Merryn Somerset Webb interviews economist Bernard Connolly about the democratic deficit in the EU, and the certainty of a new financial crisis.
Watch the second part of Merryn's interview with Bernard here.
If you missed any of Merryn's past interviews, you can see them all here.
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Merryn:Hi, I'm Merryn Somerset Webb, editor-in-chief of Money Week magazine. Welcome to another one of our video interviews. Today we are extremely privileged we have with us Bernard Connolly, who is one of only four economists who Mark Carney named in 2008 as having correctly anticipated and analysed the great financial crisis. He's also the author of this particularly brilliant book:The Rotten Heart of Europe, which I have talked about many times, so regular readers will, I hope, have read it by now. If you haven't, go out, get it and read it.
What we're going to start by talking about today is a subject which is covered at some length in this: the European Union and, specifically, should Britain be leaving the European Union. There's a big question for you.
Bernard:It's an easy one to answer, Merryn. Yes, of course it should. And it should do that because the European Union is explicitly anti-democratic. It aims at eliminating the rule of law. It aims at instituting initially a sort of crony capitalism state that would quite quickly transmute into a bureaucratic socialist state.
It is oppressive. It is hypocritical. It has inflicted enormous misery on all its subject countries, most obviously of course through monetary union, which was presented as an economic mechanism but was always intended And we have a former Commission president, Romano Prodi, to vouch for this. It was always intended to create economic crises which would push people into giving up more of their sovereignty, democracy, legitimacy, freedom. And sad to say it's been very successful in that regard if in no other.
Stalin's Soviet constitution of 1938 was the most perfectly democratic ever devised on paper. But Stalin ran an empire. The European Union is an empire.
Merryn:Well, let's go back a bit to what you first said. It's explicitly anti-democratic. Now, a lot of people will say: How can that be? We vote for MEPs. Our MEPs go and sit in the European Parliament. It might be not as directly representative as perhaps the Westminster Government but, nonetheless, that's a democracy.
Bernard:Well I think there are three levels of an answer there. One is, if you like, the debating point answer to say: Stalin's Soviet constitution of 1938 was the most perfectly democratic ever devised on paper. But Stalin ran an empire.
The European Union is an empire. It has imperial ambitions, which extend beyond its present borders. It has the ambition to create a multi-national army which, as John Stuart Mills said on representative government 150 years ago, has been the executioner of liberty throughout the ages.
Merryn:OK, but who is It, then? You talk about the EU as if it is not the parliament, what is it?
Bernard:It increasingly is Angela Merkel. Leaving that question aside for the moment perhaps we'll come back to it it is anomenklatura. It is anomenklaturaconsisting of politicians, but even more so of bureaucrats, of bankers, of a certain number of academics, of media people. It's Davos man with power rather than just a good lunch.
Merryn:And Davos man has power through the European Council?
Bernard:Well, the European Council and the Council of the European Union, and naturally these two things are easy to confuse, but the European Council is the coming together of ministers in a specific area, in foreign affairs, in economics or transport or whatever. The European Council is the summit at which the heads of state or government gather whenever they do and stay up all night and drink coffee and come to so-called deals. But neither of those two processes has any democratic legitimacy. Neither the formal decisions of the Council of the European Union, nor the decisions of the European Council.
The European Parliament was rightly said by the German Federal Constitutional Court as long ago as 1993 as not having the potential to be the basis of a democratic system, and the reason the German Constitutional Court said that, was that for there to be a democratic system, there should be a demos. You know, in effect a community which is neither on the one hand just a collection of disparate individuals or groups, cults, sects, tribes, gangs, regiments, religions or whatever, nor on the other hand an empire.
And where the European Union is heading is towards a sort of very unfortunate amalgam of the two models. It is heading towards an anarcho-imperial state of which there have been several examples in history. Perhaps one of the most pertinent being the Austro-Hungarian Empire. And it was the clash of empires and particularly anarcho-imperial empires that produced the First World War. And when one thinks of the disgusting, obscene horror of war, I don't know how people who are in favour of the European Union can sleep at night. Because what they are doing is creating a set of social tensions By eliminating a political sense of national identity they've forced human beings, I'm not saying they do it deliberately. Perhaps they do. But certainly it has the effect
Merryn:We hope they don't.
Bernard:Of forcing human beings to seek a sense of belonging in something else. Whether it's an ethnic sense, a racial, a religious, linguistic or whatever. And we're starting to see that unfortunately happening.
Merryn:So we would say that the rise of nationalism in various countries across Europe is a direct result of that. The rise of various what we would consider to be extreme political parties is a direct result of the way the EU is working to eradicate cultural differences between nations.
Bernard:Well, I'm not sure it's seeking to eradicate cultural differences. What it's seeking to do is to eradicate the right of people to order their own existence. And in doing so, you know, people say: Why should I bother? I mean, what does it mean to be Swedish any more? What does it mean to be Danish? And they're two very good examples at the moment. Do I define my Swedishness by the fact that I have a Swedish government which Sweden makes its own laws and makes laws only for itself? No, that doesn't happen any more. What am I? Oh, perhaps I'm white Caucasian, and I don't like all these Somalis who are coming into Sweden.
Now, whatever one thinks morally of that set of attitudes, it is a plain, observable, undeniable fact that those attitudes are quite directly related to the European Union's attempt to abolish democratic legitimacy and the feeling that we run ourselves. If I've got no say in the way how things are run, let me forget about the political process. Let me forget about democracy. Let me define myself in terms of what I'm not. That I'm not a Somali. I'm not a Muslim. I'm not white. I'm not Christian. I'm not whatever I am. And one can see it, one can feel it, it is just happening in front of our eyes.
Merryn:OK. Let's go back to the second thing you said at the very beginning, which was that the EU is dedicated to removing the rule of law. Now, people would say that one thing the EU is good at, it's making laws.
Bernard:Well making laws and the rule of law are not quite the same thing, as the early Stuarts discovered when they came down from Scotland. They didn't understand English Common Law. And they made lots of laws, not necessarily through the parliamentary process, but through sovereign prerogative. And that attempt to eliminate the rule of law by making laws was of course a major factor in the outbreak of that really horrific conflict with the English and, for that matter, more generally the British civil wars which killed I think a bigger proportion of the population than the First World War did.
Who is supposed to uphold the rule of law in the European Union? Well it's the European Court of Justice, so called. Which has quite explicitly said that what matters is not international law, is not domestic law, it's not constitutions. It's not even natural law. What matters if the attempt to advanceUne certaine ide de l'Europe.A certain idea of Europe, decided by themselves. And nothing must stand in the way of that. And in pursuit of that objective, they have completely trampled over most aspects of international law, and they do that quite openly and brazenly and congratulate themselves for doing it.
Merryn:Can you give us an example of that? If you can.
Bernard:Well, the treaty itself the original treaty, the Treaty of Rome said that there shall be a court which will uphold the law. Now, what did the law mean at that point, when the treaty was written? Well, presumably it meant some mix of the domestic laws of the various member states and international law. Now public international law plays no part whatsoever in the decisions of the European Court of Justice, and there's actually
You've been plugging my book, let me plug another one from the same time, from 1995 by an Irish jurist, D R Phelan calledRevolt or Revolution?which goes into very significant detail about the way in which the idea of Community law has supplanted and overridden not only domestic law but also public international law. And that was written 20 years ago, and in the 20 years since then we've had far more examples. One of the most blatant ones recently being the ECJ's decision that outright monetary transactions by the ECB are permissible under the treaty. Absolutely contrary to the opinion of, again, the German Federal Constitutional Court, and in my view, and I think in the view of many other people who've actually read the treaty. Not all that many of us. Completely contrary to the intention of the treaty.
But the words of the treaty don't matter. The words of international law don't matter. The words of constitutions don't matter. What matters isUne certaine ide de l'Europe. And anything that drives Europe towards a political union is fine. Anything that retards that is out of the question. And one of the things that might retard that movement towards a political union is freedom of speech, freedom of expression. Freedom from arbitrary arrest and unfair trial.
But both the Charter of Fundamental Rights, which is an integral part of the Lisbon Treaty, and the series of rulings by the European Court have said in terms that all and any political rights, including freedom of expression, freedom from arbitrary detention and unfair arrest, can be overridden if necessary in pursuit of objectives of general interest of the Union. Well what does that mean? That's nothing more thanraison d'etre. They can do what the hell they like. I'm sorry. What was the follow up question from that? I've lost it for the moment.
Merryn:The original question? I haven't the faintest idea.
Bernard:I'm sure there will be one.
Merryn:My last question was for an example, which you've now given us, so I think no-one can be in any doubt on that one. But if we agree, and I think we probably can, that for reasons of sovereignty, democracy, personal freedom etc., one will be better off out than in, a lot of people seem to simply not care about that. What they care about is the economic impact of leaving. So a lot of the Remain argument is based around: Well, it will be an economic disaster for us if we leave. Our trade will collapse, three million jobs will go etc, etc, etc. Now, where are the risks there?
Bernard:Well the risk first of all is of ludicrous exaggeration, and one recalls that Martin Weale, whose work at the National Institute was misused a dozen years ago by the proponents of euro entry said that the claims about three million jobs were the most Goebbels like claims he'd ever seen as an academic researcher, and of course they are. The more measured estimates of the economic impact of withdrawal, such as that from Open Europe for instance, which is a highly respected research organisation, put it in the range roughly speaking of plus or minus 1% of GDP. Which frankly is well within the margin of statistical error of the accounts as they're published.
Now of course there would be uncertainty. There's no doubt about that. There's uncertainty before elections. There's uncertainty about any event which doesn't have an outcome known in advance. And one's seen that reflected over the past six weeks or so in a degree of weakness of sterling. Particularly against the dollar rather than against the euro. At the same time, not true today but over most of the past six weeks, the British stockmarket has outperformed continental stockmarkets. Now what is that conjunction of things saying to us? Well I think it's saying that sterling was overvalued and it's a jolly good thing that it's come off.
Now, the problem about the British economy, and of many other economies in the world, is that because of the mistakes that have been made over the last 20 years I would say. Perhaps we could talk about that a little bit later. That sterling is on, in slightly technical terms, too strong a forward curve. That is the combination of interest rates and expectation for currency movements are wrong for the state of the economy. That's true almost everywhere in the world. You say: How can that happen? How can it be true that everyone in the world has got the wrong currency for its own economy? And that's a big, big problem for the world. Again perhaps we can talk about that later, but
Merryn:We'll come back to that, yes.
Bernard:But essentially what the British economy needs is a combination of higher interest rates and a weaker currency. Higher interest rates because the low interest rates are clearly part of the reason for pretty miserable productivity growth. The
Merryn:OK, can we stop and explain that? Low interest rates are causing our bad productivity growth? I mean, the Bank of England's very confused about the productivity puzzle as they call it
Bernard:Well there is a puzzle. I mean, no-one can deny that there are aspects of the question that can't be readily explained with any great degree of confidence. The bee I have in my own bonnet is that standards of education have collapsed, of course, but that
Merryn:We can come back to that too.
Bernard:But that again is a Western world phenomenon, not just a British phenomenon. But if you have misaligned interest rates and, forgive me, I'm going to have to go into a little bit of jargon here. What is required for the successful operation of a capitalist economy is that three rates should be in some sort of alignment. I don't mean they're equal, but there is an equilibrium relationship between them. And those three rates are the real rate of interest, the anticipated rate of return on capital and the rate of time preference. The rate to which I prefer to have my lunch today rather than tomorrow.
And when those get out of line, as they clearly have done in Britain and the world over the past 15 or 20 years, you set yourself on a conveyor belt which leads to ever lower real rates of interest. Ever lower anticipated rates of return. The ever lower real rates of interest create zombie companies, they interfere with the efficient allocation of capital. Now, if we can put it like this, there's a maxim that says: What defines a capitalist society? Well, it's the maxim that "build a better mousetrap and the world will beat a path to your door". Now that's true I think, but it's a static view. And what the dynamic analogue of that maxim would be, that: "Build a better factory and investors will beat a path to your door". If you've got a higher rate of return than anyone else, you should invest, people should invest in you. The problem is that And this is drifting a little bit away from Brexit
Merryn:That's all right. We're OK drifting. We'll come back to Brexit, it's OK. I think we're interested in this.
Bernard:If you have a period like that of the early to mid 1990s when there's a burst of scientific, technological and entrepreneurial initiative, which created high anticipated rates of return in certain sectors of the economy. Not the whole economy. If you think back to the mid 90s, it was What did people call it at the time? TMT? Technology, Media, and I forget what the other T was about
Bernard:But there were a lot of firms which had new technologies, new ideas, were taking advantages of improvements in the structure of economies. Particularly in the United States post Reagan's reforms. And the central bank the Fed in the US case took the view that: Oh goody. We're going to have higher productivity growth. Higher productivity growth means lower inflation, all other things being equal, and that means we can run interest rates lower than we otherwise would have done. When what they should have been doing was saying: We've got all these firms out there. They're only one sector of the economy, but they're big enough to have an impact on the economy as a whole. They've driven up the average, if you like, anticipated rate of return in the economy. The real interest rate should go up to follow them. It didn't. And ever since
Merryn:So that was the original mistake.
Bernard:That was the original sin if you like. That was Greenspan eating the apple in the Garden of Eden. And what that did was to create over investment. Not specifically in the sectors with higher rates of return, but what it did was to create over investment in the economy as a whole. Because what should have happened was that higher interest rates would have postponed Not eliminated but postponed investment in the less sexy sectors if you like. It would also have prevented a bringing forward of consumption ahead of the materialisation of future income gains.
Now because those things didn't happen, when the tech investment boom came to an end, as all booms do eventually, very heavy investment in tech meant that supply capacity had increased. You've got to sell it to someone. Who are you going to sell it to? Well, there's no pent up demand because everyone's been investing and consuming like crazy anyway. And overcapacity developed in the economy as a whole.
In response to that, the Fed said: Oh, looks as though the rate of return on investment has declined. To prevent an investment crash and the knock-on effects of that on the overall economy, we've got to push down real interest rates, which is what they did. But in attempting to re-establish an equilibrium between a reduced anticipated rate of return on the one hand and reduce real rates of interest on the other, they pushed both of those rates further away from the rate of time preference. And what that does Am I allowed to use the technical term?
Bernard:The operation of the Euler equation for consumption implies Again, other things being equal
Merryn:I'm going to have to put a lot of explanatory notes on this interview.
Bernard:Cutting one or two corners, but I think it's innocuous here. If the real rate of interest is lower than the rate of time preference, the expected path of consumption relative to future income is downwards. Now, what that means is that every time you cut interest rates to try and support the economy, you thereby create a future gap. What do you do? Oh my goodness, we better cut interest rates some more. Or we better have a credit bubble. Or an asset price bubble, because I said I was cutting a couple of corners. Now the corners I was cutting were that
Merryn:No, you can't cut them and then bring them back.
Bernard:All right. I'll try to round them and soften them a bit. You can frustrate the operational of the Euler equation in two ways. One is that you can make people think that they can borrow without limits and it doesn't matter. You have a credit bubble, which we did in the mid-2000s.
Merryn:We had one of those, yes.
Bernard:Or you can mislead them about their future income prospects by driving up asset prices. And of course both those things happened in the mid-2000s. Both of them were unsustainable and inevitably that process led to a financial crisis. We have recreated that process over the past few years, and inevitably we will again have a financial crisis unless real interest rates go down even further. How can real interest rates go down even further when nominal interest rates are
Bernard:Zero. Well, bond yields are still not quite zero, but they're Not all bond yields are negative at any rate. You can drive those down further, and the ECB is having another go at doing that today. Almost as we speak. Ultimately, you are faced with a situation in which you can't push nominal rates down any further. Even very long rates. And then for the first time ever in the history of the world, there is a Keynesian liquidity trap. Keynes himself thought the idea of a liquidity trap was silly. Could never actually happen. Unfortunately we're having one. We're moving towards that.
And then what do you do if you want to push rates down further? Real rates. The only way you can do it is by increasing inflation expectations. If you succeed in doing that for a year or two, you'll find yourself still on the same conveyor belt. You'll need even lower real interest rates. By construction that means even higher inflation expectations at that point. Well, if you succeed in getting it, you end up with hyper-inflation. Not all of a sudden, but there will be a ratcheting up of inflation expectations, you'll end up with hyper-inflation. If you don't succeed in getting it, and the central banks have had a hard time even attempting to achieve 2% inflation, what then? There's a crash.
Merryn:OK. So there's going to be a crash then?
Bernard:There is going to be a crash.
Bernard:I think it's coming quite close. I remember five years ago saying it was going to be five or six years, and two years ago saying it was going to be 24 to 36 months, so I don't think I've departed from that timetable. What is starting to happen, and it's quite worrying, is that people, markets, are losing confidence in the ability of central banks to affect things.
Merryn:Yes. Which seems entirely reasonable. Loss of confidence.
Bernard:Well I think it's a very reasonable loss of confidence. So what can be done about that? Well, I think we're starting to see very loud signals from all sorts of people, including the central banks: Oh please, governments, please spend some more money. And some bigger [unclear] have said: Don't worry, we'll finance it.
Merryn:But this is something that central banks have been saying for ages, that it's not fair for elected governments to push all the work onto them. They end up effectively working as fiscal authorities in the way they end up transferring wealth around the place, and they end up with this sort of huge burden of policies that they know they don't really understand and they know they can't fully anticipate the effects of.
Bernard:Well it's a little bit hypocritical on the part of central banks, because they've spent many years being the Ayatollahs of sound public finance. And say: My goodness, monetary policy would be overburdened if governments go around spending freely and don't worry about their deficits and so on. Now they've turned the page completely and said: Monetary policy is overburdened if you don't go and spend all this money. Now, there is a degree of rationality in what they say. I think they do now realise that they are acting as fiscal authorities, they are acting as fiscal authorities who, even leaving aside the EU question, are not democratically legitimate in playing that role.
And they're very worried that however hard they try, they don't seem to be working. People are losing confidence in them. If people lose confidence in the ability of central banks to hold things together then it is more likely that you have a crash and a financial crisis. So they're rather desperately now saying to governments: Oh please spend some more money, and don't worry, we'll finance it for you. But suppose that happens. Government spending is another way of bringing forward demand from the future.
It's the same process as that set in train and sustained by pushing down real interest rates or creating credit bubbles and asset price bubbles. It doesn't solve anything. You then have the problem that you succeed for a year or two, the economy appears to stabilise for a year or two, but then you're back into this situation of people understanding that too much spending has been brought forward from the future. They try to cut back on their spending, you have to have an even bigger budget deficit, and you end up, if you go down this route, not with the hyper-inflation or the crash which you get through leaving everything to the central banks, you end up ultimately with a complete socialisation of economic activity.
And we've seen another sign of that today. Not from an explicit fiscal authority, but from the ECB in deciding it's going to buy corporate bonds. It's interfering far more directly in the credit allocation mechanism that it has done so far, and there's no end to the process.
Merryn:You've given us two unpleasant end games. Is there anything that either the fiscal or the monetary authorities could do, or not do, not that could bring us to a better place?
Bernard:Well if you are very brave and very optimistic, you can say they should just let everything go hang. Allow a liquidation out of which would emerge a leaner, fitter, better adjusted economy. And had they done that say in 2000, might have worked. But what I fear is things have now gone so far that if you attempt to allow a so called Austrian liquidation of the economy, that you end up with horrific Keynesian multiplier effects. That's another route to a financial crisis. You would end up with an even more direct and immediate socialisation of activity. I think if that were to happen again, no bank is going to be allowed to go down I think, but politics won't allow the banks to get away with it as in the popular perception they did last time.
There will be much greater, tighter government control not just over the banks but over the whole financial system. Now, in a number of instances that's not turned out to be too bad a thing, if you think of the Nordic financial crisis at the end of the 1980s and beginning of the 1990s. Well, there was a mix of solutions in the three countries concerned. Finland, Sweden and Norway. But since Norway was the most extreme and there was effectively a nationalisation of the banking system, but the Norwegian political process was such that it could be denationalised again when the crisis was over.
I think that the fear one has, one has to have, is that if we had a Nordic or for that matter a kind of 1998 South Korean type response to a crisis, that the financial sector would never be denationalised and we would end up with a government run financial system, and a government run financial system means effectively government control not just over the distribution but over the allocation of income and expenditure, and that would not be a good thing. Now what I've been suggesting is that we're probably going to get there anyway, and the balance to be struck is between saying: OK, well let's carry on as we are. Let the frog be boiled and we end up with a socialist system. Without having an overt crisis first. Or we take the risk of allowing the liquidation crisis which might, if we're very lucky
Merryn:Get us through it.
Bernard:Get us to a better place. But if we're less lucky, would just take us more rapidly to government control.
Merryn:OK. So basically it's a crash, crash or crash
Bernard:It's only a question of how and when.
Merryn:On that basis, what's a private investor supposed to do?
Bernard:Well, I think first of all one should have bonds. The route to the crash will involve a period in which the central banks push down nominal interest rates even further. So those bonds which have a reasonable political backing behind them and still offer some yields US Treasury Bonds I think are well worth holding. I have a personal preference for gold. In the sort of scenario I've been outlining there is going to be at least a period of massive risk-off behaviour and fear about either liquidation or financial crisis, in which case you don't want to hold anyone else's debt. You want to hold an outside asset, of which gold is one. Or there is going to be rapidly accelerating inflation. In which case again gold is a decent hedge.
Looking further ahead in the scenario I've outlined, you know, the government's just not going to allow you to hold it, but in the intervening period I think it is a useful hedge. It's been an insurance policy, and there has been a premium to pay for holding that insurance policy, and one hopes by and large, you know, you pay an insurance premium and you hope you never get paid out on it. And I think that's the attitude to adopt now. That one hopes that one never gets paid out on gold, but in the all too foreseeable scenarios that I've outlined, then it is a policy that's worth holding.
The other thing I would suggest is that given everything I'm saying, and one doesn't want to sound hedonistic, but leaving moral overtones aside, just spend, spend, spend. You know, eat, drink and be merry, but you're not going to have much yield on your savings and someone's going to take it away for one reason or another.
Merryn:OK, well that's I think it's good advice.
Bernard:It always sounds good today.
Merryn:It sounds good today. I don't know how it's going to feel in five years.
Bernard:Tomorrow when we've spent You know, and what I'm saying, it's almost a sort of turning Mervyn King's paradox of policy on its head and suggesting that the problem has been that people have spent too much relative to the future and that's what has got into the mess. But given that I don't see any way out of it, then the
Merryn:Might as well buy the new car now.
Bernard:Lifetime utility is probably going to be much nicer by spending now.
Merryn Somerset Webb started her career in Tokyo at public broadcaster NHK before becoming a Japanese equity broker at what was then Warburgs. She went on to work at SBC and UBS without moving from her desk in Kamiyacho (it was the age of mergers).
After five years in Japan she returned to work in the UK at Paribas. This soon became BNP Paribas. Again, no desk move was required. On leaving the City, Merryn helped The Week magazine with its City pages before becoming the launch editor of MoneyWeek in 2000 and taking on columns first in the Sunday Times and then in 2009 in the Financial Times
Twenty years on, MoneyWeek is the best-selling financial magazine in the UK. Merryn was its Editor in Chief until 2022. She is now a senior columnist at Bloomberg and host of the Merryn Talks Money podcast - but still writes for Moneyweek monthly.
Merryn is also is a non executive director of two investment trusts – BlackRock Throgmorton, and the Murray Income Investment Trust.
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