Paul Krugman writes:

I’ve been playing around with the IMF’s historical public debt database, which has long-term information on ratios of debt to GDP. And you really have to marvel, given that historical record, at the deficit panic now so widespread. Here’s debt as a percentage of GDP in Britain, back to 1830:

That uptick at the end — you’ll see it if you squint — is what’s driving the Cameron government’s insistence on slashing spending in a liquidity trap.

It’s also interesting to note — contrary to what you often hear — that at the time Keynes was writing, and calling for fiscal stimulus, Britain was substantially deeper in debt than Britain or the United States are now.

Link to the original.

The ECB’s Battle against Central Banking

BERKELEY – When the European Central Bank announced its program of government-bond purchases, it let financial markets know that it thoroughly disliked the idea, was not fully committed to it, and would reverse the policy as soon as it could. Indeed, the ECB proclaimed its belief that the stabilization of government-bond prices brought about by such purchases would be only temporary.

It is difficult to think of a more self-defeating way to implement a bond-purchase program. By making it clear from the outset that it did not trust its own policy, the ECB practically guaranteed its failure. If it so evidently lacked confidence in the very bonds that it was buying, why should investors feel any differently?

The ECB continues to believe that financial stability is not part of its core business. As its outgoing president, Jean-Claude Trichet, put it, the ECB has “only one needle on [its] compass, and that is inflation.” The ECB’s refusal to be a lender of last resort forced the creation of a surrogate institution, the European Financial Stability Mechanism. But everyone in the financial markets knows that the EFSF has insufficient firepower to undertake that task – and that it has an unworkable governance structure to boot.

Perhaps the most astonishing thing about the ECB’s monochromatic price-stability mission and utter disregard for financial stability – much less for the welfare of the workers and businesses that make up the economy – is its radical departure from the central-banking tradition. Modern central banking got its start in the collapse of the British canal boom of the early 1820’s. During the financial crisis and recession of 1825-1826, a central bank – the Bank of England – intervened in the interest of financial stability as the irrational exuberance of the boom turned into the remorseful pessimism of the bust.

In his book Lombard Street, Walter Bagehot quoted Jeremiah Harman, the governor of the Bank of England in the 1825-1826 crisis:

“We lent…by every possible means and in modes we had never adopted before; we took in stock on security, we purchased exchequer bills, we made advances on exchequer bills, we not only discounted outright, but we made advances on the deposit of bills of exchange to an immense amount, in short, by every possible means consistent with the safety of the Bank, and we were not on some cases over-nice. Seeing the dreadful state in which the public were, we rendered every assistance in our power…”

The Bank of England’s charter did not give it the legal authority to undertake such lender-of-last-resort financial-stability operations. But the Bank undertook them anyway.

Half a generation later, Britain’s Parliament debated whether the modifications of the Bank’s charter should give it explicit power to conduct lender-of-last-resort operations. The answer was no: granting explicit power would undermine confidence in price stability, for already there was “difficulty restrain[ing] over-issue, depreciation, and fraud.” Indeed, granting explicit lender-of-last-resort powers to the Bank of England would mean that the “millennium of the paper-mongers would be at hand.”

But the leaders of Parliament also believed that the absence of a codified authority to act as lender of last resort would not keep the Bank of England from doing so when necessity commanded. As First Lord of the Treasury Sir Robert Peel wrote: “If it be necessary to assume a grave responsibility, I dare say men will be willing to assume such a responsibility.”

Our current political and economic institutions rest upon the wager that a decentralized market provides a better social-planning, coordination, and capital-allocation mechanism than any other that we have yet been able to devise. But, since the dawn of the Industrial Revolution, part of that system has been a central financial authority that preserves trust that contracts will be fulfilled and promises kept. Time and again, the lender-of-last-resort role has been an indispensable part of that function.

That is what the ECB is now throwing away.

Many times, I’ve tried to put together a brief narrative of the causes of World War I, and I invariably find (after the fact) that I’ve left something out. So here’s the latest (and, one would hope, final) attempt…

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There were at least three causes that in confluence led to World War I. Let’s take them one at a time and put them together a little later.

1. Germany unable to feed itself

In his book The Economic Consequences of the Peace (1919), J.M. Keynes cited contemporary estimates suggesting that immediately before the war, Germany had a population of 67 million, while producing enough food to feed about 40 million. Austria was in a qualitatively similar position. This state of affairs was largely caused by the legacy of feudal land ownership, whereby the aristocracy controlled vast amounts of land and extracted substantial rents from them.

2. The gold standard

Under the gold standard, a nation can expand its money supply only as far as its gold stock allows. To expand its gold stock, a nation must have a trade surplus. So expanding the money supply under the gold standard is only possible if a nation has a trade surplus.

Expanding money supply is the quickest way of ending recessions and thus keeping the population gainfully employed and reasonably happy. But under the gold standard, it is only possible if a nation has a trade surplus, so governments, instead of abandoning the gold standard (which was considered the holy cow of economic policy back then), started working on ensuring that their nations always have a trade surplus.

3. The continuing rule of the military aristocracy

All major European countries (with possible exception of Britain) were de-facto ruled by the military aristocracy, educated, if at all, in humanities and the art of war, not in economics (which, having begun in earnest with Marshall’s Principles published in 1890, was barely out of diapers in 1913). Three things were the direct result of this, (1) the ruling class, unable to comprehend the evils of the gold standard, upheld it, (2) the ruling class, being a military elite, actively sought military solutions to economic problems, and (3) the ruling class extracted substantial rents from its vast land holdings, making domestic agriculture prohibitively expensive compared to that of U.S., Canada, Australia, or Argentina.

Put all three together, and what do you get?

To keep the growing urban population employed, you need to expand money supply, which, under the gold standard, is only possible if your country has a trade surplus. To ensure that you have a trade surplus, you begin pressuring other countries into opening their markets for your exports while keeping imports off your domestic market using tariffs or non-tariff barriers. The pressure tactics gradually escalate from diplomacy to the threat or war, until Europe is completely polarized, with all major countries joining one of the two blocs that eventually went to war with each other. Germany, which desperately needs to export manufactures in order to pay for food, is especially aggressive in its attempts to secure export markets for its manufactures. So Europe becomes a powder keg that sits there waiting for a random spark to ignite its explosion. That spark was the assassination of Franz Ferdinand, the heir to the Austrian throne, by a group of Serbian conspirators. Had it not happened, another “cause” (having as little to do with the real causes as the assassination of Franz Ferdinand did) would have been found in a pretty short order…

Murat Iyigun writes:

The graph below shows a 10-year moving average of the number of wars and domestic conflict in continental Europe for the half millennium between 1450 and 1950. It depicts various intriguing facts, some of which have been identified long ago and some others that are recently surfacing.

For starters, the 18th century was the most peaceful on record. In fact, as the political science literature established in the 1960s, this trend holds true not only for Europe, but also for violent confrontations globally.

But why did violent conflicts rise in the 20th century as they did after a remarkable decline commensurate with Europe’s economic ascend in the 17th and 18th centuries? How will a reshuffling and steady evolution of the world political order affect these patterns (remember the League of Nations)?

And how does technological change influence the propensity to engage in conflicts? Here is an intriguing paper by Nippe Lagerlof which attempts to deal with that question.

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