Keynes’ Advice from the 1940s
Marie Christine Duggan, Guest Blogger
Marie Christine Duggan is a professor of economics at Keene State College in New Hampshire. In this article, originally published in the May/June 2015 issue of Dollars & Sense magazine, she argues that the kinds of system proposed by Keynes for adjustment to international imbalances in the 1940s would represent a way out of crisis for Greece and Europe today.
Is there a way for Greece to honor its debts without impoverishing its people? Most people see only two ways out of the current crisis: Either Greece services its debts, and the wealth gap between creditor and debtor nations in Europe rises; or Greece defaults, and the European banking system is forced to write-down its assets by the value of the Greek IOUs. However, there is a third way: creditors could promise to spend the money they receive from Greece (in the form of debt service payments) on Greek imports or on long-term for-profit investments in Greece. This third way involves re-aligning institutional incentives so that the creditors only gain when the debtors themselves grow.
Problems like those Greece faces are not new. And, in fact, the best solutions are not new either. During the Second World War, Britain faced a similar situation of trade deficits coupled with a cut-off of international credit. John Maynard Keynes devised a solution which did not impose all the burdens on the debtors by reducing wages. Instead, it would not be just debtor countries—but also creditor countries—that would have to “adjust.” The creditors would have to spend their surpluses (rather than building up reserves), allowing the debtors, in turn, to grow their economies and pay back their debts. Dependence on the fickle whim of the foreign investor is the story line that unites the post-war British context with that of Greece today. In another similarity, the subtext for Greece, since it joined the eurozone in 2001, has been the need to increase its productive capacity and infrastructure so that its products—priced in euros—are produced efficiently enough to compete with those from other eurozone countries. A solution like the one Keynes proposed for Britain towards the end of the war would offer Greece the best way out today.
The Trap of Short-Term Debt
The euro became Greece’s sole currency in 2002. This opened the door to marketers of credit from wealthier eurozone nations. The Greek government, firms, and households had previously been making payments in drachmas, which were considered “funny money” by international investors because the currency could lose value in a depreciation of its exchange rate relative to the euro. But after 2002, the Greeks began making payments in euros on loans denominated in euros, so the creditors faced no risk of exchange rate loss. No one had ever been so enthusiastic before about lending to the Greeks. Between 2005 and 2008, foreigners opened bank accounts or moved into the country (capital account increases), or invested in Greek stocks and government bonds (portfolio investment), as shown in the top half of Figure 1. As these moneys flowed in, they permitted Greece to finance an excess of imports over exports which resulted in the growing current account deficit shown in the bottom half of Figure 1. The fact that investors from other European countries were willing to lend to Greece was not the problem. Rather, the problem was the short-term nature of the loans. There are basically two types of foreign investment: short-term and long-term. Portfolio investment and foreign bank accounts are both short-term purchases of paper assets. Foreign direct investment, on the other hand, involves an institution in a creditor nation opening a physical business in Greece as a subsidiary, or engaging in a joint venture with a Greek business partner. Without the option of a quick and easy exit, the direct investor has more of a stake in ensuring the growth of the business activity undertaken in Greece.
Figure 1. Greek Balance of Payments, 2005-2008
Source: IMF Balance of Payments (billions of euros); bank accounts also include “other.” Note: The figures are based on the IMF balance-of-payments data. In this accounting system, foreign portfolio investment (purchases/sales by private foreign sector or foreign governments of stocks and bonds) and foreign direct investment are included in the “financial account.” The financial account “other” includes government-to-government loans, bank loans, loans to and from international organizations, and trade credits.
In 2008, foreign lenders provided Greece with short-term funds to the tune of 16.4 billion euros, while foreign direct investment was barely one-tenth that amount, only 1.7 billion euros! Such a predominance of foreign portfolio investment and bank accounts is problematic because the flow can reverse in the time it takes to push a button on a computer, giving the portfolio investor incentive to flee at even the slightest hint of trouble. As Figure 2 shows, net portfolio investment demonstrated its short-term nature by turning negative—into a net outflow from Greece—in 2010. The outflow reached panic proportions by 2012.
Figure 2. The Greek Financial Account:
Capital Flight from 2010 to 2012
Source: Greek Article IV Report, IMF June 30, 2013 in billions of euros. “Other” refers mostly to bank accounts.
When short-term investment dominates, foreign creditors hold the debtor nation hostage. If the creditors don’t like the country’s public policies, they can quickly sell off their holdings. Had the eurozone wanted each nation to preserve its political sovereignty, it should have put in rules to heavily discourage short-term speculative loans between eurozone partners. In fact, the opposite occurred. Greek entry into the eurozone was viewed as a marketing opportunity for short-term credit from financial institutions in wealthier nations.
When foreign holders of Greek government bonds decided to sell in 2010, Greece was running a fairly high trade deficit, on the order of 10% of GDP. It is possible for a nation to import more than it exports, but only so long as foreigners are willing to lend to or invest in the nation. In 2008, foreigners were interested in lending to Greece, but the global economic crisis in 2009 made them jittery. By 2010, they no longer wanted to lend to the Greek government, but rather to sell off their holdings of Greek government bonds (for 8.5 billion euros). Meanwhile, Greece planned to import more than it exported (23 billion euros), so the IMF came up with 31.5 billion euros to fill the gap. In the short term, it would have been very punitive to the economic base to cut off imports completely, since some are inputs to the economy (such as computers) and others are essential to subsistence (such as medicine).
Why did the international banking system step in with the first 31.5 billion euro bailout? The answer is that creditor institutions were unwilling to let Greece default. Between 1990 and 2010, many banks made loans around the world to borrowers who might never be able to pay those loans back. If the international banking system were to admit that some loans will never be repaid, then banks would have to write down their assets by the amounts of those loans. Greece is just the tip of the iceberg in that regard. The last thing that the international banking system wants is for Greece to repudiate the loans.
IMF loans are designed to rescue the international banking system, rather than to assist the debtor nation. That explains why the loans did not end Greece’s problems. The IMF wanted Greece to let holders of Greek bonds sell them off—for the money that the IMF had newly lent. The IMF hoped that the ability to liquidate Greek bonds would deter the bondholders from actually selling. The IMF was playing a confidence game to prevent portfolio investors from hitting the “sell” button.
The long-term solution for Greece, however, is completely different. To reduce reliance upon foreign financing, Greece would like to export more than it imports. Winning over international buyers will require lowering Greek production costs. The way to lower costs significantly and sustainably is to invest in new technology and infrastructure that permits the same workers to produce more during any given period. However, the IMF insisted that Greece lower the cost of production while also reducing imports (read: no more new technology) and ceasing to borrow above emergency levels. Under those circumstances, the only way for Greek products to gain any market share would be for wages to drop—by a lot. Real wages did drop and unemployment rose to 27%. Many households had accumulated debt between 2002 and 2010, and as they lost jobs, debt burdens relative to incomes rose. At the same time, the Greek government could no longer borrow by issuing bonds (because Europeans, including Greeks, were no longer willing to buy them), so the government reduced benefits (as the IMF was also urging). By 2014, the Greek people had endured enough and voted the left-wing SYRIZA coalition in on a platform to end IMF control of government policy.
IMF loans are not meant to rebuild a country, but rather to tide it over through a panic until the private sector is willing to lend to the country again. If IMF loans fail to reverse a temporary panic, they wind up growing dangerously large (look at 2010 to 2012 in Figure 3). As the SYRIZA government’s finance minister, Yanis Varoufakis, has pointed out, “We have resembled drug addicts craving the next dose. What [SYRIZA] is all about is ending the addiction.” Greece is in a bind: IMF loans are emergency funds that cannot be used to improve productive capacity, educate the people, or build infrastructure. Wages and employment are falling at the same time as social insurance, so the people are understandably bitter. If Greece leaves the eurozone now, the return to the drachma will put salaries back into drachma, which will not have the purchasing power of euros. All exits seem to lead to a lower standard of living for the people of Greece and greater income inequality between nations in Europe.
Figure 3. IMF Bailouts Plug Ever-Larger Hole in Greek Balance of Payments, 2010-2012
Source: Greece: Article IV Report, IMF on June 30, 2013 (in billions of euros).
Enter John Maynard Keynes
Let us now turn to Keynes’ suggestion for Britain at the end of World War II. Like Greece today, Britain at the time had a damaged industrial base and poor infrastructure (due to Hitler’s bombs). Furthermore, wealthy foreigners who had lent Britain money in a short-term way were trying to liquidate their British holdings just when Britain needed long-term credit. In Britain’s case, the short-term holdings of foreign money came in the form of the London bank accounts of imperialists in South Africa, Canada, Australia, India, and other nations of the collapsing British Empire. These wealthy families wanted to transfer their money to New York banks, and to import products from the United States as well. Britain was running a trade deficit, and the rest of the world was trying to remove funds all at the same time. In both respects, the situation was similar to Greece today.
Keynes gave considerable thought to the problem: How could Britain’s banks honor the commitment to permit depositors to remove funds while also rebuilding its industrial base? And he came up with a logical solution: put pressure on creditors as well as debtors to “adjust.” His logic was that debtors always feel the pressure to make payments—on pain of cut-off from future loans, threat of asset seizure, or other punitive measures (such as the threat today of pushing Greece out of the eurozone). However, creditor nations do not feel a similar pressure to spend what they get from exporting more than they import—i.e., running a trade surplus. They can hoard the surplus by building up reserves. The first rule for Keynes, then, was that creditor nations should have their surpluses confiscated if they did not spend it by the end of the year. He never anticipated any confiscation actually taking place—like any “use it or lose it” account, the point was to provide an institutional incentive for the creditor to spend the entire surplus by a certain time.
The second rule would have consisted in limiting the types of spending that creditors could make to long-term investments, imports, or donations. This brings us to the way out for the eurozone and Greece. It will be safe for Greece to repay its debts to the creditor nations of Europe, if the eurozone nations agree that the creditor nations will spend the money they receive from Greece on Greek imports or long-term loans or joint ventures in Greece. Since Greece is not exporting enough to pay for imports that will build up its infrastructure, then by definition the eurozone nations do not find it sufficiently enticing to buy imports from Greece. In this case, eurozone nations would make long-term investments in Greece so that Greece could generate the capacity to produce imports that were appealing to Europe.
Perhaps this scenario seems too draconian— forcing creditors to purchase from or make long-term investments in Greece on penalty of losing the income from annual Greek debt payments. Consider, then, that the eurozone nations could simply make a rule that every member nation would need to spend its trade surplus with other eurozone nations by end of year, and that such spending take the form of imports, long-term investment, or donations. (Portfolio investment would be highly discouraged.) Each nation could import, invest in, or donate to the individual country of its choice, but since any surplus would have to be spent by a certain time, the effect would be to make every eurozone economy balance its international payments. Imagine an inflatable rubber glove. As air goes into one finger, that finger inflates. Once that finger is filled, the air will naturally flow to another finger. In the end all five fingers of the rubber glove will be equally inflated. In just this way, if every creditor nation must spend its current account surplus by the end of the year in other eurozone nations, then the entire eurozone economy will expand.
Postscript for Europe Then, Prescription for Europe Now
Keynes’ plan did not pass at the Bretton Woods Conference in 1944, but his proposal did influence debate. The United States rejected the “use it or lose it” clause that would have required it to import from or physically invest in debtor countries until its huge post-war surplus was gone. However, the United States did donate via the Marshall Plan, and financed long-term loans through the International Bank for Reconstruction and Development. Britain obtained a long-term loan from the United States for reconstruction (see photo on p. 19), rather than the gift that Keynes sought, and it was several years before Britain permitted deposits to be freely converted out of London banks. Yet the negotiations did result in restrictions on portfolio investment, so that foreign direct investment became the dominant form of international investment between 1945 and 1973. During that period, global income inequality was reduced.
In 1944, Europe and the United States had been chastened by two world wars and the rise of Nazism and Fascism. All 44 nations sending representatives to Bretton Woods understood that economic forces had contributed to the horror in which so many had lost so much. Nobody wanted to live through it again. To prevent political extremism and its deadly consequences, governments were willing in that moment to put restrictions on how banks made money, and to commit to economic policies that would bring jobs and prosperity to the working class. For a similar scenario to come off today, policymakers must remember the fragile nature of global institutions and the importance of curtailing investments where creditors escape with profits while debtors lose ground. Europe is a family, and when the business owned by one family member is small and precarious, other members do not make short-term loans at high interest, or push the firm into bankruptcy and seize the assets. Family members buy from each other and invest for the long-term in each other’s enterprises because such willing and profitable action fosters family strength and stability.
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