Capital in the Twenty-First Century (95 page)

Such a solution is extremely tempting. Historically, this is how most large public
debts were reduced, particularly in Europe in the twentieth century. For example,
inflation in France and Germany averaged 13 and 17 percent a year, respectively, from
1913 to 1950. It was inflation that allowed both countries to embark on reconstruction
efforts in the 1950s with a very small burden of public debt. Germany, in particular,
is by far the country that has used inflation most freely (along with outright debt
repudiation) to eliminate public debt throughout its history.
¹⁰
Apart from the ECB, which is by far the most averse to this solution, it is no accident
that all the other major central banks—the US Federal Reserve, the Bank of Japan,
and the Bank of England—are currently trying to raise their inflation targets more
or less explicitly and are also experimenting with various so-called unconventional
monetary policies. If they succeed—say, by increasing inflation from 2 to 5 percent
a year (which is by no means assured)—these countries will emerge from the debt crisis
much more rapidly than the countries of the Eurozone, whose economic prospects are
clouded by the absence of any obvious way out, as well as by their lack of clarity
concerning the long-term future of budgetary and fiscal union in Europe.

Indeed, it is important to understand that without an exceptional tax on capital and
without additional inflation, it may take several decades to get out from under a
burden of public debt as large as that which currently exists in Europe. To take an
extreme case: suppose that inflation is zero and GDP grows at 2 percent a year (which
is by no means assured in Europe today because of the obvious contractionary effect
of budgetary rigor, at least in the short term), with a budget deficit limited to
1 percent of GDP (which in practice implies a substantial primary surplus, given the
interest on the debt). Then by definition it would take 20 years to reduce the debt-to-GDP
ratio by twenty points.
¹¹
If growth were to fall below 2 percent in some years and debt were to rise above
1 percent, it could easily take thirty or forty years. It takes decades to accumulate
capital; it can also take a very long time to reduce a debt.

The most interesting historical example of a prolonged austerity cure can be found
in nineteenth-century Britain. As noted in
Chapter 3
, it would have taken a century of primary surpluses (of 2–3 points of GDP from 1815
to 1914) to rid the country of the enormous public debt left over from the Napoleonic
wars. Over the course of this period, British taxpayers spent more on interest on
the debt than on education. The choice to do so was no doubt in the interest of government
bondholders but unlikely to have been in the general interest of the British people.
It may be that the setback to British education was responsible for the country’s
decline in the decades that followed. To be sure, the debt was then above 200 percent
of GDP (and not barely 100 percent, as is the case today), and inflation in the nineteenth
century was close to zero (whereas an inflation target of 2 percent is generally accepted
nowadays). Hence there is hope that European austerity might last only ten or twenty
years (at a minimum) rather than a century. Still, that would be quite a long time.
It is reasonable to think that Europe might find better ways to prepare for the economic
challenges of the twenty-first century than to spend several points of GDP a year
servicing its debt, at a time when most European countries spend less than one point
of GDP a year on their universities.
¹²

That said, I want to insist on the fact that inflation is at best a very imperfect
substitute for a progressive tax on capital and can have some undesirable secondary
effects. The first problem is that inflation is hard to control: once it gets started,
there is no guarantee that it can be stopped at 5 percent a year. In an inflationary
spiral, everyone wants to make sure that the wages he receives and the prices he must
pay evolve in a way that suits him. Such a spiral can be hard to stop. In France,
the inflation rate exceeded 50 percent for four consecutive years, from 1945 to 1948.
This reduced the public debt to virtually nothing in a far more radical way than the
exceptional tax on capital that was collected in 1945. But millions of small savers
were wiped out, and this aggravated the persistent problem of poverty among the elderly
in the 1950s.
¹³
In Germany, prices were multiplied by a factor of 100 million between the beginning
of 1923 and the end. Germany’s society and economy were permanently traumatized by
this episode, which undoubtedly continues to influence German perceptions of inflation.
The second difficulty with inflation is that much of the desired effect disappears
once it becomes permanent and embedded in expectations (in particular, anyone willing
to lend to the government will demand a higher rate of interest).

To be sure, one argument in favor of inflation remains: compared with a capital tax,
which, like any other tax, inevitably deprives people of resources they would have
spent usefully (for consumption or investment), inflation (at least in its idealized
form) primarily penalizes people who do not know what to do with their money, namely,
those who have kept too much cash in their bank account or stuffed into their mattress.
It spares those who have already spent everything or invested everything in real economic
assets (real estate or business capital), and, better still, it spares those who are
in debt (inflation reduces nominal debt, which enables the indebted to get back on
their feet more quickly and make new investments). In this idealized version, inflation
is in a way a tax on idle capital and an encouragement to dynamic capital. There is
some truth to this view, and it should not be dismissed out of hand.
¹⁴
But as I showed in examining unequal returns on capital as a function of the initial
stake, inflation in no way prevents large and well-diversified portfolios from earning
a good return simply by virtue of their size (and without any personal effort by the
owner).
¹⁵

In the end, the truth is that inflation is a relatively crude and imprecise tool.
Sometimes it redistributes wealth in the right direction, sometimes not. To be sure,
if the choice is between a little more inflation and a little more austerity, inflation
is no doubt preferable. But in France one sometimes hears the view that inflation
is a nearly ideal tool for redistributing wealth (a way of taking money from “German
rentiers” and forcing the aging population on the other side of the Rhine to show
more solidarity with the rest of Europe). This is naïve and preposterous. In practice,
a great wave of inflation in Europe would have all sorts of unintended consequences
for the redistribution of wealth and would be particularly harmful to people of modest
means in France, Germany, and elsewhere. Conversely, those with fortunes in real estate
and the stock market would largely be spared on both sides of the Rhine and everywhere
else as well.
¹⁶
When it comes to decreasing inequalities of wealth for good or reducing unusually
high levels of public debt, a progressive tax on capital is generally a better tool
than inflation.

In order to gain a better understanding of the role of inflation and, more generally,
of central banks in the regulation and redistribution of capital, it is useful to
take a step back from the current crisis and to examine these issues in broader historical
perspective. Back when the gold standard was the norm everywhere, before World War
I, central banks played a much smaller role than they do today. In particular, their
power to create money was severely limited by the existing stock of gold and silver.
One obvious problem with the gold standard was that the evolution of the overall price
level depended primarily on the hazards of gold and silver discoveries. If the global
stock of gold was static but global output increased, the price level had to fall
(since the same money stock now had to support a larger volume of commercial exchange).
In practice this was a source of considerable difficulty.
¹⁷
If large deposits of gold or silver were suddenly discovered, as in Spanish America
in the sixteenth and seventeenth centuries or California in the mid-nineteenth century,
prices could skyrocket, which created other kinds of problems and brought undeserved
windfalls to some.
¹⁸
These drawbacks make it highly unlikely that the world will ever return to the gold
standard. (Keynes referred to gold as a “barbarous relic.”)

Once currency ceases to be convertible into precious metals, however, the power of
central banks to create money is potentially unlimited and must therefore be strictly
regulated. This is the crux of the debate about central bank independence as well
as the source of numerous misunderstandings. Let me quickly retrace the stages of
this debate. At the beginning of the Great Depression, the central banks of the industrialized
countries adopted an extremely conservative policy: having only recently abandoned
the gold standard, they refused to create the liquidity necessary to save troubled
banks, which led to a wave of bankruptcies that seriously aggravated the crisis and
pushed the world to the brink of the abyss. It is important to understand the trauma
occasioned by this tragic historical experience. Since then, everyone agrees that
the primary function of central banking is to ensure the stability of the financial
system, which requires central banks to assume the role of “lenders of last resort”:
in case of absolute panic, they must create the liquidity necessary to avoid a broad
collapse of the financial system. It is essential to realize that this view has been
shared by all observers of the system since the 1930s, regardless of their position
on the New Deal or the various forms of social state created in the United States
and Europe at the end of World War II. Indeed, faith in the stabilizing role of central
banking at times seems inversely proportional to faith in the social and fiscal policies
that grew out of the same period.

This is particularly clear in the monumental
Monetary History of the United States
published in 1963 by Milton Friedman and Anna Schwartz. In this fundamental work,
the leading figure in monetary economics follows in minute detail the changes in United
States monetary policy from 1857 to 1960, based on voluminous archival records.
¹⁹
Unsurprisingly, the focal point of the book is the Great Depression. For Friedman,
no doubt is possible: it was the unduly restrictive policy of the Federal Reserve
that transformed the stock market crash into a credit crisis and plunged the economy
into a deflationary spiral and a depression of unprecedented magnitude. The crisis
was primarily monetary, and therefore its solution was also monetary. From this analysis,
Friedman drew a clear political conclusion: in order to ensure regular, undisrupted
growth in a capitalist economy, it is necessary and sufficient to make sure that monetary
policy is designed to ensure steady growth of the money supply. Accordingly, monetarist
doctrine held that the New Deal, which created a large number of government jobs and
social transfer programs, was a costly and useless sham. Saving capitalism did not
require a welfare state or a tentacular government: the only thing necessary was a
well-run Federal Reserve. In the 1960s–1970s, although many Democrats in the United
States still dreamed of completing the New Deal, the US public had begun to worry
about their country’s decline relative to Europe, which was then still in a phase
of rapid growth. In this political climate, Friedman’s simple but powerful political
message had the effect of a bombshell. The work of Friedman and other Chicago School
economists fostered suspicion of the ever-expanding state and created the intellectual
climate in which the conservative revolution of 1979–1980 became possible.

One can obviously reinterpret these events in a different light: there is no reason
why a properly functioning Federal Reserve cannot function as a complement to a properly
functioning social state and a well-designed progressive tax policy. These institutions
are clearly complements rather than substitutes. Contrary to monetarist doctrine,
the fact that the Fed followed an unduly restrictive monetary policy in the early
1930s (as did the central banks of the other rich countries) says nothing about the
virtues and limitations of other institutions. That is not the point that interests
me here, however. The fact is that all economists—monetarists, Keynesians, and neoclassicals—together
with all other observers, regardless of their political stripe, have agreed that central
banks ought to act as lenders of last resort and do whatever is necessary to avoid
financial collapse and a deflationary spiral.

This broad consensus explains why all of the world’s central banks—in Japan and Europe
as well as the United States—reacted to the financial crisis of 2007–2008 by taking
on the role of lenders of last resort and stabilizers of the financial system. Apart
from the collapse of Lehman Brothers in September 2008, bank failures in the crisis
have been fairly limited in scope. There is, however, no consensus as to the exact
nature of the “unconventional” monetary policies that should be followed in situations
like this.

What in fact do central banks do? For present purposes, it is important to realize
that central banks do not create wealth as such; they redistribute it. More precisely,
when the Fed or the ECB decides to create a billion additional dollars or euros, US
or European capital is not augmented by that amount. In fact, national capital does
not change by a single dollar or euro, because the operations in which central banks
engage are always loans. They therefore result in the creation of financial assets
and liabilities, which, at the moment they are created, exactly balance each other.
For example, the Fed might lend
$
1 billion to Lehman Brothers or General Motors (or the US government), and these entities
contract an equivalent debt. The net wealth of the Fed and Lehman Brothers (or General
Motors) does not change at all, nor, a fortiori, does that of the United States or
the planet. Indeed, it would be astonishing if central banks could simply by the stroke
of a pen increase the capital of their nation or the world.