Learning from past mistakes

The history of finance is partly the history of a struggle for a stable, secure way to measure value. And, like any quest for certainty in our unpredictable world, it was doomed to failure.

The latest financial crisis powerfully highlights this vulnerability, as it destroys any sense that we can put an accurate price on assets. Most people are now convinced that this shortcoming is inherent in the financial system. But uncertainties about value also expose deep problems in the political order.

In the past, metallic money provided an inconvenient and unsatisfactory solution to the question of value. It was inconvenient because gold was awkward for everyday transactions, and silver had too little value for major transfers. Moreover, metallic money was prone to unpredictable shifts in value with the discovery of new supplies. The arrival of silver from the New World in the sixteenth century triggered sustained inflation. The discovery of gold in California in the mid-nineteenth century, and in Alaska, South Africa, and Australia 50 years later, also produced mild inflation, while the absence of such new discoveries in the 1870s and 1880s led to mild deflation.

Consequently, many economists and politicians concluded that paper money could be more easily controlled and more stable. This innovation, dependent on high-security paper-making and printing techniques, transformed the twentieth century. But it initially produced a much less stable outcome, because of the strong temptation of political abuse. Instead of moderate inflation, most of the twentieth century was wildly inflationary, as governments over-issued currency.

In the last two decades of the twentieth century, however, an intellectual revolution occurred. Entrusting monetary policy to an independent central bank promised to be a perfect way to counter the political pressure to print money. At the United States Federal Reserve, Paul Volcker engineered a successful process of disinflation beginning in 1979. Europe learned the same lesson with the move to a monetary union and the creation of the European Central Bank to manage the euro.

As a result, people assumed that the problem of monetary stability had been solved, and they could pile up assets and then use them as collateral to borrow ever-larger sums. But the large-scale destruction of financial assets because of underlying uncertainty about the extent of losses in the wake of the subprime crisis, and especially after the bankruptcy of Lehman Brothers, shook that assumption.

Deflation that emanates from the financial sector is more difficult to deal with than inflation, in part for the technical reason that interest rates can be cut only to zero. The closer to zero they fall, the more problematic monetary policy becomes. The policy instruments no longer work. Central banks have expanding balancesheets, but prices continue to fall and uncertainty rises.

There is a further reason why deflation is such a threat, and why policymakers setting out to eliminate it have a much tougher task than inflation fighters: all prices do not move down; in particular, debts do not adjust because they are fixed in nominal terms.

Inflation and deflation of debts produce very different outcomes. Inflation reduces the value of debt. Deflation, on the other hand, increases debt. In the interwar Great Depression, the economist Irving Fisher accurately described the process of debt deflation, in which lenders, worried by the deterioration of their asset quality, called in their loans, pushing borrowers to liquidate assets. That, in turn, merely drove down prices further, leading to more credit rationing, bankruptcies, and bank failures.

The political response to deflation is to call for a stronger state. Only the state is reliable enough to take on all debt, which private institutions are too risk-intolerant to hold. But economists' abstract description of the resulting state intervention as an expansion of "aggregate demand" conceals the fact that the government conducts specific expenditures and makes political decisions that rescue specific businesses and individuals.

In the climate of scarcity that characterises debt deflations, the specificity of bailout operations inevitably leads to intense political debate. We see this in the current discussion about the distributional effects of rescuing the automobile industry; or the worry that hedge funds, widely blamed for today's financial malaise, should have access to the Fed's emergency credit lines.

Statism has been a characteristically twentieth-century response to new uncertainty. Its inadequacy may lead to the formulation of a much older answer: revulsion against the market economy, accompanied by indiscriminate condemnation of debt and debt instruments.

As governments scramble to respond to the current crisis, we should remember that deflation tends to produce not only radical anti-capitalism, but also a profound hostility to any kind of economic or political organisation.

- Project Syndicate

(Harold James is Professor of history and international affairs at the Woodrow Wilson School, Princeton University and professor of history at the European University Institute, Florence.)