The Devil's Trifecta

The Mundell-Fleming "unholy trinity" is that a small open economy can choose two, but not all three, presumably desirable policies: capital account openness, a fixed exchange rate, and monetary independence. Quite a lot of political economy research goes into figuring out which two countries will choose.

But what do we call it when a country chooses none of them? Cyprus right now has a closed capital account, no monetary independence, and severe limitations on external exchange at any rate.

I nominate "The Devil's Trifecta" but I'm not great at titling things so perhaps readers can do better.

This is a nice way to think about just how screwed up the EU is right now: tasked with choosing one suboptimal policy, they choose three.

But non-economists can play too! Take Rodrik's trilemma, in which states can choose two of national sovereignty, democracy, and economic integration. In Cyprus, the last is gone and the former two are questionable: it looks like democracy might win the day but it was dicey there for a minute, while Cyprus's sovereignty is restricted by the EU and faces a possible threat from Russia. So let's score it a 1.5 with a negative outlook.

Time to Update the Priors: Not All Policies Matter for All Outcomes

In response to my previous post Mark Thoma and I had a bit of a roundabout on Twitter. His first point is that he wasn't addressing our article in his blog post. I mentioned in my post that that was obviously the case, even though he quoted Farrell's summary of it before launching his discussion on unrelated topics. But through the Twitter discussion several interesting topics were raised. Thoma asked me two main questions:

1. Is it your argument that peripheral crises can never lead to systemic crises?

2. Is your answer to #1 completely independent of crisis response policies?

My response to #1 is that the likelihood is exceedingly low. I base that on the fact that not a single peripheral crisis* from 1970-present (using the IMF's database) has turned into a systemic crisis. Obviously crisis management policies have varied quite a lot, but the global (i.e. systemic) outcome has not.

That leads me to believe that policy considerations are not very important from the perspective of preventing systemic contagion from peripheral crises. In peripheral crises, policy matters a lot locally -- i.e. for the peripheral country experiencing the crisis and maybe one or two others connected to it -- but not systemically. In systemic crises, policy in the core matters a lot globally; policy in the periphery matters less**.

Thoma disagreed. Obviously that's fine, but I'd like to explain why I think he's wrong. Since I've heard others make it in plenty of other contexts, I thought I'd make the point here. These Tweets of his seems to sum up his view, which I believe is a common view:

@whinecough @dandrezner So if ridiculous policy enacted, you wouldn't worry (see first proposal)? Glad policymakers didn't share that view.
— Mark Thoma (@MarkThoma) March 26, 2013

@whinecough @dandrezner You're right. I can't prove what would have happened under an alternative policy. But not willing to risk it.
— Mark Thoma (@MarkThoma) March 26, 2013

@whinecough @dandrezner Again, this is a very simple question.Either policy in Cyprus could have mattered, or not. We disagree on the answer
— Mark Thoma (@MarkThoma) March 26, 2013

We went around like that for awhile. So here's my position: if policy mattered for global outcomes things would likely be much more worse right now than they are. Why? Because the Cyprus deal is basically the worst possible policy from the perspective of preventing contagion. Cyprus has been hacked off from the global financial system. Capital controls are in force. Its entire banking system has been closed for two weeks, its second-largest bank will be closed permanently, and its largest bank will be forcibly restructured. Foreign depositors, bondholders, and shareholders are being gutted.

If you were trying to start a systemic crisis, this is the way you would do it: repudiate a huge chunk of claims, and close the capital account. And yet markets around the world are up today. Even in Russia.

Or take the examples of Iceland and Ireland. Iceland repudiated the debt of its banks, imposed capital controls, and told international investors to take a hike. Once again, this is a recipe for contagion yet systemic crisis did not result. Ireland did the opposite: it guaranteed the debt of its banks, did not institute capital controls, and paid off international investors. Systemic crisis also did not result. The opposite local policy response produced the same global outcome. Only the local outcome varied.

Contrast those cases (and all the other eurozone cases, and Argentina, and E Asia, and etc.) with the US in the Fall of 2008. A couple days of dithering -- of the sort that the eurozone has made its speciality -- lead to an immediate and profound downturn in global markets, including the largest single-day evaporation of wealth in absolute terms in history. The US tried to kick the can down the road, but couldn't because it is the core node; the EU has been able to repeatedly kick the can down the road because those crises are in the periphery.

I conclude from this that policy always matters locally, but it only matters systemically when the crisis is in a core node. No matter what the policy response to peripheral crises is, systemic contagion is exceedingly unlikely. I am prepared to hear arguments counter to this, but they must go beyond assertion or "I'd rather not chance it". Evidence is preferable, but I'd even countenance an evidence-free logical argument with a clear causal mechanism. These are every bit as rare as the claim that systemic outcomes depend upon local policies is common.

*Note that we're making it hard on ourselves by calling essentially every country but the US and UK "peripheral". This is not a common view (or was not prior to the crisis). Many thought that Iceland, Ireland, Cyprus, and other tax havens were significant global financial centers (or rapidly becoming so).  We're not talking about Somalia here... we're talking about OECD countries. Yes, we realize this is a bold claim. We think we have evidence and argument to support it.

**Remember that Spain was winning awards for prudential regulation a couple of years before the crisis. Ireland was held up as a model too. In the end that didn't help them.

A View from Cyprus on Austerity

Andreas Assiotis is an acquaintance of mine. He also has a PhD in economics from the same American university where I did my undergraduate economics degree. At least at the undergrad level they were a New Keynesian bunch, not freshwater RBC. Now Andreas is on the faculty at the University of Cyprus in Nicosia. A few days ago he posted the following on Facebook (reprinted with his permission, although I have no idea if he agrees with any of my commentary which follows):

We had a party, and it's hangover time. From an economic perspective we did what we ought to do to save our country. An alternative would have included salary cuts, more layoffs, the already high unemployment rate skyrocketing, and extreme taxes that would have made this burden sharing even more unfair. There is a bright side: Starting from this moment we should all roll our sleeves and start planning for the future. Instead of demanding more money, higher salaries, and more goods we should demand more transparency, better institutions, law enforcement, better regulations... There is not a reset neither a boost button that any Xristofias or Anastasiades could hit...we, the populace, are the only entities that could change the future, OUR future...

This is much closer to the Schumpeterian view of austerity than the Alesina view*. In fact, it sounds like nobody in Cyprus views this austerity as expansionary; hence today's rejection of the "bailout" plan, or whatever we're calling it. This was more like a old-school shakedown than anything in Alesina's model.

This is why I think we need to be careful about how we use the language of "austerity". If I understand him correctly, Blyth's main thesis has absolutely nothing to say about the Cypriot case. And probably not the Greek case or the Portugese case or the Irish case. More traditional models of political economy have plenty to say about these things. So why are we insisting that very different things be described in the same way? Why not have distinct terms for distinct concepts?

What's happening to Cyprus, Greece, Portugal, Spain, and Ireland is austerity. Not expansionary austerity. Contractionary austerity. And they know it. It's a grinding political battle over who bears the burden of debt. There's no hood-winking going on, no zombies ideas or confidence fairies or animal spirits or any other mythical beasts which need conjuring. Just old-fashioned materialist politics.

*Also, this has nothing to do with Alesina's model and in fact basically none of the EU austerity plans have. Nor the U.S./U.K. plans. More about that in another day or several.