July 23, 2010 11:12 am

Trichet rejects the counsels of history

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ECB chief should know better, writes Brad De Long

What lessons does history have to teach us about Jean-Claude Trichet’s call for immediate, rapid, and substantial fiscal and monetary retrenchment and austerity – about his full-throated endorsement of the agenda of the Pain Caucus?

Well, history tells us that there are times and circumstances when countries’ refusal to listen to calls for retrenchment and austerity has led to economic disaster. Times when a country’s supply of savings is inelastic and more government borrowing leads to sharp rises in and high real interest rates are times in which government budget deficits have drained the pool of savings, reduced private investment, and slowed growth – as they did in the US in the second Reagan and the first Bush administration. Times when monetary and fiscal laxity leads to an expectation that government debt will be monetised and to rapid rises in inflation expectations are times in which policy has made a deep recession to restore price stability inevitable – as happened in the US in the Nixon, Ford, and Carter administrations. And times when irrational exuberance on the part of foreign investors leads a country’s public or private sector to borrow heavily in foreign currency, it needs to pre-emptively retrench before foreign investor exuberance wears off, or else – as happened to east Asia in 1997-98, to Mexico in 1994-95, or to Argentina innumerable times since 1890.

The first key to the current situation, I believe, is that none of the core economies of the Global North – not France and Germany which are the heart of eurozone, not Britain, not the United States, and not Japan – are in any of these three positions right now. All of the mechanisms and channels that have in the past made countries regret their failure to pursue policies of retrenchment and austerity are inactive. There are no clear and present dangers that would be fended off by retrenchment and austerity right now.

What else does history tell us? It tells us that in 1925 chancellor of the exchequer Winston Churchill was ill-served when he rejected the arguments of John Maynard Keynes and accepted the arguments of his Treasury staff that Britain required retrenchment and austerity: Churchill thus gave Britain a three-year head start on suffering from the Great Depression. It tells us that from 1930-36 the belief of government after government of France’s Third Republic that if only they retrenched a little longer that the confidence of world capital markets in France would be so great that it could escape the Great Depression unscathed: the length of the Great Depression and the class war thus engendered in France weakened it enormously in the late 1930s – it is hard to stand up for freedom when the graffiti on the banks of the Seine reads “better Hitler than Leon Blum”. It teaches us that Weimar German SPD leader Rudolf Hilferding was extremely ill-advised to commit the SPD to policies of retrenchment and austerity when his labour economist Wladimir Woytinsky was calling for the SPD to develop a plan for a New Deal for Germany. And it teaches us that in his memoirs US President Herbert Hoover, who was bitter about many things, was bitterest that he had let Treasury secretary Andrew Mellon hamstring Hoover’s progressive impulses and lead the Hoover administration to policies of retrenchment and austerity.

History teaches us that when none of the three clear and present dangers that justify retrenchment and austerity – interest-rate crowding-out, rising inflationary pressures on consumer prices, national overleverage via borrowing in foreign currencies – are present, you should not retrench and austerity: don’t call the fire truck when there is no smoke. And history teaches us that when economies suffer from high unemployment, enormous excess capacity, incipient deflation, businesses terrified of a lack of customers, and an enormous excess demand for high quality assets, then is the time for expansion and stimulus: when the deck is awash, start bailing.

Yet Jean-Claude Trichet rejects these counsels of history. He seems to me to place himself in the position of, as British interwar bureaucrat R.G. Hawtrey described his precedessors at the start of the Great Depression, somebody: “crying ‘Fire! Fire!’ in Noah’s flood.”

The writer is professor of economics at the University of California, Berkeley

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