Ferguson on Krugtron

A fun show is breaking out. Niall Ferguson on "Krugtron the invincible."

Paul Krugman, for a while now, has been lambasting those he disagrees with by trumpeting their supposed "predictions" which came out wrong, and using words like "knaves and fools" to describe them -- when he's feeling polite. These claims often are based on a rather superficial, if any, study of what the people involved actually wrote, mirroring the sudden narcolepsy of Times fact-checkers any time Krugman steps in to the room. Niall has lately been a particular target of this calumnious campaign.

Niall's fighting back. "Oh yeah? Let's see how your "predictions" worked out!" Don't mess with a historian. He knows how to check the facts. This is only "part 1!" Ken Rogoff seems to be on a similar tear. (and a new item here.) This will be worth watching.

As regular blog readers know, I don't think science advances by evaluating soothsaying. You make good unconditional predictions with very badly wrong structural models, and very good structural models make bad unconditional predictions.  The talent of predicting and the talent of understanding are largely uncorrelated.  The judgmental forecasts of individuals are poor ways to evaluate any serious economic or scientific theory.  I carefully don't make "predictions" for just that reason. So, I don't regard this cheery deconstruction effort as a useful way to show that Krugman's "model," whatever it is, is wrong. I also can't see that anyone but the devoted choir of lemmings is paying much attention to Krugman's mudslinging any more.  But it is nice that Niall and Ken are taking the effort to ask the great doctor if perhaps he also doesn't need a bit of healing; perhaps they will force Krugman to go back to actually writing about economics. 

Update: Benn Steil Chimes in, this time on the Baltics, Iceland, and the supposed wonders of currency devaluation.

Rogoff on UK Defaults

Ken Rogoff wrote a very interesting FT oped on UK finances (FT original, Rogoff webpage if you can't see FT.)

The issue: Should we worry about huge sovereign debts of advanced countries? Or was the only problem with fiscal stimulus that it was not big enough?


A little history:

Yes, from the 1800s until the first world war, the UK was a global superpower that commanded vast colonial resources and investments. Over long periods, these foreign assets yielded returns well in excess of interest on debt. But comparing government debt ratios back then, when the UK was a massive net creditor, to debt ratios today, when British foreign liabilities exceed foreign assets, is utterly misleading. Moreover, back in the 1820s, the UK was pioneering the industrial revolution; things are not quite the same today. Back then, the UK did not have to worry about pension liabilities or existential threats to the banking system that could require massive injections of cash to fix. ...

During the 1930s, Britain defaulted on debt to the US accumulated during the first world war and its aftermath. ...

It is often stated that after the second world war the UK debt reached almost 250 per cent of gross domestic product and was brought down merely through growth and inflation. This is a myth ...

Then there is the high-inflation era of the 1970s – another de facto default. Last but not least, what about the UK’s serial dependence on International Monetary Fund bailouts from the mid-1950s until the mid-1970s? This is hardly a country with an indestructible credit status. ...

Being a UK bondholder has had its ups and downs.

Looking forward, an important point: a country needs to be substantially below its ultimate borrowing limit, or it loses its ability to fight crises going ahead.

..a euro collapse would have triggered a stampede out once investors realised that the UK banks and trade would be savaged, a flexible currency notwithstanding. In that scenario, UK leaders would have been forced to close massive budget deficits almost overnight. That would have been truly catastrophic austerity. ...

We now know the euro did not collapse. [yet -- JC] With 20-20 hindsight, yes, the UK could have borrowed more. But we do not have hindsight at the moment decisions have to be taken. 

Kan and Carmen Reinhart have been at the receiving end of Paul Krugman's tender commentaries lately, and I'm interested to see Ken taking up the issue. Krugman likes to lambaste people for "predictions" that he imagines they made which didn't come out. On the euro blowing up, Ken seems to be offering a taste of his own medicine, made more bitter by the fact that Krugman actually did say what Ken says he said:

...This was the big call – the one that everyone was focusing on. To state that credit risk was gone by 2010 is ludicrous. None other than The New York Times columnist Paul Krugman prognosticated the euro’s early demise regularly from April 2010 to July 2012. His big call has turned out – so far – to be dead wrong.

I will be curious if we see more of that from Ken. Stay tuned.

Cyprus and Resolution Authority

Holman Jenkins has a revealing Cyprus update in today's Wall Street Jounal. For those of you who haven't been following the news, Cyprus' banks failed, borrowing huge amounts of money and investing it in Greek debt (yes).  Cyprus was bailed out by the EU after a chaotic week, including an agreement that large depositors would lose some money, called a "bail-in."


Since us economists have been saying that unsecured creditors and uninsured depositors should lose money when banks fail, it was sort of a watershed moment. I expressed some reservations at the political, discretionary, and chaotic nature of the bail-in. It turns out I underestimated that nature.

From Holman:

A few weeks ago, the Central Bank of Cyprus published a curious set of "clarifications for the better understanding of the resolution measures." The principle of a bail-in—that uninsured creditors should suffer losses before taxpayers are on the hook—turns out to contain a few lacunae. "Financial institutions, the government, municipalities, municipal councils and other public entities, insurance companies, charities, schools, and educational institutions" will be excused from contributing to the depositor haircuts, though insurers later were removed from the exempt list.

There will be no haircut on the €9 billion ($11.8 billion) the European Central Bank injected, for political reasons, in 2012 to keep Cyprus's Laiki Bank temporarily afloat—€9 billion that has now somehow become a liability of Bank of Cyprus depositors, whose losses are bigger as a result.
...
We should mention another possible offense, in a sense, against creditor priority in reports that certain connected customers withdrew funds just before the haircuts. A daughter and son-in-law of Cyprus's president seem to make a good case that their transfer of €10.5 million to a London bank was a coincidence, but then they proffered a "voluntary haircut" anyway via a donation to a church fund for the poor. Hmm
...
we have to chuckle when legislators on Capitol Hill talk about ending "too big to fail"—as if there is any chance of stopping politicians from bailing out whatever institutions politicians decide their own interests require bailing out, or any chance of imposing legal order on what are invariably chaotic, highly politicized decisions in the heat of crisis.
...
Cyprus turns out to be a good template after all. Modern financial systems may be incompatible with the rule of law that mankind has labored so mightily to build over the centuries.

This all matters for our financial "reform." Recall, lots of financial institutions were bailed out in 2008-2009, meaning really that their creditors were bailed out. (Normally, when an institution fails, who gets what is determined by bankruptcy law; the creditors become the new owners, the institution is suddenly recapitalized, and either continues or is carved up depending on what makes more sense to the new owners.)

On the theory that "bankruptcy doesn't work for big banks" the Dodd-Frank law posits a "Resolution Authority," composed of Administration officials, that will sit in the place of bankruptcy court and decide who loses money, with pretty much discretion to do what they want. To get paid off, make sure you persuade the "authority" that you losing money would be a "systemic" danger. It might help to have your campaign contributions up to date. I wrote about that danger in a Regulation article here.

The GM bankruptcy here is a small template. As Holman points out,  when politicians and political appointees have great power to decide who gets money and who doesn't, watch out. Oh, no, I forgot; our political appointees are so much more uncorruptible than the Eurocrats that sort of thing can't happen here. (That was a joke)

His last two paragraphs are better than anything I can write. Go read them again. My one disagreement: Modern financial systems are fine. Modern political systems have abandoned rule of law in favor of a monarchic rule by discretion of appointed bureaucrats. That is incompatible with any financial system.

ECB dilemma

It was announced yesterday that  Europe will have a new, central bank supervisor run by the ECB, much as our Fed combines monetary policy and bank supervision. Be careful what you wish for, you just might get it.

One big unified central agency always sounds like a good idea until you think harder about it. This one faces an intractable dilemma.

Here's the problem. Why not just let Greece default?" is usually answered with "because then all the banks fail and Greece goes even further down the toilet." (And Spain, and Italy).

So, what should a European Bank Regulator do? Well, it should protect the banking system from sovereign default. It should declare that  sovereign debt is risky, require marking it to market, require large capital against it, and it should force banks to reduce sovereign exposure  to get rid of this obviously "systemic" "correlated risk" to their balance sheets. (They can just require banks to buy CDS, they don't have to require them to dump bonds on the market. This is just about not wanting to pay insurance premiums.) It should do for the obvious risky elephant in the room exactly what bank regulators failed to do for mortgage backed securities in 2006.


Moreover, it should encourage a truly European market. Greek, Spanish, Italian banks failing is no problem if large international banks can swoop in, pick up the assets, and open the doors the next day. Bankruptcy is recapitalization.  Greece needs a national banking system as much as Chicago (same population) does.

All well and good. And all diametrically opposed to the ECB's "crisis-fighting" agenda. The right arm of the ECB should be protecting the banking system in this way. But the left arm of the ECB is using banks as sponges for sovereign debt.

In trying to manage the sovereign debt crisis, the ECB has bought huge amounts of sovereign debt. It has lent  euros to banks that in turn have bought large amounts of sovereign debt (often, I gather, with not so subtle pressure from their governments).  It has lent more euros to the same banks to replace deposits that are quite wisely fleeing out of those banks.

How can the right arm protect the banking system from sovereign default, while the left arm wants to stuff the banking system with sovereign debt?

Converesely, how can the left arm do anything but print euros like mad, now that the right arm has responsibility for the banking system?  Lending to banks who buy sovereign debt was always excused by the idea that the bank shareholders bear the credit risk and national supervisors take care of that problem. Now it's in the ECB's lap. Politically, can the ECB really shut down national banks, stiff the creditors, and let them be taken over by big pan-european banks?

I bet on the outcome: print euros like mad, keep pretending sovereign debt is risk free, and prop up existing banks. Let's hope I'm too cynical. For once.

Unraveling the Mysteries of Money

Harald Uhlig and I did a fun interview run by Gideon Magnus (Chicago PhD) at Morningstar. We talk about the foundations of money, fiscal theory, monetary policy, European debt problems, etc. Gideon framed it well, and Harald is really sharp. Somebody combed my hair. A cleaned up version of the interview appeared in the Morningstar Advisor Magazine (html) (A prettier pdf)



A link in case the video doesn't work or doesn't embed well (if you see "server application unavailable" the link usually still works), or if you want the original source.

The video starts a little abruptly, as it left out Gideon's thoughtful introduction (it's in the Magazine) and framing question:

Gideon Magnus: I want to discuss the value of money and the idea that money is valued similarly to any other asset. Are there really assets backing money? If so, what are they? John, please explain.

Bad Hair Day

A short interview by Betty Liu on Bloomberg TV: (if that doesn't work a link). The ECB's big bond buying program, how "sterilizing" won't solve everything, and discussion of the WSJ Oped on the future of the Fed

Bloomberg TV Interview

An interview on the Tom Keene's show this morning on Bloomberg TV


I always feel bad after these things, that I could have answered much better or clearer. Or found a better tie. Well, we do what we can. A direct link

A good Greek story

Matt Jacobs sent along a link to a great story from Greece on Reuters,  "Lessons in a shrimp farm's travails." The whole article is worth reading, but here are a few tidbits:

Just over a decade ago, Napoleon Tsanis set out from Sydney with 11 million euros and a dream to build a shrimp farm in his ancestral homeland... What he got was years of wrestling Greek bureaucracy and a court battle with a civil servant...

it's the civil servants that are throwing you into this labyrinth on purpose," Tsanis, 44, said. "The law gives them the latitude to delay you or punish you."

...A process that would take just two or three months to complete in Australia got stuck in a maze of official opinions and permits across several ministries. Greek politicians assured him that the paperwork would be done in 18 months, but that date came and went with no progress.

... then, though, another law change that sought to keep aquaculture projects small meant Tsanis had to break up his farm into sections to go ahead.

...One of the main obstacles to more investment is the legal jumble that dictates how Greek businesses work. Even government officials admit the lack of clear laws and the endless requests for opinions, studies and permits are there to give work to unionized specialists.

"There are whole businesses and technical offices employing engineers and experts specifically for the purpose of licensing," said Tsakanikas at the IOBE think tank.

Red tape often leads to corruption.

Tsanis said he steadfastly refused to bribe anyone. In one incident, in 2005, he appealed to a minister in Athens to get a permit unstuck. "The minister called in the public servant who was refusing to give us the permit and ordered him to issue it the next morning," he said, declining to specify the minister or ministry involved. "When we went back to get it, the civil servant told me: 'Australian, that guy is a politician and he'll be gone tomorrow, but I'll be here waiting for you.

The only European Union country not to have a fully functioning land registry - despite collecting EU funds to set it up and then paying penalties when it failed to do so - Greece still lacks a comprehensive zoning law and building rules.

"Several interests prefer a fuzzy system they can manipulate," Papaconstantinou said. "We must simplify building permits, which are a hub of corruption."

After his shrimp farm opened, Tsanis had hoped to build a 120 million euro golf resort. But when the local authorities decided they didn't want it, he opted not to fight.

This story rings with several of the themes on this blog, and I can't resist hitting you over the head a bit.

The nature of "regulation." In the popular discussion "regulation" means a wise system of rules that keep order in markets. Here is regulation in action.

There are different kinds of regulation. This is "regulation" by a deliberately vague forest of laws and rules, which give great discretionary power to the functionaries who administer those regulations. And clearly, they and their cronies like to keep it that way.

This is not "regulation" by clear rules, which you can quickly appeal in court if they are misapplied. The lack of title, zoning, and property rights falls in the same bucket.



Let us not feel superior, fellow Americans. This is the system of regulation to which we are crashing. Dodd Frank and Obamacare look a lot like Greek zoning laws, as far as the power of appointed officials vs. the rule of law are concerned.


Currency. Many of my macroeconomics colleagues think the main problem with the Greek economy is an "overvalued" exchange rate and thus too high wages. Rather than see high unemployment drive down wages that are "sticky" by some magic mechanism (even Paul Krugman admits he doesn't really know why wages are "sticky"), they would like to see Greece have a Drachma to devalue, or what the heck, devalue the whole euorozone, as even Anil Kashyap and Martin Feldstein have recently argued, along with Austan Goolsbee and more reliable liberals.

How much of Mr. Tsanis' troubles does this analysis describe? Not zero, in fact. The article says

He survived, he said, thanks to the 30 percent appreciation of the Australian dollar versus the euro in recent years

He doesn't even mention wages. I guess you have to open a factory before you have to start paying people.

You assign a percentage. Add up whether, faced with this story, the first thing you want to do is devalue the currency, or maybe if as economists we should be writing opeds about "shock liberalization" instead. Decide if this economy will liberalize on its own, given time, and "breathing space" by more German subsidies.

Micro vs. macro. In Greece's slump, as in ours, how much is this, "microeconomic" problems solveable only by micro liberalization, and how much is "macroeconomic," solveable by central banks, "stimulus" programs and the like?

Common sense from France

Today's WSJ has a lovely editorial from Pascal Salin, professor emeritus of economics at the Université Paris-Dauphine. It echoes many of the things I've said about the euro crisis, but with deeper political insight....and it's from France.

A few tidbits with comment

Contrary to what is claimed daily in the media by politicians and many economists, there is no "euro crisis." The single currency doesn't have to be "saved" or else explode.

The present crisis is not a European monetary problem at all, but rather a debt problem in some countries—Greece, Spain and some others—that happen to be members of the euro zone. ... there is no logical link between these countries' fiscal situations and the functioning of the euro system.

A currency union can work just fine without fiscal union.

..the deficits now plaguing these countries were, in large part, justified only a few years ago as necessary to initiate so-called "recovery policies."  But it is always an illusion to believe that governments could increase total demand and thereby induce producers to produce more....The present state of affairs in countries that engaged in stimulus blowouts in 2008 and 2009 should serve as proof of the failure of the Keynesian model.

A letter from Europe that rejects the confusion between common currency and sovereign default, and  sees the abject failure of stimulus? There is still hope. 

I found Prof. Salin's view of the political situation most interesting:

The "euro crisis" is a pure political construction without any economic content. It could even be said that the crisis is a splendid opportunity for many politicians to impose some of their longstanding goals on everyone else. For instance, before the introduction of the euro, many politicians who called themselves Europeans considered monetary union a stepping stone to political union....

So, in Prof. Salin's view, the Euro worthies are deliberately linking sovereign default to breaking up the euro zone in a deliberate effort to scare wary voters into accepting fiscal union. 

This process has begun and continues to develop. Politicians now argue that "saving the euro" will require not only propping up Europe's irresponsible governments, but also reinforcing and centralizing decision-making. This is now the dominant opinion of politicians in Europe, France in particular.

It's really the "centralizing decision-making" that is the problem not "political union." The US at least historically had a political union without requiring the rules on provenance of prosciutto to be written by bureacrats in Brussels.

There are a few reasons why politicians in Paris might take that view. They might see themselves as being in a similar situation as Greece in the near future, so all the schemes to "save the euro" could also be helpful to them shortly....

Yeah, but the Germans may not have any money left by then!

What to do instead? Someone else likes "shock liberalization:"

The real solutions to Europe's debt problems lie in tax cuts and deregulation, and it's here that national politicians should turn their attention. Pan-European cooperation won't deliver any government from its fiscal or economic crises. Only national governments, each working independently to implement the best possible policies, can hope to achieve that.

What a breath of fresh air.

I can't wait to read Prof. Salin's next letter on France's 75% tax -- especially in the face of the UK's disastrous and quickly repealed experience with a 50% tax.  (16 billion pounds forecast revenue turned in to two.) 

The Devaluation Chorus Sings again

The chorus to devalue (and then inflate) the euro as the key to solving Europe's ills is singing again.

Ken Griffin and my colleague Anil Kashyap have a big OpEd on the Euro in the New York Times. They want Germany to leave the Euro, followed by quick euro depreciation relative to the Mark and Dollar.

Martin Feldstein, writing in the Wall Street Journal, echoes this faith in devaluation

The only way to prevent the dissolution of the euro zone might be a sharp decline in the value of the euro relative to the dollar and to other currencies

As you might have guessed, I think it's a terrible idea.

The biggest reason is the vanity that you can do it just once. "Devalue and inflate the currency" is hardly a new idea. Portugal, Italy, Spain, and Greece lived on a cycle of continual devaluation and inflation until they joined the Euro.  Going on the Euro was a hard won transformation to precommit to get off this cycle.

Imagine that  your brother in law had been drinking too much for 40 years, perpetually on and off the sauce, never really able to give it up. He went  through a painful 12 step program and rehab, and finally quits the sauce for 10 years. He threw away all the liquor in the house. Then he loses his job. Is "one more big night out to soothe the pain, and then I'll really really never do it again"  at all a credible plan?  That's exactly what my normally sensible colleagues are advocating.

Kashyap and Griffin make some sharp predictions.

Reintroducing the mark [and devaluing the Euro] would not solve the debt burdens of southern European countries, but it would give them needed breathing room to restructure their economies, reform labor markets, collect more taxes and reassure investors

When in human affairs has "breathing room" ever led to expeditious "reform," especially when such reform meant stepping on the toes of very powerful interests?

Witness: The Germans gave Greece three years of "breathing room" already, repeatedly bailing out and rolling over its debts. And look at the great progress Greece has made on "structural reform." Not. Italy just backed off its effort to repeal its stultifying labor law. Heck, look at the "breathing room" of the forty previous years of perpetual devaluation when all the "structural rigidities" were enacted.

With the "breathing room" of currency depreciation and inflation, won't the unions and other powers arrayed against reform just reassert themselves?

A crisis is indeed a terrible thing to waste. Nobody ever reforms in good times. Heck, look at how well the US is doing -- we have the same entitlement disaster heading our way, we just have a few more years of "breathing room." And we're  really putting the pedal to the metal on tax and entitlement reform, aren't we?  We advocate "structural reform" in Greece, yet where is the deregulation effort here?

Kashyap and Griffin make some more interesting cause-and-effect predictions

 a weaker euro would give a boost in competitiveness to all members of the monetary union, including France and the Netherlands,

A weaker euro would also encourage greater foreign investment. For example, Spain’s distressed real estate market would become far more attractive.

Let's see if they come true. The first: Is there any exchange rate at which France ships Citroens to Stuttgart? Are Europe's "compeititiveness" problems really all about some mysterious exchange rate misalignment and not pervasive sand in the gears? Would Detroit roar back if it could only introduce a Detroit dollar and finagle its monetary policy?

The second: When Germany goes its own way, and Spain has embarked on a let's-all-inflate-our-way-out-of-this-mess along with its neighbors, will this really be the signal of great times to invest?

My prediction -- investment runs to Germany anyway. Even faster, Why? Ken and Anil recognize

Although repeated currency devaluations are not the path to prosperity,

Right. Just this once. But how do you sin just once? How do you devalue once, then convince the rest of the world that the rump euro is now a hard-money area, determined for structural reform, and not back to its  pre-euro history of  repeated and continual devaluations?

Investmet and growth are about expectations, institutions, rules, commitments, not one-time devaluations with empty promises not to do it again. That's what the euro was about. You can't throw out the euro and have anyone believe a devaluation is just this once, and not back to the perpetual stagnation of the 70s and 80s.

Kashyap and Griffin go on twice to argue that devaluation will lead to greater "dignity" for Southern workers. We know a little about how printing money devaules a currency and inflates. We know a tiny bit about whether that effort can give a one time boost to exports, and sets up poor expectations about another bender. This is the first time I've heard serious economists adduce that we know a cause and effect relationship from monetary policy to "dignity," and that depreciating the currency promotes more of the latter.

Doesn't devaluation automatically mean inflation, at least eventually? Kashyap and Griffin are silent. Feldstein goes on to 

Although a decline of the euro would mean higher import prices in euro-zone countries, it need not mean higher inflation or even a higher overall price level. The ECB could in principle continue to aim at a 2% inflation rate with lower prices of domestic goods and services offsetting the higher prices of imports from outside the euro zone. At worst, the ECB could allow a one-time pass-through of the higher import costs but prevent any further increases in inflation rates.

I thought the one thing we all agreed on is that money is neutral in the long run.  Certainly the repeated devaluations of the 70s and 80s were almost perfectly matched with extra inflation. Why would this time be different? We might as well hope that the Physicists at CERN will repeal conservation of energy with the new Higgs Boson.

OK, one point of agreement: 

What is essential is the preservation of the European Union’s greatest accomplishment: the free movement of labor, goods and services.

Yes. Keep the euro, and all its comitments against devaluation and inflation. [Update to clarify in response to comments: the most important commitments are that the South, as part of the euro, does not resort once again to devaluation and then inflation relative to the North. The second most important commitement is that the ECB was once set up as a central bank with a pure inflation target. This is a precommitment against deliberate devaluation and inflation relative to the rest of the world.]   Recognize that a currency union, without fiscal union, works only if you countenance sovereign default and default of banks who invest in sovereign debt.

In the end, the devaulation idea is this: In the warmth of summer, the crickets of Europe voted in laws that you can't fire people, can't lower wages, and they will only work 35 hours, with long paid vacations. Now those structures are no longer tenable. In winter, der ants don't want to buy stuff that crickets are producing with those huge labor costs. What to do? Let's devalue the hour! Pass a law that the hour is 75 minutes.

Really. The euro is the unit of value, as the hour is the unit of time and the meter is the unit of value. You could engineer a one-time boost by fiddling with the hour, the meter, the kilo and the euro. Until people catch on and rewrite contracts. And then they are aware you will do it again, since you throw out all the precommitments not to devaule built in to the current system of units.

Anyone for a drink?

Bloomberg TV link

I did a Bloomberg TV interview this morning on Euro debt crisis. I can't seem to insert the video here, so you'll have to follow the link if you're curious.

Update: I figured out how to embed bloomberg vidoes!

A glimmer of hope?

Weekend Update.

On Monday the Greeks decide whether to vote for the Easter Bunny or Santa Claus to solve their fiscal problems. What is Europe planning to do next?

Sunday's New York Times had an unusually cogent article on European events over the weekend, reporting on events with thoughtful analysis:

The head of the European Central Bank and other euro zone leaders worked on Saturday on a grand vision... the plan will push for countries to remove the regulations and layers of bureaucracy that inhibit competition, keep young people out of the work force or make it difficult to start a new business....

Over the years, countries have repeatedly pledged to clear the rules that hinder competition and led to chronically anemic growth. If the euro zone grew faster, tax receipts would rise and the debts of countries like Spain or Italy would seem less daunting

Halelujah! Growth -- the classical, growth-theory, higher productivity, bend-up-the-trendline, long-run kind of growth, not the quick espresso stimulus kind of growth (if that even works) -- is the only hope for Europe to repay debt rather than face the awful choices of default or inflation. At least we understand this is the central answer and without it, all the rescue plans will fail.

For years the mantra has been, stimulus and crisis management today, and "structural reform program" to be implemented in the vague far off future. They've figured out it won't work. Decades of previous good times did not bring structural reform. 

“There is a long-standing agenda on growth,” Mr. Draghi told a gathering of economists on Friday in Frankfurt. “It is time to implement it.”

---

But..

But it is unclear whether yet more pledges of reform, which would face significant hurdles, will calm financial markets.

The euro zone has no shortage of plans and pacts intended to end years of sluggish growth and impose discipline on its 17 members.

The challenge for Mr. Draghi and the plan’s authors....will be to package their plan in a way that makes investors believe something will get done.

The most difficult task for Mr. Draghi and the other leaders may be to establish a binding timetable, to ensure that political leaders do not drag their feet.

Correct. Quite a challenge, I'd say. How do you establish a "binding timetable?"

The leaders are “only capable of acting at gunpoint” — when markets force them to, Willem H. Buiter, chief economist at Citigroup, said...

But once markets "force them to" act, by a huge bank run, refusing to buy government debt, running from the currency, it will be too late for a structural reform plan to have any chance.

---

What about the immediate problem, the bank run, no longer "imminent" but gaining steam every day?

Under the plan, euro zone leaders will seek to establish the central bank as supreme bank regulator with broad powers, in place of the relatively toothless European Banking Authority.

Countries would also create a deposit insurance program to augment national programs. The goal would be to reassure ordinary depositors and prevent bank runs, an imminent danger in Spain as well as Greece. But any sharing of financial burdens almost automatically encounters opposition in Germany.

Catch 22. We've got a bank run. How to stop it? Ah, deposit insurance! But who is going to pay for that? "Countries" are not credible. The whole problem is that "countries" used their banks as piggy banks, stuffing them with sovereign debt. So, if the countries default on their sovereign debt, the banks go under, and the same "countries" obviously don't have the money to guarantee deposits.

A cross-national deposit insurance scheme, while banks are already stuffed with sovereign debt, is back to Plan A, run for the exit and stiff Germany with the bill. Which "automatically encounters opposition in Germany."

A Supreme Bank Regulator  to stop banks from gorging on sovereign debt in the first place might have been  good idea, perhaps. (The concept "sovereign debt is risky" isn't necessarily beyond the ability of national regulators to comprehend, even with Basel rules denying it.) But it's way too late for that now.

Bottom line: Waffling again. No serious plan to stop the bank run already in place. You can't stop the crisis by saying you'll invent a totally new regulation regime to keep the banks from taking risks.

----

What about looming sovereign defaults?

For now, the most important new tool is a half-dozen rules known as the Six-Pack, which took effect in December. In coming months, the European Commission will be able to impose fines on euro zone countries of up to 0.2 percent of their gross domestic products if they flout rules on public debts and deficits.

Oh yeah, right. The same Spanish government you just lent 100 billion euros to pour down the rathole of its banks, that one. You're going to tell them to pay you a fine of 0.2 pct of GDP because they're borrowing too much money..from you?

The one big lesson to learn from this debacle is that deficit limit rules do not avoid sovereign defaults. A currency union without fiscal union needs to allow sovereign default.

As far as quelling the panic, good luck that "we really mean the deficit targets this time" will have any effect.

---

What are they going to do now, to stop the unraveling that is likely to happen in weeks?

Mario Draghi, the president of the central bank and one of the authors of the plan, said Friday that it would be unveiled within days, ahead of a meeting of European leaders at the end of June.

Well, that's good. I hope there still is a euro at the end of June.

---

Bottom line. Mr. Draghi is saying the right words on growth. But these plans to address bank runs and sovereign defaults are not realistic. And the pace of events is quickening. The time to actually implement a pro-growth policy, and stop financial panic by convincing markets it will really happen, is getting shorter and shorter.

Euro explosion

The European bank run is on, and with it the slow-motion train wreck  will move to high speed.

The Wall Street Journal reports €600 to 900 million  a day are flowing out of Greek banks, and  the outflow may rise above a billion euros per day. At the end of April there were only €166 Billion deposits to flow. Count the days.  And Greeks -- those who can't move money abroad or move themselves abroad -- are "hiding money in jars, under the bed, even burying it in the mountains."

In related news, I read last week say that payments are simply stopping in Greece. If there's a chance to pay in Drachma next month, why pay in euros now? Shipments are stopping -- if your invoice might get paid in drachma, no point in sending goods today. This is simple implosion.  Spain has already lost about € 100 billion of bank deposits and Italy is losing them quickly.
What's going on? Keynesian economists love to talk about how great leaving the euro will be, because then salaries can be cut by depreciation rather than explicitly.

But if you have a bank account, leaving the euro means that you go to bed one night with € 10,000 in your bank account. The next morning, you have 10,000 drachmas. Those drachmas are going to be swiftly devalued to about 1/3 or so of their original value. In addition, it's a good bet there will be capital controls and exchange controls, so you can't get money out of the country or buy things with euros.

People understand this. They get out now.  To an account holder, the country leaving the euro is the same as the government seizing bank accounts. Burglars at least know enough not to advertize their visits in newspapers for two years before they visit.

The run means everything will happen super fast from here on in. The time to dither around and make pronouncements is running out.

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How do you stop a bank run?

1. One common prescription is for the government to guarantee deposits. But that won't work, since the whole problem is that the government is out of money and the banks are stuffed full of government debt.

Spain discovered a version of this conundrum last week. Spain borrowed € 100 billion to recapitalize  banks. The result was not only a continued run on the banks, but a sharp rise in Spanish government interest rates.

Why didn't it work? "Recapitalize" means that the Spanish government owns stock in banks. If the banks lose more money, the Spanish government loses money -- but the government still has to repay the 100 billion loan. Unfortunately, the Spanish government is broke. And what do these banks own? Spanish real estate and a lot of Spanish government debt.

...That would raise pressure on the Spanish government, which has come to rely on local banks using ECB funds to buy sovereign debt. According to the latest Spanish Treasury data, while foreign investors have reduced their holdings of Spanish bonds to 32% of the total in March from 36% in December, Spanish banks have raised their holdings to 41% of the total in March from 35% in December

2. The second run-stopping prescription is for the central bank -- the ECB in this case -- to open the spigots. They already are. Ask yourself, where are banks getting the cash to redeem all these deposits anyway? They sure aren't selling assets -- real estate loans and government bonds. The answer is, the ECB is lending them the money.

But wait, isn't the ECB only supposed to lend against collateral? Yes, and that collateral is largely government bonds.  The ECB knows it's taking junk collateral.  If the ECB doesn't stop this massive lending, it understands well that it will essentially end up monetizing all the debt of the southern tier, and a huge inflation will eventually break out. The ECB knows that too. How long will it continue to lend?

If the ECB decides to stop this massive lending, then the game is up. The banks fail, the governments guaranteeing the banks fail, and chaos erupts --whether or not the governments decide to turn the remaining euros in to monopoly money.

3. As in the US "bank holiday," governments can try to shut down the banks, impose capital controls, etc. But if it's not just very temporary illiquidity, the run starts up the moment you reopen the banks. And if you so much as breathe a word you're thinking of doing it, the run starts ahead of time. Whoops, it's too late. Continuing from the journal here

According to the senior [Greek] banker, the current rate of deposit outflows--of €1 billion or less per day–remains "manageable" since the banks keep large cash buffers on hand to deal with the withdrawals. But if those outflows were to grow four- or five-fold, Greece would be forced to impose deposit and other capital controls.

4. The last way to stop this run is to try, even at this late date, to commit fully and forecefully that no country will leave the euro.

That will be hard. Pronouncements at this date have little weight. The only way to do it is to be very clear of the awful things a government will allow rather than leave. It will default on its sovereign debt. It will cut government salaries and entitlements. It will allow bank failures, and it will allow foreign banks to come in and swoop up the assets. All of these things will be awful. But the government has to persuade voters it understands that leaving the euro will be worse.

Even that will not be enough. To a government in fiscal stress, bank accounts look like an ice cream bar to a hungry child. Greece and Italy have already passed wealth and property taxes. "Tax the rich" rhetoric is strong. People with bank accounts fear expropriation and punitive wealth taxation as much as devaluation. Somehow, the government has to persuade them their bank accounts are safe from depredation in the euro.

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Why are we here?

I've been writing for two and a half years about mistakes in Europe, and won't repeat all of that now. But there are two central points to make.

1. The euro was explicitly set up as a currency union without a fiscal union. (And it turned in to one without a bank regulatory union.) That can work, a fact which practically all commentators ignore.

The central ingredient is: sovereigns who can't pay their bills default. The European central bank does not print up euros to bail out sovereign creditors, either directly or via the subterfuge of lending to banks who then buy the sovereign debt.

The euro was explicitly set up this way. The main problem is, when the crisis came, nobody bothered to read the instruction manual.

2. As many times in history, strapped governments have forced banks to take on their debts. A sovereign default is manageable. A country-wide banking crisis is much worse.

The liberal consensus wants "more regulation" to stop banks from taking risk. The regulators stuffed the banks with sovereign debts, and treated those debts as riskfree for years. They also confused "the banking system cannot fail" with "no individual bank can fail."

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Paul Krugman, writing May 18, wrote a few almost-sensible paragraphs about Europe, echoing many of these points. (His article is for once about economics, not the evil character of Republican politicians, so there is some substance to talk about.) Since I agree so rarely with Krugman, I thought I'd celebrate with a few quotes, though with some quibbles and some interpretations that I'm sure he would disavow.

Mostly, I agree with his main point, that the emerging bank run means the crisis is likely going to move much more quickly now.

Right now, Greece is experiencing what’s being called a “bank jog” — a somewhat slow-motion bank run, as more and more depositors pull out their cash in anticipation of a possible Greek exit from the euro. Europe’s central bank is, in effect, financing this bank run by lending Greece the necessary euros; if and (probably) when the central bank decides it can lend no more, Greece will be forced to abandon the euro and issue its own currency again.

Comment: As above. Change "forced to" to "choose to" and I'm on board. There is an option. Sovereign default. Let banks fail -- meaning their senior debt becomes equity and they are recapitalized. Good banks buy the assets of bad banks.  But the Europeans probably won't have the stomach for it.

This demonstration that the euro is, in fact, reversible would lead, in turn, to runs on Spanish and Italian banks. Once again the European Central Bank would have to choose whether to provide open-ended financing; if it were to say no, the euro as a whole would blow up.

Comment. Right again. The only thing keeping any money in Spanish and Italian banks is the idea that leaving the euro really can't happen. Once it's clear that exit, devaluation -- along with likely currency controls, bank closures, deposit seizures, and sky-high wealth taxes -- are on the table, the run will start in earnest.

Yet financing isn’t enough. Italy and, in particular, Spain must be offered hope — an economic environment in which they have some reasonable prospect of emerging from austerity and depression. Realistically, the only way to provide such an environment would be for the central bank to drop its obsession with price stability, to accept and indeed encourage several years of 3 percent or 4 percent inflation in Europe (and more than that in Germany).

I agree with the first two sentences. But the only hope for such an economic environment is shock liberalization. (Despite Krugman's "savage cuts" these economies still spend half of GDP, with direct intervention, state industries, and other off the books interventions bringing the total even larger.)

Not only is inflation not "the only way" to provide such long-term growth, it isn't a way. When has deliberate, anticipated and announced inflation ever brought long-term prosperity? You must be kidding.

On the other hand, I agree that inflation is the most likely path that Europe will choose. Not because inflation works any Phillips curve magic, but because inflation is the "easy" way to engineer a massive default of government and bank debt.

By arithmetic, here are the options:

1) Government default. (Restructuring, really)  If done right away, this would have meant private-sector losses. Now that so much debt has been rolled in to banks, it means bank failures too.

2) The Germans pay for everything. Not happening. There is not enough taxing power in Germany to repay the entire debt of Portugal, Spain, Italy, and Greece, plus their banks losses and their ongoing deficits.

3) The ECB buys up the sovereign debt, or lends to banks on sovereign "collateral," effectively doing the same. By turning trillions of debt in to money, we get inflation. Inflation engineers the sovereign default and bank debt default implicitly.

4) Shock liberalization, privatization, freeing of markets, selling state assets. Remove the highly distorting taxes of the "austerity" plans, which said loudly "don't start businesses here, don't hire anyone here, and if you have some wealth I suggest you get it to the Bahamas ASAP." Return quickly to strong real growth. Pay back the debt. Fairly radical reform of unsustainable entitlements.

My obvious choice is number 4. The Europeans' most likely choice is number 3. It can be sold as "stimulus" and "liquidity provision," and it kicks the can down the road. The inflation won't happen for several years. Then it will be easy to blame speculators and hoarders and markets and expectations and so on.

But Krugman's wrong on the size of the inflation. Several years of 3-4 percent inflation is nowhere near enough. To write down PIGS debt by half, you have to double the price level. And you have to do it before the debt rolls over. So that means doubling the price level -- 100% inflation -- in under two years or so. If you do it over several years, the overall rise in the price level has to be even higher.

To my mind an inflation so large that it wipes out half of PIGS and bank debt is about the same result as breaking up the euro directly. And the Germans will probably leave before that happens. 

Both the central bankers and the Germans hate this idea, but it’s the only plausible way the euro might be saved. For the past two-and-a-half years, European leaders have responded to crisis with half-measures that buy time, yet they have made no use of that time. Now time has run out.

I'll go with this only because "plausible" includes the chances that European leaders will take it. I agree with the second sentence, though I suspect the "full measures" in my mind -- default, bank restructuring, commitment to euro and open markets, shock liberalization -- are different from what I presume from other writing that Krugman does -- endless stimulus financed by Germany

So will Europe finally rise to the occasion? Let’s hope so — and not just because a euro breakup would have negative ripple effects throughout the world. For the biggest costs of European policy failure would probably be political.

Think of it this way: Failure of the euro would amount to a huge defeat for the broader European project, the attempt to bring peace, prosperity and democracy to a continent with a terrible history. It would also have much the same effect that the failure of austerity is having in Greece, discrediting the political mainstream and empowering extremists.

And now in full-throated agreement. The currency union, without fiscal union, will be a horrible thing to lose.

But what's kicking off the run is that governments are being tempted to leave. I wonder whether Mr. Krugman and his colleagues have any regrets for the many elegies they have written to the wonders of separate currencies and devaluation, the prospect of which is now causing the run.

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Bottom line: I'm pretty pessimistic. The run is on and will intensify.  Alternatives exist, but they are so unpalatable to standard views that I think massive intervention by the ECB as the most likely current policy.

The ECB will print euros like mad and lend them to banks, which will continue to buy government debt.  Southerners will take the ECB money and put it in Northern banks. The ECB ends up owning the debt through the banking system. The ECB understands the danger full well, but will give in.

After that, there is a sliver of hope. A shock liberalization could give a return to robust growth and sustainable government finances within a year. Then the debt would not default, and the ECB and its banks could sell back all the sovereign debt they have bought.

But unless that miracle happens, within a year or so the ECB's collateral will evaporate in the inevitable sovereign defaults, the sovereign defaults will mean bank defaults, and the euro will inflate away rather than break up. An immense, and utterly avoidable tragedy.

So, given that there's no way they'd take my radical advice, if I were in charge I would recommend changing the "austerity" conditions on bailouts and ECB financing, with their emphasis on higher distorting taxes and vague promise of structural reform sometime in the next century, to "reform" conditions demanding a tight schedule of structural reforms within months.

Economist's Haiku for Europe

A lovely letter to the Economist says it all.

Sir: 

Leaving the euro zone is no option for Greece (“Fiddling while Athens burns”, May 19th). The new drachma would be valueless, as there would be no demand for it. A country that finds it difficult to run its fiscal affairs cannot manage a national currency. The restored drachma would stay in circulation only if the Greeks were denied access to foreign exchange, preventing the informal use of the euro. That would require draconian exchange controls of the type put in place by Germany after the first world war, which ensured the circulation of the depreciating mark during a period of hyperinflation.

What can Europe do for Greece? It can provide it with a stable monetary unit: the euro. What can Europe not do for Greece? Well, it cannot give it a sound fiscal system. The Greeks have to achieve that themselves if they wish to remain a sovereign country.

Ernst Juerg Weber
Associate professor of economics
University of Western Australia
Perth  

Good news from Europe

This morning's Wall Street Journal article on renewed bank competition in Europe is one little bright spot. Apparently, large healthy international banks are competing for deposits in Greece, Spain and Italy.

Banks from Northern Europe are offering...the safety of having your money parked in large, well-capitalized institutions based outside Europe's danger zone. The campaigns aren't subtle: HSBC Holdings PLC promotes its "safety and security" in Greece...

In Italy, consumer group Altroconsumo has been offering advisory services to jittery depositors since December. As a precautionary measure, the group is recommending that customers consider moving their deposits from domestic Italian banks to foreign banks that operate in Italy...

In Greece, HSBC's local unit is trumpeting "the safety and security of the bank with the greatest capitalization in Europe." The bank, with 16 branches scattered around Greece, is offering depositors 3.5% interest if they lock up their money for at least six month...

Foreign banks are offering competitive prices and the allure of safety. Barclays recently launched its new "depositos solvencia" Spanish savings product

Why is this good news, you may ask? It's just feeding the run away from local banks, which have invested heavily in now-tanking local economies and loaded up on sovereign debt.

Here's the answer. My favorite solution for Europe is sovereign default and keep the common currency. (Actually, that's my second favorite. Free market reforms tomorrow, start growing like China on Monday and pay back the debt is my real favorite, but we can only dream so much.)

The natural rejoinder is, what about the banks? Since the local banks have all loaded up on sovereign debt, then the banks will all go under, and won't that be a disaster?

My response has been to remind people of the difference between existing banks and a functional banking system. Countries need a functional banking system.  They do not need all of the existing banks to continue, nor do they need all of the existing bank's creditors not to lose a cent.

Europe offers a particularly good playground here, because it's supposedly an open market. Greece is about the size of metropolitan Chicago. It can function well as Chicago does, with banking dominated by local branches of diversified international banks. If the local banks fail, that does not mean Greece will not have a banking system. Just transfer the assets and deposits of failed banks to HSBC, put up a new sign on the front window, and open for business.

And this news adds important facts to my scenario. Those large banks are already operating in Greece, Spain, and Italy and ready to take over.

Of course I am guilty of a bit of wishful thinking here. The article also shows how local banks are fighting back to keep their deposits. And it can't be long before local governments intervene to "save our banks from destructive international competition." In fact, the localization of bank regulation is one of the sadder parts of this whole mess. Had Europe really gone for a europe-wide banking system in the first place, that system would be in a lot less mess now. 

Side note: The US discussion is all full of "the financial crisis proves we need more regulation." Europe's banks woes are entirely the product of regulation. What's failing is sovereign debt, debts of the governments that regulate things, not mortgage backed securities put together by greedy wall street bankers. The banks are full of sovereign debt because their regulators told them to do it, not because sneaky financial engineers got them to do it. Here is the fully regulated system on display for us.

Simon Johnson on the Euro

Simon Johnson has a good blog post on the end of the euro. Digging in, the run is on, the end is near, and the chaos will be worse than you thought.T he ECB has also monetized a lot more than you thought.

Still, I do not understand why even Simon cannot imagine the idea of sovereign default while staying in -- and firmly committing to stay in -- the currency union. The picture Simon paints of the euro breakup is a catastrophe. So why not even talk about sovereign default (restructuring) without euro breakup?

It strikes me as really the only way out, and the longer Europe waits, the harder it will be. 

Austerity, Stimulus, or Growth Now?

(This is also a Bloomberg "Business class" column, with minor improvements.)

Austerity isn't working in Europe. Greece is collapsing, Italy and Spain’s output is declining, and even Germany and the U.K. are slowing down. In addition to its direct economic costs, these “austerity” programs aren't even swiftly closing budget gaps. As incomes decline, tax revenue drops, and it is harder to cut spending. A downward spiral looms.

These events have important lessons for the U.S. Our government cannot forever borrow and spend 10 percent of gross domestic product each year, with an impending entitlements fiasco to boot. Sooner or later, we will have to fix our finances, too.  Europe's experience is a warning that austerity -- a program of sharp budget cuts and (even) higher tax rates, but largely putting off “structural reforms” for a sunnier day -- is a dangerous path.

Why is austerity causing such economic difficulty? What else should we do?


Lack of “stimulus” is the problem, say the Keynesians, epitomized by the New York Times and its columnist Paul Krugman, who has been crusading on this point. They claim that falling output in Europe is a direct consequence of declining government spending. Yes, 50 percent of GDP spent by the government is simply not enough to keep their economies going. They -- and we -- just need to spend more. A lot more.

Where will the money come from? Greece, Spain and Italy simply cannot borrow any more. So, say the Keynesians, Germany should pay. But even Germany has limits. The U.S. can still borrow at remarkably low rates, they point out. But remember that Greece was able to borrow at low rates right up to the moment that it couldn’t borrow at all. There is nobody to bail out the U.S. when our time comes. What should we do then?

The traditional Keynesian answer was: move on to monetary stimulus. Deliberately inflate and devalue. Break up the euro so the southern European countries can inflate and devalue even more.

Lately, Keynesians have been pushing an even more audacious idea: deficits pay for themselves. In a March 17 column, Krugman wrote: “there’s a plausible case that spending more now actually improves the long-run fiscal picture.”

U.S. Federal revenue is less than 20 percent of GDP. For deficit spending to pay for itself, then, $1 of spending must create more than $5 of output. Economists have been arguing about whether this “multiplier” is more or less than one; five is beyond any reported estimate. Keynesians made fun of “supply siders” in the 1980s, who made similar claims for tax cuts. At least those cuts had incentives on their side, which stimulus doesn't.

Is there another explanation, and a more plausible way forward?

The stimulus explanation is curious for what it omits. Think of Greece. Is it irrelevant that Greece is 100th on the World Bank’s “ease of doing business” list, behind Yemen, 135th on “starting a business” and 155th on “protecting investors?” Is it irrelevant that professions from truck driving to pharmacies are still rigorously protected, that businesses can’t fire people, that (according to a Greek colleague) you can’t even get a driver’s license without paying a bribe? Does it not matter at all that, as the International Monetary Fund delicately put it in its latest report on Greece, the “structural reform program” aimed at “deeply ingrained structural rigidities in labor, product, and service markets” got nowhere?

Does it not matter that Greece has a high combination of individual, corporate, wealth and social taxes, higher still under "austerity?" True, Greeks famously don’t pay taxes, but businesses that must operate illegally to avoid taxes are much less efficient.

Money is fleeing Greece, Italy and Spain. Does talk of exiting the euro, followed quickly by devaluation, inflation (the IMF predicts 35 percent in Greece, should it leave), and capital controls, have nothing to do with lack of investment?

Keynesians urge devaluation to gain competitiveness. Greek wages have in fact declined about 10 to 12 percent, according to the IMF -- so much for the impossibility of nominal wage declines. Yet investment and production aren’t turning around. Greek “demand” needn’t matter -- the whole point of the euro area is that Greece can sell to Germany, so long as Greece stays in the Eurozone. But it isn't happening. Is that a mystery? Would lower wages compel you to invest money in Greece, surmount a thicket of regulation, expose yourself to the threats of wealth, property and business taxation, currency expropriation and capital controls, or even nationalization?

In sum, isn't it plausible that a good part of Europe’s austerity doldrums are linked to “supply,” not “demand,” “microeconomics” not “macroeconomics,” weeds in the economic garden, not a want of fertilizer? Isn't it plausible that factors beyond simple declines in government spending matter in the economy’s response to a debt crisis?

That insight suggests a different strategy: Let’s call it “Growth Now.” Forget about “stimulating.” Spend only on what is really needed. We could easily stop subsidies for agriculture, electric cars or building roads and bridges to nowhere right now, without fearing a recession. Most "spending" is in fact transfer payments, which even Keynesian economics recognizes are not very stimulative, not the mythical (and curiously carbon-intensive)  roads and bridges, and most of that goes to people who are relatively well off

Rather than raise tax rates further on “wealth” and the “rich,” driving them underground, abroad, or away from business formation, fix the tax code, as every commission has recommended. Lower marginal rates but eliminate the maze of deductions. In Europe, eliminate the fears of wealth confiscation, euro breakup and currency devaluation that are driving saving and investment out of the south.

Most of all, remove the profusion of regulation and (increasingly) direct government management of the economy.

Growth is the key to paying off debts. The only way to escape large debt/GDP ratios is to embark on a decade or more of solid  growth. Growth like this comes from long-run productivity, not short-run stimulus. 

Europe is beginning to figure this out. Italy’s prime minister, Mario Monti, is addressing his country’s debt crisis by proposing far-reaching deregulation, now. While his proposals aren't complete or close to radical enough, and they are combined with some unfortunate business-stifling tax increases, it’s remarkable that anyone in Europe is beginning to talk about this approach.

“Structural reform” is vital to restore growth now, not a vague idea for many years in the future when the stimulus has worked its magic. Europe learned that it’s also a lot harder politically than the breezy language suggests. “Reform” isn’t just “policy” handed down by technocrats like rules on the provenance of prosciutto; it involves taking away subsidies and interventions that entrenched interests have grown to love, and support politicians to protect. They will fight it tooth and nail.

That is even more reason to address growth now, while there is a crisis. The will to do so will evaporate if better times return, and the ability to do so will disappear if the economies plunge.

Sargent on debt and defaults

Tom Sargent's Wall Street Journal oped is well worth reading closely. It's a very short summary of his Nobel prize speech

As readers of this blog will probably know, I think Europe should stop bailing out bondholders of Greek and other debt. (See the Euro collection and Euro tags to the right.)

"What about Alexander Hamilton?" has always been a nagging doubt.


Hamilton famously brokered the deal by which the Federal Government assumed state debts. By doing so, he created a group of citizens with a strong interest in the success of the Federal Government. But it was a bailout of the states; it was a bailout of their creditors, many who had bought up debts cheaply. It was explicitly a case of greater "fiscal union."  Perhaps this is Europe's Hamilton moment?

As Tom points out, there are some important differences. The states had borrowed money to fight the revolutionary war, not to import Porsches or build cozy crony economies and fat welfare states. U.S. Taxation was low everywhere. Even the new Federal taxes were only tariffs, amounting to 2% of GDP, not 50% and up taxation in the Eurozone.  The Federal debt ("Eurobonds") was backed by directly levied Federal taxes, not by voluntary contributions or even by remittances from member states. And those direct taxes were to be legislated by a directly-elected legislature, not Brussels technocrats.

Tom points to a second episode: the state defaults of the 1830s and 1840s. Here, many states had borrowed a lot to finance infrastructure projects ("canals to nowhere?") that were not generating enough revenue to pay back the debt. 

Reputation, pre-commitment and moral hazard are big in Tom's thinking and his account of the sophisticated thinking of our ancestors. The US chose to pay off its revolutionary war debt, according to Tom, to enhance its reputation and credibility as a serious nation and future borrower. But this decision led to moral hazard: states and their creditors believed the US would always bail them out. The US chose not to bail out the states (really, their creditors) the second time around. It suffered a financial crisis as a result, but put state overborrowing and default off the table for a hundred and fifty years.  (When Tom talks about reputation and pre-commitment, he's not blowing smoke; he understands the equations.)

This second episode strikes Tom as a better antecedent to the Eurozone. Let Greece and the others default precisely to save the euro and European union.  Now is the time to clarify that the no-bailout clause is real, and that the euro will not be inflated. A crisis is the price of not having been clear about that moral hazard up front. But the union project is too important to abandon.

There are lots more  little gems in Tom's paper. The interaction of monetary and fiscal policy is one; the fact that framers spent all their time on fiscal policy, and money was, as in the constitution, considered just part of the definition of weights and units.

This post is a bit interpretive, and I'm sure I put some words in Tom's mouth here and there. He's always scholarly, informative and precise. If so, well, there's no substitute for the original. 

Important Note: The comments section is running off the rails. Please be polite and stay on topic. You're welcome to disagree, or point out flaws in my arguments or facts -- actually I like that, as I learn something. But if you want to spew venom, go back to Krugman and DeLong's blogs. I'm going to turn off comments if this doesn't end asap.

What zero bound?

German bond yields turn negative, as reported in the Wall Street Journal.

Source: Wall Street Journal

Negative interest rates are a big puzzle. Easy stories miss the point: "flight to quality," "need for collateral," etc. Those stories don't explain why bonds are worth more than money.  There's no more quality or better collateral than cash!

So why would anyone suffer a negative rate on government bonds when they can hold cash instead?

For some of us it might make sense. Cash is clunky, dangerous and expensive to put under a mattress. Many banks now charge for the privilege of depositing. So an individual might prefer a very slightly overpriced government bond to cash.

But a bank has a better option. Why not just hold reserves? Reserves are like cash, and as safe and liquid (more so) than government bonds. I might have guessed that only people were buying these bonds. It seems I'm wrong (unconfirmed rumor) -- banks are buying and holding the bonds.

So why would a bank hold a bond at negative interest rate rather than hold reserves? Sometimes there are arcane technical, accounting or regulatory reasons, but so far nobody I've talked to has identified one here.

The best story I've heard so far, suggested by one of the smart students in my MBA class, is this: It's a bet on Germany leaving the Euro. If Germany leaves the Euro, it is likely to redenominate its bonds and so pay off in new DM. The ECB is likely to leave reserves in Euros. So, if you want an asset that will pay off in new DM after Germany leaves the Euro, German government bonds are a good bet.

That story pierces the zero bound. There really is no limit to how low bond yields can go if you think bonds might be paid off in a better currency than the one you can stuff in your mattress. 

It sounds a little outlandish, and the chances that Germany leaves the Euro in 6 months seems pretty low to me. Still, it's a nice story. Does anyone have a better one? Remember, you can't answer why bonds look so good -- you have to explain why bonds are a better asset than reserves, for a German bank to hold!

Should Greece Devalue?

Two weeks ago I wrote the following in a little Bloomberg column about the Euro 

Defenders [of devaluation] think that devaluing would fool workers into a bout of “competitiveness,” as if people wouldn’t realize they were being paid in Monopoly money. If devaluing the currency made countries competitive, Zimbabwe would be the richest country on Earth. No Chicago voter would want the governor of Illinois to be able to devalue his way out of his state’s budget and economic troubles. Why do economists think Greek politicians are so much wiser? 

This paragraph set off a little kerfuffle in the Cochrane-is-a-moron section of the blogosphere. I won't respond in detail, because I presume you're more interested in economics than what anyone thinks of anyone else's intelligence.

But the paragraph was mighty distilled, and the evident interest in the question suggests a little fuller examination of whether devaluation is a good idea or not for a country like Greece, and trying to understand why people come to such different views.

I think I can sum it up this way: Devaluation is like a cigarette. The Keynesian camp basically says, "Boy, a cigarette would perk me up right now."' Modern macroeconomists (I'm looking for a good name -- "Dynamic?" "Intertemporal?" "Equilibrium?" Really everybody else, including new-Keynesians) basically say "Maybe, but smoking is a really bad lifestyle decision." We think of policies as rules, not decisions.

The following discussion resembles that between a teenager and the parent who found a pack of cigarettes. It sounds like facts are at issue -- just how good does it really feel, just how long does it take to get addicted, how bad are the long-run effects -- but there is a deeper difference in perspective, which is why the arguments are a lot more heated than the simple facts suggest. 



So, just how good is a cigarette anyway?

Devaluation works if prices and wages don't adjust. If the Drachma goes from 1:1 Euros to 2:1 Euros and Greek prices and wages double, nothing happens. On the other hand, if prices and wages don't change, then Greek goods are cheaper and Greece will produce and export more. Similarly, inflation can goose output a bit. For example, if prices go up faster than wages, then companies will hire more workers and make more goods. (Standard disclaimer: I'm simplifying dramatically. Don't write that I'm an ignoramus because I can't get the whole modern theory of the Phillips curve into one sentence of a blog post written for a popular audience.) 

So, sometimes devaluation or inflation work, at least temporarily. We've known this for a long time. In his Nobel Prize address, Bob Lucas cites Hume in 1752.  "Temporarily" is an important qualification. We all agree (I hope) that money is neutral in the long run. Inflation eventually catches up to devaluation. Wages eventually catch up to prices. So even here, the question is just how long the high lasts before the hangover sets in.

And devaluation and inflation often don't work, or are indeed counterproductive. The US and many other countries in the 1970s experienced stagflation -- devaluation and inflation accompanied by worse economic performance. Most economic basket cases -- Zimbabwe was my example -- are junkies, continually inflating and devaluing. Most really successful countries -- Switzerland -- are famous for strong currencies. We've known that for a long time as well.

When does devaluation work? The most important consideration suggested by modern macroeconomics is whether the devaluation or inflation is expected or unexpected. This is the heart of Milton Friedman's famous AEA presidential address, and Bob Lucas' and  Edmund Phelps'  Nobel prizes. (Standard disclaimer.)

This will likely not work: the Greek government declares that on January 1 2013 it will change from Euros to New Drachmas at 2:1. I think we would all predict that "devaluing" in this way would have exactly the same effect on real prices and wages as joining the Euro did: none. On Jan 1 2013, prices, wages, contracts, bank accounts, etc. are just multiplied by 2 and a "D" replaces the "E" in front of the number. Whatever "price stickiness" means, this isn't it.

If the Greek government went on, "and then we will devalue the Drachma relative to the Euro by 5 percent per month," it still would have little real effect. With that announcement and a year to plan, Greece would simply return to an economy familiar to anyone who lived through the 1970s, steady 5% wage and price inflation.

The trick for Greece, in its current situation, is to change to a New Drachma, and convince everyone that new Drachma will have a stable value. Then, it has to surprise everyone by devaluing, or devaluing more than they expected.

That will be difficult to arrange. It could easily backfire. People could expect much more inflation and devaluation than the Government had planned. Money could fly out of the country, interest rates spike, and a panic wage and price inflation take off. Then Greece would get stagflation, not a boom.

Devaluation also "works" by engineering wealth transfers, from lenders to borrowers.  But you have to surprise the wealth in order to transfer it.

So, devaluation is not an "always and everywhere" proposition. Yes, if the US were to announce that we are pegging the dollar at $2 per euro, and the ECB went along with this policy, it's a good bet that prices and wages would not adjust overnight. Dollar goods would be cheaper in Europe, and the US would export more and import less for quite a while. Countries, who already have their own currencies, a good reputation, and stable values, can devalue unexpectedly and boost exports and output.  It does not follow that a return to the Drachma and devaluation will work for Greece.

The experience of small countries around the Eurozone is also not immediately applicable. They already have currencies. The combination of leaving a currency union, establishing a new currency and immediately devaluing it does not have much precedent. And for every Iceland, where devaluation helped, there is a Hungary, where it does not seem to be producing riches.

I don't deny that it could be done. But it's not so easy as the devaluation camp makes it sound.


But that's not even the main issue. How did I let the teenager drag me in to talking about how good it feels to smoke that first cigarette? Back to the nagging parent: is smoking a good lifestyle decision?

Is it better over the long run for a country like Greece to have its own currency, and routinely resort to devaluation and currency depreciation when its economy is in the doldrums or the government is discovered to have overborrowed? Or is it better to stick with the Euro, and rule that option out? Greece has plenty of experience with inflation, devaluation, and default. Much of the world was on a binge of inflation and depreciation in the 1970s. It didn't work out so well.

This is where modern macroeconomists and Keynesians start talking different languages. Modern macro discussions are full of words like "precommitment," "rules vs. discretion," "dynamic efficiency" that are absent in the cigarette-by-cigarette, live-for-today-for-in-the-long-run-we're-dead mode of Keynesian thinking.

Just one example: Before Greece joined the Euro, it paid very high interest rates. When it joined the Euro, all of a sudden it was able to borrow at German interest rates. It did, massively, as we know. Porsches went South, and pieces of paper flew North. Greece boomed. If the money had been properly invested, Greece would still be booming. The money was wasted, but the opportunity was there.

Now, why did joining the Euro give Greece this opportunity to borrow at low rates? Cynics say, because the Eurozone meant eveyrone thought Germany would bail them out, as people correctly expected the US to bail out Fannie and Freddie. But even I am not that cynical. The Eurozone was set up, remember, specifically denying sovereign bailouts.

A second explanation seems more plausible to me: by joining the Euro, Greece precommitted against devaluation.  It could no longer take the easy way out. If the economy got in trouble, Greece would feel much more pressure to fix it, not to rely once again on a quick bout of devaluation. If the government got in trouble, it would have to deal with a messy default, not a quick depreciation. And the Eurozone makes that default harder than Greece's many previous sovereign defaults.(A short history by Benn Steil here.)

Nonsmokers get lower health-insurance premiums. Non-devaluers get cheaper loans.  Precommittment has real benefits. We've known that for a long time too, at least since Ulysses had himself tied to the mast so he could hear the sirens.

Furthermore, countries like Greece with chronic devaluation and inflation routinely resort to capital controls, price controls, exchange rate controls and other interventions to prop up their currencies. Junkies start stealing. These steps ruin small open economies. 

There is still room for debate. At least now we have both views on the table, and you see that national currency with occasional devaluation vs. precommitting against devaluation and staying in the Euro is not such an easy question. Reasonable people can disagree. Unreasonable people can disagree more.  


A lot of the answer is also political, not purely economic. Does a country have solid enough political institutions so it will use devaluation only when really necessary, and not to get out of stupid policies which it really ought to fix instead? Does the teenager really have the willpower to only smoke occasionally?  Do you trust the patient to self-administer the morphine? That's part of a bigger political worldview on whether you trust the benevolent discretion of politicians or whether you think they need to be constrained by strong rules and institutions.

I come down on the latter side of the fence, but mine is most assuredly an opinion, based on thinking through all these considerations, not a Fact Of Nature.

Whew, I tried to get a lot in those 4 sentences!