Politics, Not Economics, Will Decide Europe's Path

I'm jealous. Waldman's response to me got links from Financial Times, The Economist, Naked Capitalism, and Krugman, and I'm sure many others. I got none of that*. Even worse, Krugman jumped in and completely missed the point, as he has since this crisis began:

Steve Randy Waldman has a good post critiquing the now widespread notion that debt-troubled economies will have to engage in the same amount of austerity regardless of what they do with their currencies.

But I would go further than Waldman here; it’s not just that the fiscal deficit and the external deficit are different things; even the fiscal deficit becomes much easier to reduce if you can have a devaluation-led boom.

The "now widespread notion" is just me. I haven't seen anybody else make the argument. (I'm sure someone has, but it doesn't seem like many. I don't have unlimited time to scour the interwebs for every stray blogger or columnist, but I read Krugman every day and if it really was widespread I'm sure I'd've seen him rant about it several times by now.) But set that aside.

Iceland, Krugman's favorite crisis country, begs to differ. Debt-to-GDP has trebled, and with a devalued currency servicing any external debt is now much more expensive. Yes, they're getting to fiscal balance, but only because of... austerity. Krugman cites Argentina as a positive example, and their experience has been better than most. But Argentina's debt-to-GDP doubled after default. Their real GNI/capita halved (Atlas method), and took nearly a decade to get back to its prior level. They can't borrow on international markets, so they've had to boost domestic saving (and reduce domestic consumption). That's austerity. And that's the most positive example.

Anyway. Before SRW says the thing Krugman likes he agrees with me that austerity in some form is unavoidable for the Europeriphery, so all of Krugman's talk over the past few years needs to be heavily qualified. As to whether it's the "same amount" (I never said it was, so not even I am part of the "now widespread notion"), that's unknowable ex ante. But here's what we do know:

1. Domestic polities in Ireland and Greece are pissed off at austerity. They have already voted out their governments. Nevertheless, no EMU economies have defaulted/devalued. Not only that, but the crisis Baltics that peg to the euro have held firm too, and Iceland is hoping to join. That to me strongly indicates that there is a common belief among politicians and publics in those countries that default/devalue is among the worst options, and that other forms of austerity should be pursued first. Hell, they'd rather run into the arms of the IMF than default/devalue. Given the history of many of these countries, that should tell you something. In other words, these countries think default/devalue is worse for them than any other realistic alternative. But whatever; I'm sure Krugman knows what's best for them.

2. Krugman (and to a lesser extent Waldman) is imagining a static world in which there's a default/devalue... and then nothing else happens. But other things happen. The people you defaulted on get pissed off. They freeze your assets. They sue you in EU courts. They might restrict IMF funding. They might place trade restrictions or other sanctions. They never lend to you again. These are the richest, most powerful countries in the world. Poking them in the eye is a bad idea.

And this brings me to the only thing that matters. It's not the size of austerity under different scenarios. It's who pays. This isn't a utility maximization problem. It's politics. Krugman might have all the economics right, but it would be completely irrelevant if the politics doesn't match. So what do we know about the politics of fixed exchange rate regimes during crises?

Stephanie Walter wrote an article in 2008 on how states responded to the Asian crisis: with internal devaluation (measured by high interest rate increases to defend the exchange rate) or external devaluation (abandonment of the exchange rate peg). Her conclusion is that policy choices depended the size of political constituencies in those economies. In Hong Kong, which was highly financialized, the state defended the exchange rate at all costs. In less-financialized economies, particularly those with export-biased economies -- e.g. Taiwan, South Korea, and Thailand -- states either devalued immediately or gave up defending their pegs fairly quickly. This should not be a great surprise, but it's worth pointing out.

Then of course there's Beth Simmons' classic study of the interwar period, Who Adjusts? (In our case, we might ask Who Pays?) Simmons argues that small open economies with stable governments that are dependent on trade were more likely to internally adjust in order to maintain the gold standard. Larger countries with less stable governments were more likely to devalue. Why? Small, trade-dependent countries with stable governments were more able to credibly commit to reforms, thus preventing capital flight. Others weren't. A sharp depreciation in the capital account not only makes keeping a fixed exchange rate more difficult, it also impoverishes an economy through a decline in investment**. This also needs to be built into the cost of austerity-via-devaluation.

So what lessons can we learn. Ireland is a small open economy, that is highly financialized and trade dependent. It has a stable government that has made a commitment to maintain its exchange rate, which, in this case, means staying in the euro. Because of its high financialization, it would be hurt terribly by a devaluation and capital flight. Considering how battered its financial sector already is, that would likely cause the economy to totally collapse. And of course it's already happening, but its low corporate tax rates have kept a lot of foreign finance in the country that would otherwise be gone. So expect no devaluation, unless there is literally no other choice.

Iceland, on the other hand, never had a fixed exchange rate to defend. The krona bounced around a lot to the euro even before the crisis, although that pales in comparison to what's happened since. Iceland tried fix the krona to the Euro it in late 2008, but that only lasted one day. Devaluation wasn't chosen as a rational option or a lesser evil; it happened because Iceland couldn't stop it. Now, as mentioned previously, Iceland is seeking membership in the EMU and adoption of the euro to prevent the sort of turbulence that they've recently gone through.

Greece? Not as highly financialized, a less stable government that is unable to make credible commitments to much of anything. Not as small or dependent on trade as Iceland and Ireland, although the difference might not be meaningful. Capital flight has already happened. A long history of profligacy, and a citizenry that didn't pay taxes in the best times. Internal devaluation is likely impossible even if it were desirable. Looks like a devaluation to me.

There are important political dynamics in the Eurocore as well, but this is (again) already too long. In a nutshell, it matter who owns the debt the periphery has accrued. That is mostly the core. They, obviously, don't want default. So they'll try to commit to my #2 above as credibly as they can. Maybe that makes austerity worse in aggregate than if they were nicer. Maybe not. The point is that question is irrelevant. It's like asking what nice things Obama would do if he didn't have to bother with elections.

*I am jealous, of course, but I don't begrudge Waldman anything. He's got a great track record, writes carefully and well, and is very smart. Plus fun to converse with on Twitter. I have no track record, write nothing until after at least four glasses of wine, and am cantankerous on social media.

**For those playing at home, this relates to Waldman's "as long as" statement that I honed in on in my last post.

The Lesson of Iceland

I've been thinking a lot lately about exchange rates, capital flows, and related issues. While looking for something else, I came across many news articles since the crisis Iceland's bid to join the EU, including the EMU. Many of the articles focused on how Iceland's refusal to pay Icesave's creditors might jeopardize their accession, but the screening process appears to be at a fairly advanced stage already, so negotiations leading to accession in 2013 or so are realistic. Emmanuel's discussed some of this.

All that reminds me of Krugman's constant arguing that Iceland was doing so much better than Ireland and the Baltics, because having their own currency allowed them to depreciate quickly. As I noted here, that's all fair and good, but a large depreciation massively increases the burden of external debt, and also leads to a large increase in costs of living for a small open economy. Particular one as small and open as Iceland. Iceland's 50% currency depreciation made them much poorer, and their debt-to-GDP not only quadrupled after the crisis but became much more expensive to service. Note that before the crisis, Iceland had no desire to join the EMU, and no intention of doing so, although it did "Euroize" the krona somewhat.

In other words, I was right. Iceland is applying for EMU membership so as not to be as exposed to currency risk and balance of payments problems as they are now, and they're willing to give up plenty of policymaking flexibility to achieve that. Including the right to depreciate.

We'll see whether the EU lets them in. I imagine that will have a lot to do with what happens to Greece, Ireland, and Portugal in the meantime.

Iceland Is Not A Good Example For Running An Economy

Krugman posts the above graphic showing GDP declines in the Baltics as compared to Iceland. He uses it to argue that the Baltics, which chose internal devaluation rather than sacrifice their exchange rate pegs to the Euro, did much worse than Iceland, which had no currency peg to defend, and so devalued their currency rather than their internal economy. The below picture, covering roughly the same time period, shows this:



Ignore that sharp downward tick at the end and what you see is that the krona fell by roughly half against the euro from the end of 2007 to its 2009-2010 levels, which then stayed fairly constant. To which Krugman says:

Now it’s true that the Baltic countries have been able to maintain their fixed exchange rates. And this is crucial because ….?

I'm not sure if "crucial" is the right word, but a 50% currency devaluation hurts a small open economy like Iceland quite a lot. Before the crisis Iceland mostly produced two goods: fish and finance. It imported almost everything else, and many of those imports came from the eurozone. When its currency dropped in value by 50%, that means that those imports became 100% more expensive. This represents a huge drop in standards of living.

Krugman approvingly references this IMF report on Iceland, noting:

Iceland, as even the IMF says, has been able to “preserve the Nordic social model”; there has been a lot of distress, but not much extreme hardship.

Yes, but according to that report Iceland has only been able to preserve the Nordic social model by exploding sovereign debt from under 30% of GDP pre-crisis to over 115% of GDP now. Of course, servicing that debt becomes much more expensive when the krona is devalued. The IMF also suggests that to get its fiscal house in order Iceland will need to go on its own austerity program to run a 6% of GDP primary surplus over the medium-run. Also note that the Icesave situation has not been resolved; Iceland may yet need to redistribute funds to depositors in Britain and the Netherlands. This will be much more expensive with a devalued currency, but Iceland's IMF funding is contingent upon reaching an agreement.

None of this is to say that the Baltics have had it any better. Output and employment losses have indeed been more severe there, partially because they kept their exchange rate pegs, but also because they are just generally not as well developed politically or economically as Iceland (a member of the OECD with strong economic ties to Europe's center, remember). The point is that these crises are just not easily resolved. The choice between internal devaluation and currency devaluation is not simple for small open economies. Both involve major reductions in standards of living, even if only one of them shows up in the GDP statistics.

The Importance of Starting Points

This is a very good object lesson on why starting points matter when making time series comparisons, especially cross-sectionally:

But is Iceland’s post-crisis “miracle” real? No. It is an illusion created by the starting date Krugman chose for his figure. If we shift it back just one quarter – the quarter before Latvia and Estonia’s GDP peak – Iceland’s performance no longer stands out...

Iceland’s massive devaluation improved the country’s trade competitiveness, while imposing huge losses on its krona-based savers. Ireland’s inability to devalue protected its citizens’ euro-based savings, but has forced it to improve competitiveness in other ways, such as through wage cuts. Of the lessons that can reasonably be drawn from Iceland’s experience over the past decade, the benefits to tiny statelets of having a currency to debase is hardly one of them.

Graphs and more analysis at the link. One lesson is that a whole lot of time series stats are questionable, especially those coming from partisan think tanks or public ideologues. Another is that sometimes it's really hard to make appropriate comparisons, because choosing a starting date is arbitrary by nature. I don't mean to pick on Krugman here (this time) because I don't think he's doing anything intentionally wrong. The point is to be careful when producing, or consuming, statistical information.

All Is Full of Growth Potential

It isn't all that often that avant-garde pop music and investment banking can be mentioned in the same breath, but this was probably inevitable: Bjork is on a mission to save the Icelandic economy, and she's doing it in typically weird fashion:

As a million bankers flee the plunging markets, one brave Icelandic singer – known for coos, shrieks and a swan dress – is proudly taking their place. Björk has turned venture capitalist, with a new fund that aims to revive Iceland's economy.

Björk is working with Audur Capital, a Reykjavik-based investment company founded and managed by women. Audur Capital will oversee the fund's day-to-day dealings, directing an initial investment of 100m Icelandic krona (£575,000) toward sustainable, environmentally-friendly businesses. ...

Björk's fund will be called, er ... Björk. ...

Though Audur Capital has not divulged the material investment of Björk the singer in Björk the fund, knowing her work we imagine it is something along the lines of one heron feather, five regrets and 16 baby teeth.

(ht: Blattman)

How Iceland Imploded

Illustrated. I still haven't heard any good plan for getting Iceland back on its feet.

Viking Solidarity...

The IMF has approved a $2.1 billion credit for Iceland. This marks the first time since 1976 that a western European country has drawn from the Fund (last to do so was...the UK). The agreement unlocks Iceland's access to an additional $2.5 billion from Norway, Sweden, Denmark, and Finland . Additional money could come from Russia and Poland. None of the Scandinavians would support Iceland until the IMF signed off on the deal.

Iceland reached agreement in principle with the IMF in late October; Great Britain (and perhaps the Dutch as well) apparently refused to support the agreement at the IMF Executive Board until the Icelandic government agreed to guarantee the deposits that British residents had made in Icesave, an Icelandic internet bank that disappeared when the government nationalized its parent, Landsbanki.

The government finally agreed to guarantee these deposits on Sunday. "It was made clear to us that the IMF package and the $3.9 billion of loans from other countries would not be forthcoming unless we cleared the Icesave dispute," said Urdur Gunnarsdottir, a spokeswoman for Iceland's foreign ministry.

This would seem to be yet another instance in which governments use the IMF to protect the interests of private creditors at home (rather than the financial position of the borrowing country). This may be the first time, though, that the private creditors are individual depositors rather than large financial institutions.