Bad Paper: On Philip Coggan
Walter Bagehot, arguably the most influential editor of The Economist, is best known today for his classic work on finance, Lombard Street, first published in 1873. Bagehot was writing during an era when financial crises convulsed the economy on a regular basis—most recently in 1866, when Overend, Gurney and Company, a massive British bank, went under, taking down a number of other banks and corporations in the process. Such cataclysmic events left many of his contemporaries baffled, even terrified, and Bagehot set out to demystify the causes of these crises by offering a simple, straightforward exposition on the subject of credit and debt for Victorian readers. “Credit,” he explained, “means that a certain confidence is given, and a certain trust reposed.” But confidence was one thing, repayment another: “credit is a set of promises to pay,” he observed, but “will those promises be kept?”
Probably not, warns Philip Coggan, who writes the “Buttonwood” column for the magazine Bagehot made famous. Echoing his illustrious predecessor, Coggan writes in Paper Promises that “when we borrow or lend money, it is an act both of trust and of confidence.” Coggan is evenhanded and lucid, and he shares with Bagehot a keen appreciation of the fragility of modern finance, the perils of speculative booms and the brutal consequences that often accompany the inevitable busts. Both speak as well from extensive experience: Bagehot as a banker and financial commentator, Coggan as an accomplished journalist covering the City and financial matters generally.
But there the similarity ends. Bagehot believed that central banks had a duty to serve as a lender of last resort during a financial crisis, and much of Lombard Street offered a blueprint for how the Bank of England (and, later, the Federal Reserve) should respond to crises. The president of the Dallas Federal Reserve recently described Bagehot (along with Milton Friedman) as one of the “patron saints” of modern central banking, an authority who bequeathed a playbook for how central banks could serve as a lender of last resort.
Coggan is less optimistic. The current financial crisis, he avers, is not a problem of liquidity; it is a pervasive problem of solvency. “The massive debts accumulated over the last forty years can’t be paid in full, and they won’t be paid,” and no amount of easy money from the world’s central banks will cure the problem. Nor will more unorthodox measures such as quantitative easing, in which central banks intervene in the markets by purchasing long-term government debt, and which Coggan pointedly compares to the hyperinflationary policies of the Reichsbank under the Weimar Republic (and, somewhat more distant in memory, to medieval debasements of the coinage).
It comes as no surprise, then, that Coggan is sympathetic to the Austrian school of economics associated with Friedrich Hayek, Ludwig von Mises and other luminaries of libertarianism. The Austrians have a deep skepticism of central banks and their meddling ways; indeed, they are deeply suspicious of attempts to “fix” the economy, viewing this ambition as nothing more than hubris. It’s far better, they argue, to leave such matters to the market.
Though Austrian economists are often as zealous in their beliefs as the members of certain fundamentalist religious sects, Coggan is a halfhearted convert at best. He accepts the idea that central banks helped cause the present financial crisis by keeping interest rates far too low. “The tricky bit,” he writes, “is accepting the Austrians’ conclusion that the only option is to let the crisis blow itself out.” This Coggan cannot stomach, calling it the “counsel of despair.”
Yet despair pervades Paper Promises: while Coggan occasionally engages with the ideas of Keynes and his latter-day adherents, one imagines he is doubtful that more “stimulus” (and thus more debt) will solve much of anything. Keynesians like Paul Krugman have railed against the fatigue and alleged ignorance of contemporary policy-makers as a perverse form of “learned helplessness,” but Coggan clearly thinks that there isn’t a whole lot that can be done to fix the problems that beset the global economy. As he states bluntly at one point, “there are no easy answers in economics.” Such fatalism stems from Coggan’s Austrian leanings, but it is also a reflection of his deep, if tragic, reading of financial history. Like Carmen Reinhart and Kenneth Rogoff, whose This Time Is Different (2009) has become the standard reference work on financial crises past and present, Coggan believes the current debt crisis fits a historical pattern, one that will inevitably end in tears for the developed world.
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To prove his point, Coggan takes the reader on a familiar, if entertaining, journey through financial history. We learn about John Law, the Scottish rogue turned economist and banker, as well as the crisis he created in 1720 in France: a speculative bubble inflated by enormous emissions of paper promises in the form of money and stock certificates. The resulting mania led Voltaire to wonder: “Has half the nation found the philosopher’s stone in the paper mills?”
The truth, Coggan believes, falls somewhere in between, and the tale of Law’s rise and fall hovers over the rest of the book. Coggan concedes that credit in the form of paper money or bank loans is indispensable to capitalism, yet he is skeptical of the paper promises that have fueled economic growth for several centuries. But not all paper promises are equal in Coggan’s mind: he draws a sharp distinction between the paper that circulated in Bagehot’s time and the IOUs that circulate within the contemporary financial system.
The key difference is that paper could formerly be exchanged for a set amount of precious metals. This system went by various names, depending on the metals that backed the paper promises: the gold standard, silver standard, or a mix of both known as bimetallism. Before the twentieth century, paper money was a form of debt, but one that could be redeemed by something with an intrinsic value. Put differently, money made of precious metals, Coggan observes, “are no one else’s liability.”
The relationship between precious metals and paper became increasingly sophisticated in the nineteenth century, when a growing number of advanced industrial nations shifted exclusively to the gold standard. Whether an economist views this arrangement as satisfactory depends on his or her intellectual leanings. Keynes famously mocked the gold standard as a “barbarous relic,” and his twenty-first-century apostles have greeted calls for its revival with derision.
Coggan doesn’t think going back on gold is feasible, but like many Austrians he clearly views the nineteenth century as, literally, a golden age. In an unguarded moment he writes that the classical economists of the era “knew that the only way of ensuring sound money was to base it on gold.” Any other arrangement opened the door to the possibility that governments would abandon their dedication to balanced budgets and sound money and resort to the printing press. “Tying the value of money to gold was like tying Odysseus to the mast,” Coggan writes—a way of overcoming the siren’s call.
To his credit, Coggan does not view the gold standard as “natural” or its abandonment as the product of some baroque conspiracy, as some on the political fringes seem to believe. He echoes the standard scholarship on the origins of the gold standard and deftly (and dispassionately) traces its slow, painful demise after World War I, when a modified version of the standard fostered global financial instability. In 1931 Britain abandoned it altogether, and the other nations of the world quickly followed suit, a move that Coggan believes was a matter of acknowledging “economic reality.”
But the gold standard was reborn in a new form after World War II. At that time, the United States held nearly two-thirds of the world’s gold reserves, making it impossible for the global economy to return to the conventional gold standard. The Bretton Woods Agreement struck in 1944 finessed the problem, stipulating that national currencies would now be redeemed in US dollars. In turn, central banks could present those dollars to the United States, which was obligated to redeem them in gold.
This was an ingenious, if ultimately unsustainable, arrangement. The United States got to print dollars at no cost in order to purchase goods overseas, a prerogative that the French Finance Minister Valéry Giscard d’Estaing labeled an “exorbitant privilege.” But all privileges come at a price, as Coggan recognizes. The United States had to keep its finances in order so as to maintain the credibility of the system. It could not go on spending sprees; it had to be prepared to redeem the dollars held by other countries in gold. The United States, Coggan wryly observes, “was required in a sense to be the designated driver, staying off the Keynesian booze.”
But what began as an occasional drink with dinner became a full-blown addiction to deficit spending, especially as the United States tried to juggle the costs of the Great Society programs and the Vietnam War. By 1971, the United States could no longer redeem all of its dollars in gold, and President Richard Nixon abruptly refused to honor the terms of Bretton Woods. Treasury Secretary John Connally neatly captured the new order when he told his European counterparts that “it’s our currency, but your problem.”
This story has been told countless times, but Coggan relates it well, even though he makes it into something of a morality play. If, as he clearly believes, the road to perdition is paved with paper, the demise of Bretton Woods was the final fall from grace. Currencies—and the debts they denominated—ceased to have any connection to precious metals; money and debt became one and the same. The results were stunning. In 1971, gold bullion traded at $35 an ounce; in 2011, the price hit $1,900. In terms of gold, the dollar had lost approximately 98 percent of its purchasing power. This, Coggan wryly observes, “is progress of a kind. The Romans took two hundred years to devalue their currency by the same amount; our generation has achieved the trick in just forty.”
Those forty years are the crucial ones for Coggan. After the demise of Bretton Woods, there “was no limit to the amount of money and credit that could be created. Countries no longer suffered a gold drain when they ran a trade deficit.” The result, Coggan argues, has been asset bubbles of growing size and severity. Central banks have messed things up further by intervening to cushion the effects of bubbles popping, setting the stage for even greater problems down the line.
Coggan doles out an equal share of the blame to the financial sector. Most commentators ascribe the metastatic growth of banks to deregulation, but Coggan attributes much of the problem to the demise of Bretton Woods, which put an end to capital controls and ushered in a new regime of floating exchange rates. The uncertainty this system generated led to the growth of a massive market in hedging via derivatives, which in turn fostered the development of too-big-to-fail banks capable of managing such large-scale bets. Many of those same financial institutions also enabled consumers, banks and even countries to assume ever greater amounts of debt.
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Coggan considers the crisis that erupted in 2007 as the beginning of the end of the developed world’s dependence on debt. He traces how a crisis of confidence in a bunch of subprime loans swiftly turned into a firestorm, one that governments and central bankers brought under control only with massive interventions in the financial system—guaranteeing debts, buying up distressed assets and dropping interest rates to zero.
But these moves didn’t make the underlying debt disappear; instead, they merely transferred it from consumers, banks and corporations to the balance sheets of governments and their central banks. For Coggan, this is the key point: the financial crisis has not rid the world of debt; it has only moved it from one account to another. Things remain much the same as they did before the crisis, except that investor anxiety has shifted from subprime homeowners to subprime governments.
Though he rarely resorts to alarmist language, much less apocalyptic predictions, Coggan cannot see a path forward. And, indeed, when all the debt that individuals, companies and the governments of developed nations owe is added up, the situation looks pretty scary. Citing an influential McKinsey study published in 2010, Coggan reports that total debt levels—of individuals, companies and governments—amount to a whopping 466 percent of GDP in Britain, with Spain (366 percent), France (322 percent), Italy (315 percent) and the United States (296 percent) not far behind.
Worse still, most nations with heavy debt loads have aging populations and will be forced to devote ever growing resources to obligations like pensions, many of which are unfunded, meaning that they will require ever greater infusions of cash to honor promises already made. As birthrates drop in the developed world and fewer workers subsidize more retirees, the strain on the system will only grow. This bodes ill for countries like Italy, where the birthrate isn’t sufficient to keep pace with the existing population. Barring an unforeseen uptick in fertility rates (or, less pleasant, “a disease that culls the ranks of the elderly,” as Coggan writes), the situation is grim.
Is there a way out? The most obvious answer is for indebted economies to grow once again. But that’s unlikely, given that the demographic dice are loaded against most of the developed countries with the possible exception of the United States, where the birthrate sits at 2.06 per woman, and where approximately 1 million new immigrants arrive every year. A return to frugality and balanced budgets, however well-intentioned, will only exacerbate matters: the entire world can’t simultaneously run surpluses; some countries will have to run deficits.
For Coggan, that leaves an “unholy trinity” of likely scenarios: stagnation, inflation and default. We’re already living with stagnation, as growth rates sputter along. In Coggan’s estimation, stagnation is simply a prelude to inflation and default, as electorates become tired of pleasing bondholders and “opt to erode the debt, in real or nominal terms.” This could take several forms. In the case of countries like the United States and Britain, both of which can print more money to pay off their debts, depreciation via inflation is an option. But this is simply default (albeit a managed one) by another name. Other nations, Coggan believes, will simply default on some or all of their debt. The debtors have had their day—forty years, actually—and the hour of reckoning draws near.
This may well be true, but there are different ways of managing the coming pain. Coggan offers only the “counsel of despair,” refusing to say much about possible ways to navigate the stormy weather he sees on the horizon. Consider, for example, the ongoing debt crisis in Europe. Coggan dutifully relates this story and predicts stagnation and, eventually, some kind of default in nations like Portugal, Ireland and Spain. But if the example of Greece is any guide, the existing method of handling these problems has been downright destructive. Austerity measures aimed at restoring Greece’s bond ratings instead pushed the country to the edge—and it still defaulted on much of its debt. The same scenario is now unfolding in Spain. Why, then, put the other PIIGS (the less than charitable acronym for the ailing countries of the eurozone) through the same treatment? Why not cut to the chase and default?
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More generally, why maintain the European currency union at all? Coggan rightly suggests that these countries are unlikely to grow themselves out of debt, and he notes as well that they are no longer competitive in part because they can’t depreciate their own currencies; they’re chained to the euro. Given that, why shouldn’t the PIIGs leave the eurozone and regain control over their currencies? The new drachma or peso would depreciate, but exports from these countries would be cheap and competitive in global markets.
Instead, Coggan seems resigned to a torturous and prolonged period of suffering in which Portugal, Spain, Ireland and possibly other nations are forced to take measures that destroy their economies in order to please bondholders they will never repay in full anyway. That stra tegy—“the beatings will continue until morale improves,” as Krugman has described it—isn’t working. It truly is the counsel of despair.
Coggan ends Paper Promises with some speculations about the future. Like many observers, he believes that the twenty-first century belongs to China. It may not dominate the world overnight, Coggan concedes, but as the world’s largest creditor, it will ultimately set the terms for a new financial system, much as the United States did with Bretton Woods. “A new order will emerge,” he predicts. “And, like so many of the goods sold in Western supermarkets, it will be made in China.”
However, this outlook necessarily assumes that China hasn’t already succumbed to the siren call of paper promises, and that it hasn’t been hitting the “Keynesian booze” to excess. But what exactly do we make of a nation with enough vacant housing units to accommodate 200 million people, and with enough in various stages of planning and construction for millions more to come? Or its many empty airports, trains, even cities? How do we characterize the staggering growth in credit since the financial crisis, when Beijing encouraged banks and local governments to make loans with no regard to need?
Indeed, on close inspection, China looks like a textbook case of precisely the sort of government-sponsored misallocation of capital that rankles Austrian economists. That realization, formerly articulated by an outspoken minority of short-sellers, is now seeping into the mainstream. Commentators have discovered that nonperforming loans are sprouting up all over the Chinese economy, from local governments to state-owned enterprises to obscure, little-understood funding vehicles. Someone is going to have to assume responsibility for that debt, and by some recent estimates of these hidden liabilities, China’s government will likely end up shouldering a debt burden that puts it on a par with the United States. Some calculations put it at even higher levels, though exact figures are hard to obtain. Moreover, China will soon face the same kind of demographic pressures that European countries know all too well. China’s birthrate is approximately the same as Europe’s, and in a couple of years the country will reach a turning point in which the elderly population will begin to grow relative to twentysomethings.
None of this disproves Coggan’s larger point: the world is awash in debt, and much of it won’t be paid. But even a quick inventory of China’s financial difficulties should prompt one to wonder whether Beijing, which recently castigated the United States for its “addiction to debts,” could assume the starring role in the global financial system that Coggan envisions. There may now be no single country powerful enough to impose its will on the planet in the way that Britain and the United States did in the nineteenth and twentieth centuries. There may be no “new world order” on the horizon. If so, the United States will not cede its hegemonic role in the global economy anytime soon. As Coggan notes at one point, when it comes to debt, the United States is the de facto leader—the proverbial “one-eyed man in a sightless world.” The image of a crippled, if singular, superpower may offer scant consolation to politicians who dream of another American Century, but it’s not cause for despair, either.