMF, have responded by pumping an unfathomable amount of financing into Europe. But, instead of reversing the disorderly deleveraging and encouraging new private investments, this official financing has merely shifted liabilities from the private sector to the public sector. Moreover, many emerging-market countries have noted that the policy conditionality attached to the tens of billions of dollars that have been shipped to Europe pales in comparison with what was imposed on them in the 1990’s and early 2000’s.

Fortunately, despite having lagged rather than led this process of consequential (and increasingly disorderly) global change, it is not too late for policymakers to catch up. But doing so requires more than just better national policymaking in Europe and America; it is also time for urgent and deep reform of the multilateral system and its main institutions. That process requires joint leadership by the emerging world as a true equal and partner of Western powers

Cheap money drives out good

The ugly side of ultra-cheap money
By Bill Gross

Gresham’s law needs a corollary. Not only does “bad money drive out good,” but “cheap” money may as well. Ultra low, zero-bounded central bank policy rates might in fact de-lever instead of relever the financial system, creating contraction instead of expansion in the real economy. Just as Newtonian physics breaks down and Einsteinian concepts prevail at the speed of light, so too might easy money policies fail to stimulate at the zero bound.

Historically, central banks have comfortably relied on a model which dictates that lower and lower yields will stimulate aggregate demand and, in the case of financial markets, drive asset purchases outward on the risk spectrum as investors seek to maintain higher returns. Near zero policy rates and a series of “quantitative easings” have temporarily succeeded in keeping asset markets and real economies afloat in the US, Europe, and even Japan. Now, with policy rates at or approaching zero yields and QE facing political limits in almost all developed economies, it is appropriate to question not only the effectiveness of historical conceptual models but entertain the possibility that they may, counter-intuitively, be hazardous to an economy’s health.

Importantly, Gresham’s corollary is not another name for “pushing on a string” or a “liquidity trap”. Both of these concepts depend significantly on perception of increasing risk in credit markets which in turn reduce the incentive of lenders to expand credit. Rates at the zero bound do something more. Zero-bound money – credit quality aside – creates no incentive to expand it. Will Rogers once fondly said in the Depression that he was more concerned about the return of his money than the return on his money. But from a system wide perspective, when the return on money becomes close to zero in nominal terms and substantially negative in real terms, then normal functionality may breakdown.

A good example would be the reversal of the money market fund business model where operating expenses make it perpetually unprofitable at current yields. As money market assets then decline, system wide leverage is reduced even if clients transfer holdings to banks, which themselves reinvest proceeds in Fed reserves as opposed to private market commercial paper. Additionally, at the zero bound, banks no longer aggressively pursue deposits because of the difficulty in profiting from their deployment. It is one thing to pursue deposits that can be reinvested risk free at a term premium spread – two/three/even five year Treasuries being good examples. But when those front end Treasuries yield only 20 to 90 basis points, a bank’s expensive infrastructure reduces profit potential. It is no coincidence that tens of thousands of layoffs are occurring in the banking industry, and that branch expansion is reversing industry wide.

In the case of low yielding Treasuries the Gresham’s corollary at first blush seems illogical. If a bank can borrow at near 0 per cent then theoretically it should have no problem making a profit. What is important, however, is the flatness of the yield curve and its effect on lending across all credit markets. Capitalism would not work well if Fed funds and 30-year Treasuries co-existed at the same yield, nor if commercial paper and 30-year corporates did as well. It is not only excessive debt levels, insolvency and liquidity trap considerations that delever both financial and real economic growth; it is the zero-bound nominal yield, the assumption that it will stay there for an “extended period of time” and the resultant flatness of yield curves which are the culprits.

Conceptually, when the financial system can no longer find outlets for the credit it creates, then it de-levers. The point should be understood from a yield as well as a credit risk point of view. When both yield and credit are at risk from the standpoint of “Gresham’s law,” the mix can be toxic. The recent example of MF Global emphasises the concept, as does the behaviour of depositors in some struggling European economies. If an investor has money on deposit with an investment bank/broker that not only appears to be at risk but returns nothing, then why maintain the deposit? Perhaps an investor would be more comfortable with a $100 bill at home in a mattress than a $100 bill on deposit with a broker – Securities Investor Protection Corporation notwithstanding. If so, system wide delevering takes place as opposed to the credit extension historically necessary for an expanding economy.

Historical examples and central bank staff models will likely not validate this new Gresham’s corollary. Fed chairman Ben Bernanke blames policy rate increases in the midst of the 1930s for an economic relapse, and a lack of credit expansion for Japan’s lost decades 60 years later. But all central banks should commonsensically question whether ultra-cheap money continually creates expansions as opposed to destroying liquidity, delevering and obstructing recovery. Gresham as opposed to Keynes may become the applicable economist of this new day.

January Surprise

Is Obama preparing a trillion-dollar, mass refinancing of mortgages?

By James Pethokoukis

This could be just the beginning. If President Barack Obama’s legally dodgy appointment of Richard Cordray to head the consumer finance agency should stick, it may open the door to more such actions. Here’s Jaret Seiberg of the Washington Research Group:

To us, the most important takeaway from a recess appointment of Cordray is that the President could use this same maneuver to put a housing advocate in charge of FHFA.

And why is that important? The Federal Housing Finance Agency is the regulator and conservator of Fannie Mae and Freddie Mac. And the FHFA currently has an acting director, Edward DeMarco. If Obama replaces him with a “housing advocate” via the same recess appointment process, here’s what might happen next, according to Seiberg:

That could lead to a mass refinancing program for agency-backed mortgages that would go well beyond the existing HARP program. That could hurt agency MBS pricing and result in higher financing costs going forward. Yet it also could be a big boost for the economy and housing going into the election.

Indeed, my sources tell me the Obama administration has been eager to implement just such a plan, but needs to have its own man heading the FHFA to make it happen. The plan would be modeled after one originally devised by Columbia University economists Glenn Hubbard (a campaign adviser to Mitt Romney and AEI visiting scholar) and Christopher Mayer. In recent congressional testimony, Mayer described how the mass refinancing plan would work:

Under our plan, every homeowner with a GSE mortgage can refinance his or her mortgage with a new mortgage at a current fixed of 4.20 percent or less. … To qualify, the homeowner must be current on his or her mortgage or become so for at least three months. … Other than being current, we would impose no other qualification or application, except for the intention to accept the new rate (that is, no appraisal, no income verification, no tax returns, etc.).

Mayer estimates that some $3.7 trillion of mortgages would be refinanced. That’s right, this would be the Mother of All Mortgage Refinancing Plans. It would help roughly 30 million borrowers save $75 billion to $80 billion a year. As Mayer puts it: “This plan would function like a long-­lasting tax cut for these 25 or 30 million American families.”

On his website, Hubbard says the plan would have an immediate fixed cost to the government of $121 billion $242 billion with half that cost split equally between the government and lenders. And he calculates the economic impact as follows:

1. We estimate that 72 percent of owner occupant homeowners would be eligible to refinance at no cost to them. Their monthly mortgage payments would fall by an average of $355, for a total national fiscal injection $7.1 billion each month.

2. The typical borrower would reduce his or her principal and interest payments by about $350 dollars, a total reduction in mortgage payments of nearly $100 billion per year.

3. The macroeconomic stimulus effect should also include an additional housing wealth effect. At the low end of our estimates, improved mortgage market operations would reduce house price declines by 10 percent. With an estimated aggregate housing valuation of about $18 trillion, housing wealth would increase about $1.8 trillion relative to what it might fall to without this program. If we assume a relatively low marginal propensity to consume out of housing wealth of 3.5 percent, U.S. consumption would rise by $63 billion relative to what would otherwise have occurred.

4. Combining these estimates gives a total macroeconomic stimulus of as $118 billion per year in lower mortgage payments and any new consumer spending due to a housing wealth effect. In addition to the direct macroeconomic stimulus, jump-starting the stalled housing market will increase employment in a variety of industries that depend on housing transactions (mortgage and real estate brokers, home supply companies, moving companies, etc.) as well as increase the efficiency of the labor market by reducing impediments to households moving to take another job.

Bottom line: Talk about a political and economic game changer in this presidential election year. Obama could offer a trillion-dollar stimulus — as measured over a decade –that would directly and immediately impact tens of millions of Americans suffering from the housing depression. Cash in their pockets. Imagine the electoral impact on key states, such as Florida, suffering from both high unemployment and devastated housing markets.

And the beauty part for Obama? He wouldn’t need approval from Congress to do it. Even though many Republicans would scream that the plan would reward irresponsible homeowners who took on too much leverage — indeed, talk of a housing bailout is what launched the Tea Party movement – they probably couldn’t stop it. And Hubbard already has an answer to the moral hazard issue: “This proposal requires borrowers to give up a share of future appreciation in order to participate. Lenders must eat a portion of the losses as well. Everyone gives a little bit.”

The 2012 battle for the White House is looking razor close. A mass refinancing plan might be enough to tip it to Obama.

In the meantime, the debasement of paper money continues

“When they stop buying bonds, the game is over.”

by DETLEV SCHLICHTER

I took the title for this blog from an interview that James Turk of the GoldMoney Foundation conducted with Eric Sprott, a Canadian fund manager. You can see it here. (I also recommend you have a look at this interview with Doug Casey.) I think the quote is a succinct summation of the role that the bond market, and in particular the market for government bonds, now plays in this crisis.

As you know, I would not touch bonds with a barge pole, especially government bonds. After 40 years of unending fiat money expansion, the world suffers from excess levels of debt. A lot of this debt will never be repaid. My expectation is that the market will increasingly question the ability and the willingness of most states – and that, crucially, includes the big states – to control their spending and to shed their addiction to debt financing.

What happens to high-spending credit-dependent states when the market loses confidence in them has been evident in cases such as Ireland, Portugal and Greece. Among the big financial calamities of 2011 were notably government bond markets. Perversely, some of the big winners of 2011 were also government bond markets. As I explainedhere, market participants have so successfully been conditioned to believe in state bonds as safe assets that when some sovereigns go into fiscal meltdown it only serves as reason to buy even more bonds of the sovereigns that are still standing, even though their fiscal outlook isn’t much better. While the fate of Greek and Italian bonds should have cast serious doubt over the long-term prospect for Bunds, Gilts and Treasuries, it only propelled them to new all-time highs. Strange world.

All policy efforts are now directed toward keeping the overextended credit edifice from correcting. After decades of fiat money fuelled credit growth, the financial system is in large parts an overbuilt house of cards. What the system cannot cope with is higher yields and wider risk premiums. Those would accelerate the pressure toward deleveraging and debt deflation and default. “When they stop buying bonds, the game is over.”

They still bought bonds in 2011

2011 was another strong year for gold. Despite a brutal beating in the last month of the year, the precious metal produced again double-digit returns for the year as a whole if measured in paper dollars: up 10 percent. I believe that gold will continue to do well, as it remains the essential self-defence asset.

Amazingly, Treasuries did almost as well (+9.6%) and TIPS (inflation-protected Treasuries) did even better. German Bunds benefitted from the disaster in other euro bond markets, and they pretty much matched Treasuries in terms of total return (currency-adjusted they did less well as the euro declined slightly versus the dollar). I believe this is entirely unjustified because the EMU debt and banking woes will put considerable additional strain on Germany’s public finances. UK Gilts did better than gold and Treasuries, despite rising inflation in the UK, weak growth and a public debt load that is only ever going one way: up.

Progress is not irreversible

China’s Forgotten Industrial Revolution

by Stephen Davies 

We live in a world that has been shaped by a process that began some 250 years ago in northwestern Europe. We often call it the Industrial Revolution because one of its most dramatic features was the appearance of industrial manufacture with the rise of the factory system. However, this was only one element and not the most significant. Moreover, concentrating on industrialization suggests that the change is now complete. The process continues.

It has several important aspects, which are mutually reinforcing. The most obvious is continuous intensive economic growth. Intensive growth is marked by constant innovation and increased efficiency: doing new things and doing more with less. Extensive growth, the historical norm, means more of the same and doing more with more, that is, with no increase in efficiency or productivity. Another important part of the process is continuous technological innovation and improvement. This both reflects and encourages a growth of theoretical knowledge. (See Joel Mokyr’s The Gifts of Athena: Historical Origins of the Knowledge Economy.) Yet another part is the development of increasingly complex economic institutions and instruments.

All historians recognize the existence and importance of this phenomenon. However, they disagree about many other related matters. In particular there is no real agreement about how this process started and why it happened in Europe rather than some other part of the world. Why not in the Islamic world or in India? Above all, why not in China? The last question is the truly difficult one. As Kenneth Pomeranz points out in The Great Divergence: China, Europe and the Making of the Modern World Economy, economically China was on an equal footing with Europe until the mid-eighteenth century or later. In fact, for the greater part of human history China was by far the most innovative and technologically advanced of the great civilizations. The list of important inventions first made in China is almost endless. So why did the revolutionary process not start there?

Actually, it did start in China before it did in Europe. As Eric Jones has pointed out in Growth Recurring: Economic Change in World History, China had an “industrial revolution” comparable to that of eighteenth-century Europe—some 800 to 900 years ago. It happened under perhaps the most maligned yet fascinating of China’s imperial dynasties, the Song.

The Song reunited China following the division and chaos of the Five Dynasties (907–960). The dynasty was founded by two remarkable brothers, Song Taizu (960–976) and Song Taizong (976–997). They introduced a number of important changes in the economic policy and organization of the Empire. One was a measure that gave peasant farmers true property rights in their land, above all the right to sell it. The result was the emergence of a market in land, which led to the consolidation of smaller farms and the appearance of commercial agriculture. Even more important was their fiscal policy. Traditionally the Chinese state had depended on taxes levied on the peasantry, most often paid in kind. Song Taizu laid down the principle, “Agrarian taxes must not be increased.” Consequently, the Song came to depend increasingly on taxes on trade and so systematically encouraged it.

This had dramatic results. China rapidly became a highly monetized economy. In 750 only 4 percent of all taxes was paid in money, but by 1065, 50 percent was paid that way. In 1024, in the reign of Song Renzong, the widespread use of paper money began. Initially, paper notes had a strict three-year limit and were convertible into cash or specified quantities of commodities. With time, checks, promissory notes, and bills of exchange were all used. By the end of the dynasty, the amount of paper money in circulation was equivalent to 70 million strings of cash, or 70 billion copper coins.

Dramatic Economic Growth

Agriculture, trades, and manufacture all grew dramatically. It is clear, particularly from the agricultural evidence, that this was intensive, not extensive, in nature. Thus while the population doubled between 960 and 1020, the output of rice more than doubled. In 1078, China produced 125,000 tons of cast iron, more than the rest of the planet put together. This would not be surpassed until the 1790s, in Britain. A whole range of technological breakthroughs and improvements were made. These included movable type printing (1000), the blast furnace (1050), mechanical water clocks (1090), paddlewheel ships (1130), the magnetic compass (1150), water-powered textile machinery (1200), and most dramatically, huge oceangoing junks with watertight bulkheads, a carrying capacity of 200 to 600 tons, and a crew of about 1,000 (1200).

The period also saw rapid urbanization, most notably in cities such as Kaifeng, Liaoyang, and Hangzhou. One aspect of this was the deregulation of markets as part of the policy of encouraging commerce. Previously markets had only been allowed in specified places under tight control. Under the Song, towns and cities had street markets, shops on the major streets and thoroughfares, and specialized shopping areas with products from all over the empire and beyond. Two other aspects of Song policy were related to this phenomenon. One was the encouragement of import and export trade. In 964 total revenues from exports amounted to 500,000 strings of cash; by 1189 they came to 65 million strings. The other aspect was free movement throughout the empire, encouraged by another Chinese invention, the motel.

By the 1260s China had reached a level of technological sophistication and economic development that Europe would not achieve until the late eighteenth or early nineteenth century. All the above-mentioned features of the process that produced modernity can be found in Song China, which was clearly being transformed in the way that our world has been and continues to be. However, it did not continue. Instead Chinese society stabilized. It remained superior or equal to European society until about 1800, but the dynamic process stalled. That it did not continue is truly a tragedy. If it had we would be living in a “Chinese” world rather than a “Western” one. We would also be much richer and more knowledgeable.

Why did it not continue? As Jones says, this is the big and important question for economic historians. As ever, there are many answers. This is, however, not just of interest to historians, for the answers may have a considerable import for ourselves and our own position.

Leap in void

The Euro: The Folly of Political Currency

By Robert P. Murphy

The financial markets continue to surge and collapse based on the latest news from Europe. As of this writing, the big events are Slovakia’s unwillingness to contribute to a bailout fund and the failure of Dexia, a French-Belgian bank with assets of almost $700 billion. As the sovereign debt crisis has intensified in the last few months, it is becoming a real possibility that the euro itself will soon collapse.

Even if it managed to squeak through and survive—aided by massive taxpayer infusions along the way—the euro’s vulnerability underscores the folly of a political currency. More so than any other currency in history, the euro has been a creation of technocrats working for modern nation-states. That the euro may well be on its deathbed hardly a decade after its birth demonstrates the futility of central planning. A durable monetary system, free from recurring crises, can only emerge spontaneously from voluntary exchanges in the marketplace.

The European Union and euro were officially created by the Maastricht Treaty in 1993. In addition to the political and cultural objectives, the EU and the single currency, which went into circulation in 2002, were significant steps in the effort to turn Europe into a unified economic zone patterned after the United States.

Before the introduction of the euro, a large business based in France that, say, had a factory paying workers in Italy and which bought machine parts from Germany would be vulnerable to shifts in the exchange rate between the franc, lira, and mark. But with a single currency the firm could focus on its customers and product lines, rather than worrying about the foreign-exchange market. This stability across the continent would (supposedly) give European businesses the same advantages that U.S.-based firms enjoy, since Americans in all 50 states use the dollar.

Because a currency’s ability to facilitate transactions only increases as more people use it, at first we might expect that the nations adopting the euro would want as many of their neighbors as possible to join. Yet in reality there were formal rules (called the Maastricht criteria, also the “convergence criteria”) that new applicants needed to satisfy before adopting the euro. The rules set standards for countries’ inflation rates, budget deficits, government debt, exchange rates, and long-term interest rates.

At first glance it seems odd that the developers of a new currency would want to restrict its usage. To repeat, the whole point of a currency union is to reduce transaction costs among the individuals using it. Thus it would seem that these benefits would only increase as the group grew.

Yet there are other factors at work, which the designers of the euro understood (if only imperfectly). In particular the euro is a fiat currency, meaning that the printing press could be used to achieve political ends. This explains why governments already using the euro are reluctant to admit relatively spendthrift governments into their club: There is a danger that the more profligate members will hijack monetary policy directly, or that they will require a monetary bailout (as we are seeing in practice).

Benefits of a Commodity Standard

Notice that these potential problems would be nonexistent under a fully backed commodity standard. For example, suppose that the creators of the euro, rather than reading the work of mainstream monetary theorists such as Robert Mundell, instead had studied the proposals of Ludwig von Mises in The Theory of Money and Credit. In this alternate universe the authorities in Brussels would stand prepared to issue new paper euros to any individual or institution (including governments and central banks) that handed them a fixed weight of gold.

Not cute as Che, but still ...

Castro regime is murdering Cuban political prisoner Ivonne Malleza

The Castro regime's slow murder of Cuban political prisoner Ivonne Malleza continues.

The blog La revolucion de los gladiolos reported Wednesday that after more than a week on hunger strike, Malleza is in "grave danger." She was recently transferred to the maximum security Manto Negro prison, where she was being held in an isolation punishment cell. (There was one report that Malleza was being forced to remain in the nude.)

The blog reported that Malleza is suffering heavy bleeding caused by uterine fibroids. She has requested medical attention -- a plea that has fallen on the deaf and/or indifferent ears of her jailers.

Malleza also has gone two days without drinking water because the only available water is warm and in a dirty container. Her supporters worry that if she doesn't drink water soon and receives needed medical care, she is at risk of organ failure and eventually, death.

Malleza, her husband Ignacio Martinez and another activist, Isabel Alvarez, have been in jail since Nov. 30, when they were arrested after they went to a Havana park and unfurled a banner carrying anti-Castro slogans.

For more about Malleza, read this.

And to sign a petition demanding the release of Malleza, Martinez and Alvarez, sign this petition.

Lost in translation

What Greece Can Learn From South America

Greek demonstrators protest in Athens on Nov. 8. Similar economic crises in Argentina and Uruguay a decade ago may be instructive for Greece today.

by JUAN FORERO

As Greece struggles with a financial crisis, there have been violent protests, creditors demanding their money, people losing their jobs and officials hunkering down.

A decade ago, that was the scene in South America when Argentina and Uruguay defaulted. The two handled the economic calamity in very different ways. Economists say their approaches — and what's happened in each country since — are instructive for European leaders as they try lifting Greece from its turmoil.

In 2001, Argentine police battled with rioters in Buenos Aires, and there was a run on bank deposits. The country couldn't pay its bills.

So President Adolfo Rodriguez Saa, who served just one week, announced before Congress that Argentina would default.

And then, in patriotic fervor, everyone shouted, "Argentina, Argentina!" It was the biggest default in history — $100 billion. Economists say the chaotic response from Argentine leaders was a recipe for disaster.

They failed to heed years of warnings. And then the government froze bank accounts and defaulted without negotiating with creditors.

Poverty rose to nearly 50 percent, and millions were instantly unemployed. Argentina also became a pariah for investors.

"In crises like this, there's a tendency to think that another loan will tide you over to the next year or the next two years, when things are better and you'll have access to the markets again," says John Taylor, who was an undersecretary at the U.S. Treasury Department back then and dealt with the Argentine fallout.

"But so often, and it certainly is the case in Greece, they had to have a write-down and more loans were not going to be the answer," says Taylor, who now teaches economics at Stanford.

By a write-down, Taylor says he means a default. But he says he has in mind an orderly and negotiated default, involving international creditors.

That was the case in the country of 3.5 million people across the River Plate from Argentina — Uruguay.

Uruguay's Pragmatic Approach

Like Argentina, Uruguay had a run on banks in 2002 and couldn't pay its bills.

But Uruguay's response was all calm pragmatism, according to Argentine economist Orlando Ferreres. Ferreres recently met with 70 European businessmen who came to Buenos Aires to learn about the Argentine and Uruguayan defaults.

The Uruguay solution was telling creditors we can't pay it all, Ferreres says, but we can pay you 80 percent by extending payments. Nearly all of Uruguay's creditors accepted. Uruguay also negotiated a $1.5 billion bridge loan from the U.S. Treasury Department and made cuts to pensions and salaries.

Carlos Steneri, an economist who oversaw Uruguay's debt management at the time, says moving fast was key.

"Time in these type of situations is crucial, and I believe the insolvency of the Greece case today is in part a consequence of the delay of taking actions," Steneri says.

What happened since can also serve as a lesson for Greece.

Both Argentina and Uruguay have seen their economies expand dramatically, thanks to booming Asian demand for agricultural products that took off soon after their defaults.

That growth generated adoration from Argentine supporters of President Cristina Fernandez de Kirchner, fueling her re-election in October.

But the effects of how the two countries responded to the crisis are still readily apparent — in their access to capital markets.

Only five months after defaulting, Uruguay was once again able to borrow internationally. Argentina, on the other hand, is effectively barred from borrowing on the open market.

Ten years later, it uses central bank reserves and the nationalized pension system to fund a big-spending government.