Unless you have been living in a hole for the last year then you have probably heard that the European financial system is in a bit of a mess. Put simply, the countries of the Euro-zone have borrowed quite a lot of money. Some of the people that governments have borrowed this money off of have become less than convinced that the euro-zone countries pay it back. As a result debt holders have been selling a lot more than buying, which has forced the price/value of these loans down and interest rates up. All-in-all, not too pretty.

The question most people are asking, is how likely is it that the cost of debt gets so high for a country (say Italy), that it will have no choice but to default on its debt. This is a very hard question to answer.

So turning to the other side of the story, what happens if a country defaults? I thought it would be interesting to take a look back at one of the more colourful periods in financial history, the Spanish Bankruptcies.

A little History

In 1492, Rodrigo de Triana became the first European to set sight on the Americas in almost 500 years. Few at the time would have thought that the sighting of land sailor on la Pinta, one of three ships in the expedition led by Christopher Columbus, would transform the shape of Europe. The ships had been sent to discover a trade route around the east of the globe to the orient. The goal was to ship spices, which were extremely valuable is Europe at the time from the east, thus making a fortune. The Portuguese would get the spice route as it later became known but the Spanish got a lot more.

It became apparent, over the next few decades that the Americas were extremely rich. Areas that now include Mexico, Peru and Bolivia had huge reserves of gold and silver. At Potosi, there was a mountain which contained the largest reserve of silver ever found. So large in fact that it is still being mined to this day. The value of gold and silver was particularly important in the 16^th century as it was literally used as currency. The influx of gold and silver made the Spanish exceedingly rich, unfortunately this didn’t last.

What would you buy with all the gold in the world?

By the time the Spanish had begun to realise the extent of their new-found wealth a new family had come to power, the Habsburgs. The Habsburgs were extremely ambitious and used their money to finance a large number of wars in order to consolidate and expand their power. They fought for control of Italy, they fought against France and later they fought against protestants in the form of the Dutch, the English and later still many Germans. They didn’t just fight. They donated huge amounts to the catholic church, building the Vatican in its current form. They even built a brand new city from the ground up, which would become their capital, Madrid.

One of the problems they faced was that while the government had a lot of money to spend, by spending it they increase the supply of money in their own lands and inevitably throughout Europe. The rate at which the money supply grew was like nothing Europe had ever seen. Not only that but it grew far faster than the Spanish economy, causing a huge amount of inflation. This impoverished the lower and middle classes and the domestic economy stagnated.

The well dries up

By 1557 Spain’s finances were extremely overstretched and the Spanish were forced to declare a state bankruptcy. This caused chaos in the European financial system of the day. It bankrupted a large part of the Fugger family which had been the Habsburgs main financiers. At the same time the Spanish crown began to borrow large amounts of money, largely from the Genoese (ironically Columbus was born in Genoa).

Continued borrowing and debt led to more bankruptcies in 1576 and in 1596. They lost the great bulk of their European possessions outside of Spain itself and the financial mismanagement in the 16^th century set the stage for the perennial decline of the Spanish Empire over the next two hundred years.

I am not saying that the west is going to go bankrupt. The two situations are not very comparable. It was fiscal mismanagement, a high growth in the money supply and overspending on foreign wars that caused the Spanish Empire to decline. It’s worth not forgetting just how bad, bad economic policies can be.

Iceland has been the world’s whipping boy for the last few years.  The collapse of its banking system uncovered huge international systemic failures leading to the economic crisis.  The snowy nation has had a rough time of it.  But as we begin 2011, I ask the question, are they really still in that much trouble?  Figures released by the International Monetary Fund in December 2010 showed that Iceland’s GDP grew by 1.2% in the third quarter, ending the recession caused by the actions of those in its banking sector.  What about those European countries still in economic strife?

In direct contrast to the actions taken by almost all other western countries and most significantly Ireland, Iceland let its banks fail.  It was able to do so because the international risk of contagion is comparably lower than many of the European countries currently receiving bail-outs.  This forced foreign creditors and the banks themselves to foot the bill of failure, rather than the taxpayer.  Essentially, Iceland stuck to free market principles.  Those institutions that operated in an economically viable manner were able to survive; those that chose to take on too many liabilities in foreign currency must face the consequences.  In a system such as banking where when times are good, the mechanisms of capitalism and free market economics define the actions of agents in market, why should those mechanisms not also define what happens when it goes wrong?  In addition to the economic reasoning, there is also the moral issue of the taxpayer having to pay for the mistakes of a small elite.  The actions of many other governments in bailing out the banks served as an attempt to prop up an already unsustainable bubble.  These actions have exacerbated existing public finance problems further, the implications of which are to be felt by those who have not caused the problem.

During the recession Iceland’s economy shrank 11 – 15% depending on your source, but it did so with inflation peaking at 18%, which devalued its debt.  The soaring inflation was furthermore caused by the Icelandic central bank’s decision to halve the value of its currency, the Kroner.  The difference in terms of inflation between Iceland and those euro-zone countries thought to be in the worst economics position, the PIGS (Portugal, Ireland, Greece and Spain), is quite stark.  Iceland’s inflation soared whilst Ireland, for example, is still going through through a sustained period of deflation

Iceland’s inflation is now down to a respectable 3%, hence interest rates are now at 4.5% from an 18% peak.  These inflation rates are, however, higher than the PIGS.  Iceland’s debt situation is also looking up.  Forecasts for 2011 predict a deficit of 6.3% which will soon turn to surplus approaching the mid-point of the decade.  The IMF said Iceland has turned a corner and that its economic performance “compares favourably against other countries hard hit by the crisis”.

Iceland’s current account balance suffered greatly at the beginning of the crisis with the nation running a 26% of GDP trade deficit with the rest of the world, which is much greater than any of the PIGS.  However, due to the high inflation rates and devaluation of its currency, the trade deficit in 2010 fell to just 0.9% of GDP, with a surplus forecasted in 2011.  Comparably, the PIGS are still running significant deficits approaching and exceeding 10% of GDP.  The long-term effects of these deficits are yet to be seen.  One thing is clear, the PIGS do not have the monetary sovereignty of Iceland and hence cannot devalue their debt, they must in effect, toe the economic line of the European Monetary Union and European Central Bank.

Many have portrayed the path chosen by Iceland and subsequent recovery as a model for other beleaguered economies, such as the PIGS group in the EU.  However, such comparisons must be contextualised.  Iceland’s economy is comparably tiny and would have little chance of bringing the entire world economy down if it walked away from its liabilities compared to the aforementioned PIGS.  Defaulting in one of those economies would risk contagion throughout the euro zone and possibly beyond.

Iceland’s monetary independence from the European Monetary Union has been sighted by many as a possible reason for its recent good performance.  Having experienced the worst financial crisis in memory, the country has emerged ahead of many of its contemporaries having endured less punishment than many EU member states.  Greece and Ireland have already been forced to accept bail-outs, and it appears Portugal will soon follow with an €80bn rescue package mooted.

But how sustainable is this recovery?  Iceland’s public debt has reached in excess of 115% of GDP, over four times what it was in 2007.  Furthermore, Government bonds issued in foreign currency are becoming more and more expensive to repay due to the devaluation of the kroner.  Domestic austerity was aided by this devaluation and the subsequent increase in inflation; however, many commentators have indicated this had little to do with the recent return to positive growth.  The turnaround is attributed to the return to current account surplus from deficit.  Moreover, the aforementioned debt burden is not only applicable to government finance; house prices have plummeted in the crisis leaving many homeowners in negative equity.  By no means is Iceland out of the woods, its current account turnaround from deficit to surplus has been accredited to falling imports rather than a surge in exports.  More tough times are ahead.

The implications of bail-outs on the PIGS are also uncertain.  What is obvious is the political motivation behind their economic choices; the European Union needs the single currency.  It is those with vested interests in the Union that have the most to lose; there is an unnerving air of inevitability in what is happening.  Interest rates are remaining low, aimed at a sluggish Germany, whilst those euro-zone countries experiencing increasing inflation desperately need interest rates to rise.  Where the European project falls down is, in throwing hugely different nation economies under a single monetary policy, it lacked the complete supranational economic governance and social mobility required.

On balance, Iceland has taken a radical path of devaluation which saw violent shifts in economic measures, which all looked terrible whilst it was happening.  It may however appear preferable to the long-term damage that may be seen in those countries which have chosen austerity, debt deflation and bail-outs, but like driving a car using only the rear-view mirror, we will not know until it has happened.

About the author: Harry is a fist year undergraduate studying Politics and Economics (BA) at the University of Leicester.

Money consists of two main elements.

Photo by thejonoakley on Flickr

The first is cash (notes and coins). The total amount of cash in the UK is just over £50bn, with about £43bn circulating outside the banks and £7bn in banks’ safes, tills and cash machines.

But cash is a relatively small proportion of the total amount of money. So what is the rest?

Read More: Where has all the money gone? John Sloman

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Increased public spending on incapacity benefits, health and pensions can all help the economy recover in a slowdown or recession. That is one of the findings of new research by Professors Julia Darby and Jacques Melitz presented at the Royal Economic Society’s 2008 annual conference.

In a slowdown some policies help the economy recover automatically. A recession increases the total amount spent on unemployment benefit (as more people are claiming it) and reduces the total tax take (as people’s tax bills drop). This helps to stimulate the economy without any active government intervention.

The report finds that these automatic stabilisers play an even greater role smoothing the business cycle than previously thought. This is because programmes such as incapacity benefit, pensions and health spending all act as such stabilisers as well.

In fact, active government intervention may even destabilise the economy if it doesn’t properly take account of these automatic effects.

These benefits are likely to help prevent recession as spending on each of them grows as a slowdown starts:

• Pensions: workers tend to retire at an earlier age in recessions and at a later age in booms. So pension payments are higher in recessions and lower in expansions. This is partly because employers encourage older workers to retire in recessions, as they are relatively more expensive to employ.
• Health spending: older workers are also likely to be those with bigger health problems. Those who retire earlier in recessions may have especially severe health problems. In addition, retired people have more time to devote to health care. So health spending may increase in a recession.
• Incapacity benefits: in the UK (among other countries), workers who are laid off in a recession and who qualify for incapacity benefit may turn to it instead of unemployment benefit. These have increased substantially over the last 25 years: total spending on such benefits is about 30% more than that on unemployment benefit across all developed countries.

These automatic stabilisers play an important role in stabilising economies in the OECD. For every pound reduction in output in a recession, it is generally thought that close to 50p flows right back to the private economy automatically through a fall in tax revenues and a rise in government spending.

This report shows that the contribution of government taxes and spending to automatic stabilisation is even higher than is generally thought. Significant contributions are also made through cyclical movements in retirement benefits, public health spending and invalidity benefits.

The contributions from these other sources of social spending are more than twice as high as those coming from unemployment compensation alone. As a result, following a fall of one pound in output, private income only goes down by 40p at most rather than by 50p on average.

This means that we tend to exaggerate the role of active fiscal policy in stabilising developed economies. The government gets too much credit for the automatic forces at work.

Moreover, we know from past studies that fiscal policy can sometimes destabilise the economy. During booms, this policy can occasionally overheat the economy by generating deficits. Based on their results, the researchers argue that such destabilising behaviour is actually even greater than previously thought since the behaviour was strong enough to overcome forces that now seem more powerful.

The study also has implications for the European Union’s Stability and Growth Pact. If automatic stabilisation is greater than generally believed, then staying within the 3% deficit limit is more difficult than previously thought during recessions. This may explain some of the difficulties that countries like France, Germany, Italy and Portugal have encountered in their efforts to meet the deficit ceilings in the last eight or nine years.

Notes for editors: Labour Market Adjustment, Social Spending and the Automatic Stabilisers in the OECD by Julia Darby and Jacques Melitz was presented at the Royal Economic Societyâ’s annual conference at the University of Warwick, 17-19 March 2008.

Julia Darby is at the University of Strathclyde. Jacques Melitz is at Heriot-Watt University.

For further information: contact Julia Darby on 07971 681210 (email: julia.darby@strath.ac.uk); Jacques Melitz on 0131 451 3626 or by email (J.Melitz@hw.ac.uk); or Romesh Vaitilingam on 07768 661095 (email: romesh@compuserve.com)

Read more research papers by Jacques Melitz at EconPapers. Intute: Social Sciences features more Internet resources on the topic of economics.

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Monetary policy-makers do not make minor adjustments to interest rates when inflation is close to the inflation target  but they do respond vigorously when inflation begins to move further from the target. That is the central argument of new research by Professors Christopher Martin and Costas Milas, presented to the Royal Economic Society’s 2007 annual conference at the University of Warwick.

UK interest rates were increased in January 2007 in response to an unexpectedly high jump in inflation, to 3%. The immediate danger of higher interest rates may have passed as inflation fell below 3% in February. But the Monetary Policy Committee is known to be concerned that oil and gas prices will lead to increased wage demands; and the Governor of the Bank of England has signalled willingness to act to avoid this.

This has led many commentators to expect higher interest rates this spring. The analysis of Martin and Milas suggests that this response could be stronger than many think: further, even small, rises in inflation are likely to trigger higher interest rates.

Interest rates are often constant for long periods of time. The Bank of England base rate did not change in 2002 or between the summer of 2004 and autumn 2005. This is puzzling. The Monetary Policy Committee of the Bank of England adjusts interest rates in order to keep inflation close to the target. In these periods, inflation changed, so why where interest rates kept constant?

The argument of this research builds on the opportunistic approach to monetary policy, an analysis of the behaviour of the Federal Reserve by the Fed’s own economists. The opportunistic approach suggests that interest rates remain constant so long as inflation remains within a zone of discretion around the inflation target but are adjusted when inflation moves outside the zone (the United States does not have an official inflation target, but most observers feel the Fed aims at an inflation rate of around 2%).

This approach implies that more traditional models of monetary policy, which assume that interest rates respond proportionately to all movements in the inflation rate are wrong; they over-predict interest rate changes when inflation is close to the target and under-estimate changes when inflation is further away.

Martin and Milas estimate various statistical models of interest rates and conclude that policy-makers in the United States do indeed follow the opportunistic approach and that the traditional model is wrong. They argue that the width of the zone of discretion is 2%, so inflation is allowed to fluctuate within 1% either side of the inflation target without triggering an interest rate response. Once the zone is breached, however, the response of interest rates is stronger than previously thought.

What are the implications for the UK? The UK economy is similar to that of the United States and the UK has a similar policy-making structure. Therefore the opportunistic approach is likely to be equally applicable to the UK (other statistical analysis by Martin and Milas confirms this).

This is the likely explanation of the long periods of static interest rates in recent years. This can also explain the large rapid changes in interest rate that have occurred in recent years, for example the fall of nearly 2.5 percentage points in 9 months in the late 1990s and the fall of 2 percentage points in 2001.

But there is one important difference between the UK and the United States, which is that UK policy-makers must write an open letter of explanation if inflation deviates from the target by more than 1%. The desire to avoid this suggests that the zone of discretion in the UK is narrower, less than the 2% zone estimated for the United States.

Notes for editors: Testing the Opportunistic Approach to Monetary Policy by Christopher Martin and Costas Milas was presented at the Royal Economic Society’s 2007 annual conference at the University of Warwick, 11-13 April.

Christopher Martin is at Brunel University. Costas Milas is at Keele University.

For further information: contact Romesh Vaitilingam on 07768-661095 (email: romesh@compuserve.com).

Find more papers by Christopher Martin and Costas Milas at EconPapers and search for more Internet resources on the topic of interest rates at Intute: Economics.

Much attention has been given in the press as to whether new MPC appointments are doves or hawks. But past work by Charles Bean now the Bank’s chief economist but then an LSE professor implied that, providing the Bank remains properly independent, we should not really worry. Both hawks and doves will normally make roughly the same decision and both are likely to serve society well.

The new study by Professor Vines and colleagues shows that this conclusion is only valid if policy-makers take a long-term view of the economy. Policy-makers who take a short-term view are much more likely to disagree and may not serve society well.

We know that the MPC cares about keeping inflation stable, but how much should it also care about stabilising unemployment? The Bank’s remit does not pin this down with any precision nor is it clear how it could. So how much the MPC cares about unemployment must depend largely on the preferences of its individual members. These preferences in large part determine the differences between doves and hawks.

The issue is this. When inflation rises above target, there is a real trade-off between the objectives of controlling inflation and controlling unemployment. How much unemployment is needed to get inflation down again? How can we know how the MPC will respond in such a situation given that we do not know how much it cares about unemployment? And will it respond in a way that is in the best interests of society?

Bean’s work suggests that our lack of knowledge is not a problem. This is because policy-makers with quite different ideas on the trade-off will actually choose fairly similar policies. The reason is that to get inflation down means restraining demand, with the regrettable consequence of unemployment.

If policy-makers whether hawks or doves take a long-term view then, Bean shows, they will agree among themselves as to how this trade-off should be managed. So long as their preferences fall into a broad range that can be described as reasonable, the outcomes of policy are not likely to be much altered as policy-makers come and go. And these outcomes are likely to be similar to the policy of an ideal policy-maker, one who cares about inflation-unemployment trade-off in exactly the right way.

The new study shows that this happy conclusion will not hold if policy-makers focus on the short-term outcomes of policy, rather than taking a long-term view. The reasons are subtle. Doves who take a short-term view will be likely to want less unemployment after an inflation shock, and to prefer a policy that would take longer to get inflation down. They would like to put off the necessary unemployment until the future, when as viewed from the present it will seem less costly. They want to have a good time now rather than high unemployment now, which would deliver low inflation in the future.

But paradoxically, hawks with short-term view are likely to want to do exactly the opposite. It may be possible to get inflation down very fast by having high unemployment now. This will be especially true if tight monetary policy now can cause exchange rate appreciation and enable lower inflation to be imported through cheaper import prices. Impatient hawks might be prepared to do this now, and then to deal with any problems caused by unwinding the currency appreciation in the future, when  as viewed from the present these problems will seem less costly. They too will want to have a good time now and that means getting inflation down now, without worrying about the future consequences.

We can thus see that there will be a problem if MPC members take a short-term view: the views of hawks and doves may come to differ significantly from each other, and from the ideal policy. In becoming more short-termist, the hawks and the doves will come to disagree much more strongly among themselves, and their desired policies may differ very significantly from ideal policy.

Professor David Vines comments:

It is important to stress that there is nothing in our work to suggest that members of the MPC have in fact taken a short-term view. Indeed, the widely perceived success of the MPC process would actually suggest otherwise.

But we believe that institutional arrangements that deter short-termism from arising in the future could be very worthwhile. For example, the term of service for a member of the MPC is currently only three years. This term is unlikely to safeguard against short-termism: it implies that the average MPC member has a remaining term of only 18 months. Our suggestion is that the terms of appointment to the MPC should be lengthened.

Notes for editors: The Effect of Discounting on Policy Choices in Inflation Targeting Regimes by Brian Henry, Mathan Satchi and David Vines is published in the January 2006 issue of the Economic Journal. The authors are at the University of Oxford.

For further information: contact RES Media Consultant Romesh Vaitilingam on 07768-661095 (email: romesh@compuserve.com)

Search Intute: Social Sciences for more web resources on the issues of inflation and monetary policy