Zombie Idea: Creditanstalt Did Not Cause the Depression

Brad DeLong and Barry Eichengreen have written the preface to a new edition of Kindleberger's The World in Depression. It is a very good introduction, except for this part:

Kindleberger’s second key lesson, closely related, is the power of contagion. At the centre of The World in Depression is the 1931 financial crisis, arguably the event that turned an already serious recession into the most severe downturn and economic catastrophe of the 20th century. The 1931 crisis began, as Kindleberger observes, in a relatively minor European financial centre, Vienna, but when left untreated leapfrogged first to Berlin and then, with even graver consequences, to London and New York. This is the 20th century’s most dramatic reminder of quickly how financial crises can metastasise almost instantaneously. In 1931 they spread through a number of different channels. German banks held deposits in Vienna. Merchant banks in London had extended credits to German banks and firms to help finance the country’s foreign trade. In addition to financial links, there were psychological links: as soon as a big bank went down in Vienna, investors, having no way to know for sure, began to fear that similar problems might be lurking in the banking systems of other European countries and the US.

In the same way that problems in a small country, Greece, could threaten the entire European System in 2012, problems in a small country, Austria, could constitute a lethal threat to the entire global financial system in 1931 in the absence of effective action to prevent them from spreading.

I've covered this before, so rather than restate it all I'll just point you to that and mention the gist here. Regarding the first paragraph, Creditanstalt was the largest and most well-connected bank in the Austro-Hungarian empire. Following World War I, it remained one of the most important banks in continental Europe. It was not "relatively minor". More importantly, the Depression was already underway before the Viennese institution went under. The New York Bank of the United States had collapsed several months before along with more than 600 other American institutions. It is just not the case that everything was fine right up until Creditanstalt went under. It is much more likely that the Depression caused the collapse of the Austrian bank and not the other way around.

Why is this important? Because contagion cannot emerge from anywhere. So the ramifications for the present day are not that Greece could destroy the entire European system, as Thomas and I wrote last year in Foreign Policy. The underlying research which motivated that article has now been released in Perspectives on Politics. We were right then, and the same intuition helped us to understand why the Cyprus meltdown was going to remain localized while others were talking about how it could drag down the entire global economy.

This matters because very smart people keep saying that contagion can emerge from anywhere at any time. At the recent International Studies Association annual meeting I heard one of the most prominent scholars in IPE say to a large audience that financial contagion worked like it did in the movie Contagion: anyone can become infected at any time. This was based on no research, just an intuition. Here are some other recent examples (1, 2).

But the intuition is false. This is not how the world works. The fact that the claim keeps being made is evidence that we in the social sciences really do not grasp dynamic complexity well at all. This clearly has major consequences not only for how we view the world, but how we govern it. We need to do better.

The ECB Is Not a Central Bank

The European Central Bank should no longer be considered a central bank. Instead, it is a negotiating arm of Germany and (to a lesser extent) France. It is not surprising that the ECB does not act as normal central banks act. Instead of comparing the ECB to the Fed or any other central bank, we should compare it to the IMF.

The ECB is one arm of the Troika, along with the European Commission and the IMF. As such, it is involved in the negotiations during which bailout funds are extended to the European periphery in exchange for structural reforms. If the ECB eases monetary policy, then these structural reforms become less necessary in the short run. Indeed, this is what everyone who opposes current ECB policy is saying.

Given that, the ECB is not going to ease. It cannot, as to do so would be to cut out the leverage the European Commission has in forcing structural reforms. And the European Commission believes that without structural reforms the eurozone cannot last (absent perpetual transfers from the core to the periphery). The ECB is influenced disproportionately by the core euro countries, especially Germany. If the ECB does not keep Germany on its side, then its authority is likely gone.

So the ECB is not a central bank, and should not be considered as such. The ECB is a "lender of last resort" in the same way the IMF is, which is the way Bagehot intended: in a crisis, lend at a penalty rate. The penalty is structural reform. But the ECB is no longer tasked with stabilizing the European economy. That is no longer its remit, nor its goal.

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.

Defining Austerity Down

Henry Farrell has reviewed Mark Blyth's new book, Austerity: The History of a Dangerous Idea, which has not yet been released commercially. (I've written about Blyth's research program before. See here and more if you scroll down here.) As I've previously said, the book looks very interesting and I welcome the chance to read it. I love intellectual histories, and this looks like a good one. But Farrell's review increases my level of skepticism of Blyth's core argument regarding present circumstances, which had already been growing in me.

Here's the gist of my concern: Blyth wants to advance an argument that the practice of austerity as a crisis response has ideational causes. That's why the subtitle of the book refers to an "idea". If true, this would call us to reconsider a good bit of the political economy literature, which has focused on materialist politics as filtered through various institutional structures as the most important factor in crisis policymaking. It's a provocative claim, and in making it Blyth does the dirty work of actually reading all those old political economists -- from Locke to Hayek and beyond -- who concerned themselves with the relationship between (sovereign) debt and growth.

The problem I have arises from Blyth's definition of austerity as an idea distinct from materialist interest. I don't think he's totally wrong about any of the main causes of the current crisis, and in fact he is very convincing on some points which I hadn't previously considered. I'm less sure about his explanation of the political response to the crisis in Europe as being primarily ideational. This impression comes not only from Farrell's review, but also from Blyth's hour-long lecture from the book, a version of which is on YouTube, in which he defines "austerity" (in the Q&A) as "a claim that if you cut public debt you will grow". I.e., expansionary austerity, via the work of Alberto Alesina. He specifically says that in his view not all spending cuts constitute austerity, only those intended to facilitate growth. His argument is that European policymakers have fully bought into this belief. His evidence is that Alesina gave a talk at an Econfin meeting, and was referenced in several reports from the ECB. Farrell's review doesn't dwell on this point of definition, but it is quite important. (More on Farrell in a bit.)

Historically, "austerity" generally referred to a set of policy measures designed to facilitate structural macroeconomic adjustment through internal devaluation of wages and prices rather than external devaluation of the exchange rate (which was often a metal standard originally, and a pegged exchange rate or currency board more recently). Most often, these were necessary because external liabilities -- public or private debt owed to foreigners -- had grown past the point at which service was feasible, and the highest policy priority was some sort of fixed exchange rate which made external devaluation undesirable. Austerity policies generally included cutting social spending, raising taxes, increasing interest rates to defend the exchange rate, and trying to boost exports (i.e. production) over imports (i.e. consumption). In other words, austerity was designed to reduce society's standard of living -- on purpose, but in a temporary fashion -- in order to get out from under the debt while maintaining the exchange rate. So the basic logic has nothing to do with spurring a short-run expansion; it has to do with avoiding a long-run collapse*.

That doesn't mean it's good policy. But it does put things into perspective: governments who enforce austerity generally have no good options. Either they devalue their currency, which makes consumption more expensive; or they default on the debt, which makes immediately eliminating any external deficits (via tax increases and spending cuts) mandatory; or they raise taxes and cut spending and try to pay down the debt. All are forms of austerity. The choice between them is political, and is primarily a function of distributional politics (in my view, anyway). The underlying problem is the debt, and the debt is something more than an idea. So far I think Blyth and I are more or less in agreement.

Back to Farrell's review, in which he applies something like the above description to some countries in crisis, such as Greece today: unless the Germans give them a bunch of money in some form or another, they face austerity (in some form or another). Blyth goes a bit further in the lecture (and presumably the book): even the "unless" here is wrong. If Germany gives Greece a bunch of money then Greece may suffer less but Germany will suffer more. The "austerity" hasn't gone away... it's only been redistributed. The idea of austerity is hardly the reason why Germany won't give Greece a blank check; the materialist reality is the reason for that. And in this case, the eurozone crisis is too big for Germany to manage. Heavily-indebted European countries, and their banks, are "too big to bail".

Farrell suggests that countries such as the U.K. need not bother with austerity, but do so anyway, so this is where Blyth's book really does its work: these ideas are so powerful that they compel states to do disastrous things which are not in anyone's material interest. This is where either I misunderstand Blyth or Farrell does. Since Farrell's read the book and I haven't, I'll presume it's me. But I don't think the U.K. really fits the story. If austerity programs are bad then you shouldn't do them unless you really have to do them, in which case you are Greece and not the U.K. But, according to Farrell, the U.K. is engaged in austerity. This argument rests on a core empirical claim: that countries sometimes (frequently?) practice austerity when they don't have to do so.

Here is where limiting the definition of austerity to Alesina's "expansionary austerity" truly matters. Look at the U.K.'s budget (from HM Treasury's most recent budget document):

  

Over the past 15 years, the UK's budget as a percentage of GDP has averaged below 40%. As the crisis began, it was about 41%. In response to the crisis, it spiked to about 48%, an increase in government spending of about 17%. That is the opposite of what Alesina recommends, which is a massive, immediate cut in spending. Since 2010, British fiscal expenditure has gradually declined about four percentage points (not massive or immediate) from an exceedingly-high baseline, so that it remains above its pre-crisis level. Tax receipts have stabilized and practically normalized, but the deficit remains well above the historical norm at 7-8% of GDP per year. I.e., the U.K. is accruing more debt rather than paying it down. The U.K.'s sovereign debt level is now the highest its been since the end of WWII.

The U.K. is closer to the "soft Keynesian" playbook than Alesina's, in other words. So either I am conflating Blyth's argument or Farrell is. (Krugman also calls the U.K. policy mix "austerity", and notes that U.K. growth has lagged U.S. growth since the crisis. But whether a moderate increase in fiscal expenditure is austerity depends on the definition of "austerity". According to Blyth's definition I'm not sure it does.)

The U.K. is still hurting -- its economy was heavily dependent on the health of the financial sector, and its exports have suffered tremendously from economic weakness on the Continent -- but it is doing far better than most European economies. And the worst is probably over for the U.K. Full recovery may be excruciatingly slow but the situation does not appear to be deteriorating further (Blyth's hallmark of austerity). Meanwhile, any new debt accrued will need to be repaid, with interest. Bond rates are low now, but they will rise once the economy fully recovers, so even if taking on debt is cheap today it will be expensive to service tomorrow. The Conservative government has decided it would rather trim a bit now rather than push the whole bill back.

The prudence of that policy is certainly debatable. What is not debatable is that this is in any way analogous to Greece's situation. Yet the U.K. policy mix is frequently referred to as "austerity" in the same breath as Greece, including by Farrell in his review of Blyth. I think this is mostly Blyth's fault: he's used a common word in an uncommon way -- again, in the lecture; we'll see about the book -- so when people see it they think he's referring to something more general: contractionary austerity, of the sort written about by Schumpeter, or maybe neutral fiscal consolidation (the Treasury View) rather than Alesina's narrow conception of expansionary austerity. I initially made this mistake as well. I wrote a draft of this entire post complaining that Blyth was guilty of conceptual confusion. He's not. But because he's taken the word "austerity" to mean something different from the general/historical understanding, he's given us a fairly difficult task to overcome before we can understand what he's really talking about.

In his review, Farrell describes the U.K. situation thusly:

After enduring two recessions in the last four years, Britain is now well on its way into a third. The pain has been compounded by a succession of austerity budgets, in which Britain’s Conservative-led government has tried to hack away at spending. Repeated rounds of cuts have battered the British economy. However, Britain’s chief economic policymaker, Chancellor of the Exchequer George Osborne, wants still more pain. He is pushing the government to identify £10 billion more in cuts this year.

I think Farrell's right on the substance: to the extent that Britain has restrained the growth of fiscal deficits that has had a negative impact on the economy. But they are far from a primary surplus and don't even (optimistically) plan on running one for another 6-7 years. They're not paying back externally-held debt. The most you could say of this is that the deficit spending isn't expansionary enough. There's certainly a case to be made there. It's my own personal view, in fact. But that political decision is best explained by materialist, not ideational, politics: the Conservative government and their wealthy constituents understand that when the bill does come due, they'll be the ones to pay for it, while the benefits from increased fiscal expenditure are unlikely to benefit them much. Cameron has courted the U.K.'s business community using naked language to this effect, and prominent business leaders have supported the cutting programs. They'd rather keep the future bill low, if possible, all things considered. Hence, the attempts to "hack away at spending". Hence the tax cuts for the rich and tax increases for pensioners in the most recent budget, which were praised by business and The Economist. All very materialist.

So what does an ideational explanation (note: not necessarily Blyth's argument) bring to the table? Only that Cameron government thought this would be expansionary. But it didn't. Treasury reports under Chancellor Osborne revealed that they expected 1.3 million jobs lost.

How about monetary policy? The U.K. is not defending a fixed exchange rate or commodity standard. Its interest rates have been near zero for years, and it has engaged in quantitative easing programs. The U.K. has recently hired one of the most expansionary central bankers in the world to try to spur on the economy, and are considering changing the Bank of England's legal mandate to give him more flexibility to do so. This central banker, Mark Carney, has said that he will pursue "radical" monetary policies in an attempt to generate growth, with no apparent concern for the value of the pound sterling.

This is certainly something qualitatively different from what Greece is doing: devaluing internally in order to maintain a fixed exchange rate. It's the opposite policy. And so Blyth says in his lecture that the U.K. policies do not constitute the sort of austerity he's concerned with. He clearly distinguishes between the U.K. Conservatives' policies and the continental European policies; the implication is that the latter is "austerity" while the former is just normal distributional politics.

But, as I mentioned before, that is not what "austerity" has meant throughout history (even Blyth's own intellectual history), where "history" is as recent as the Washington Consensus responses from 1980-2000 to crises in East Asia, Latin America, and elsewhere. And, arguably, the ongoing eurozone crisis, where the roles of Thailand, Indonesia, South Korea, and Malaysia are being played by Greece, Spain, Ireland, and Portugal; and the role of the IMF is being played by the Troika. It's not what folks like Krugman and Farrell mean when they talk about austerity now. And, frankly, I don't think Blyth's restriction on that definition is helpful. I guess it's possible that the German finance ministry actually believes that Greece's economy will grow following massive public sector cuts, but it is not necessary to believe that in order to explain Germany's actions.

I look around the world and I see two kinds of (industrialized) countries facing crisis: those which have no choice but to engage in austerity, and so do, and those which do have a choice, and so do not. The former are the beleaguered eurozone states. The latter are large industrial economies which have responded to economic slowdowns with, shall we say, half-measures that fall somewhere in between the Keynesian ideal and the Treasury View*. A sort of "soft Keynesianism" which meets the partisan predilections of elected governments. The former Blyth characterizes as having been victims of "the greatest bait-and-switch in human history". Perhaps so (perhaps not, and Farrell questions this claim as well), but how they got into crisis ex ante has little to do with what is done about it ex post, and what is done about it ex post has little need for an explanation which is distinctly ideational rather than materialist.

Why am I concerned by this? Because restricting austerity to Alesina's model muddies the water, and insisting that eurozone leaders fully bought into it is a big claim which, if true, would jeopardize a lot of existing literature. Moreover, it's deceitful marketing. Describing this version as "discredited" (or as a "zombie", as John Quiggin does in a self-promoting blurb) begs the question: what is it, exactly, that has been discredited? Alesina's model hadn't been at the time it was supposedly being tried. I agree with Blyth's incredulity that anybody could have believed it in the first place -- although he's the one claiming that they did, not me -- but experiments are conducted because the outcome is not predetermined. If this was a new beast, then it wasn't an old zombie. So I guess Quiggin was fooled by the narrowness of Blyth's definition as well. That makes nearly all of us.

So the "history of a dangerous idea" is somewhat misleading: Alesina's theory wasn't formed in a vacuum, true, but it was a real break from past conceptualizations of "austerity". It was such a significant break that I don't think they really are the same concept. By referring to one subset of austerity theories -- expansionary austerity -- as if it was the only or even main one, Blyth appears to have made it tough on his audience. Maybe this is all resolved clearly in the book, and he simply elided that discussion in the lecture for reasons of brevity. I hope so, but if so that sense doesn't come out of Farrell's review. I'll read it either way, and I expect to enjoy it. I love intellectual histories like this, Blyth is a good writer, and many parts of his lecture are very good. I mean all that sincerely: I really enjoyed the lecture, and I anticipate getting a lot out of the book.

I'm just not sure about the thesis.

*The Treasury View is that fiscal stimulus will be neutral (multiplier of exactly one), so that version of austerity is a little less austere, but is still not expansionary. Most of the classics believed deficit spending would spur inflation, which is not expansionary in real terms. (Keynes' contribution was to point out that there would be no inflation if there were under-utilized productive capacity.) From what I can tell, none of the intellectual traditions Blyth covers in the lecture espouse expansionary austerity in a crisis except for Alesina.

The Eurozone Political Crisis in One Picture

Some, like Krugman, have argued that the European crisis is a technocratic failure, the result of quasi-religious beliefs in mythical creatures ("the Confidence Fairy") held by Very Serious People in government and the commentariat. If only they would just abandon their heresies and follow the One True Keynesian path, everything would be fine. The optimal policy is obvious and Pareto-improving -- more monetary stimulus, possibly combined with debt rescheduling and the end of fiscal austerity -- so all that is required is the fortitude to implement it.

Others, like me, have argued that the European crisis is a political crisis, the result of a disjunction between the interests of the Eurocore (esp Germany) and the Europeriphery. Rather than postulate cognitive dissonance or willful ignorance (or something more sinister), I focus on distributional issues: either the Europeriphery's creditors are re-paid or they are not; either the Eurozone's macroeconomic imbalances are addressed by adjustment in Eurocore or by adjustment in the Europeriphery. Ultimately these are political questions, and political questions are generally decided by those with the most political power. In the case of the EZ crisis, any resolution must involve the European Central Bank, and the ECB has traditionally been influenced by Germany more than other member nations. There is no Pareto-improving policy -- what helps some countries hurts others -- so this is not a technocratic problem.

Look at this picture (via Niklas Blanchard) and tell me which view best explains the European Central Bank's policy calculus, and thus outcomes in Europe:

Germany is running above its nominal GDP trend; everyone else is below it. That means that further monetary stimulus will increase real GDP growth everywhere but Germany, which will instead experience higher inflation*. Germany does not want that to happen, because Germany does not like inflation. Germany has disproportionate control over the monetary authority of Europe. Therefore, the Europeriphery does not receive the monetary support which they want, because it would cause inflation in Germany.

No parsing of myths necessary; it works without them. Also no moral lesson. Just normal distributional politics.

UPDATE: Fixed some typos and poor wordings, which were both more common than usual (I think) and more egregious, and thus more likely to lead to misunderstanding.

*Added at the same time as typo-fixing: Arguably an increase in German inflation would not facilitate the sort of adjustment which is needed anyway. Higher German inflation would depreciate the real exchange rate of Germany vis-a-vis the other members of the eurozone, thus increasing Germany's competitiveness in export markets relative to, say, Spain. Movement in the opposite direction is needed. Because Spain cannot devalue externally through a fall in its currency, it will have to adjust to a rising real interest rate with an even larger internal devaluation. That means even lower wages, and probably more fiscal austerity.

If I'm right about that it's a potentially very interesting point which I've seen no one else mention.

Definitely Not Expansionary, Maybe Not Even Austerity

Dan Drezner has a post on whether we are now at a focal point that will discredit the idea of expansionary austerity:

The Greek sovereign debt crisis was another such focal point. Greek profligacy seemed to be a synecdoche for excessive government borrowing and lax fiscal discipline. With the global economy seemingly still in the doldrums, a lot of Europrean governments climbed on the "expansionary austerity" bandwagon. By the Toronto G-20 summit in June 2010, the consensus had switched from Keynesian stimulus to fiscal rectitude. Oh, sure there were mutterings about "short-term austerity makes no macroeconomic sense whatsoever in a slack economy" but even Barack Obama started talking about slashing government spending. 

Are we at another focal point? Consider the following: 

1) According to the New York Times' Stephen Castle, European leaders now seem to recognize that austerity on its own ain't working... 

2) The data is starting to come in on governments that have embraced austerity whole-heartedly, and it's pretty grim. Cue Paul Krugman on Great Britain:... 

3) Even commentators who would be tempermentally sympathetic with austerity are starting to bash Germany question whether it's a solution. Consider Walter Russell Mead:...  

4) U.S. 4th quarter data reveals that, consistent with GOP criticisms, the government has been the real drag on the U.S. economy. Not quite consistent with GOP criticisms: the reason why the government is dragging down the U.S. economy. Cue Mark Thoma:...

Before I get into this too deep, I should just note that I've always thought the accusations of belief in "expansionary austerity" from the Krugman/DeLong wing have always been something of a strawman.  The strongest view I've seen regularly expressed is that fiscal policy has essentially a null effect on growth because of forward-looking rational expectations, or because the central bank moves last, not that austerity will actually lead to expansion. I haven't even seen much supply-side voodoo being expressed lately. Can't recall the last time, actually.

First of all, I'd quibble with the claim that the G-20 ever climbed on the "expansionary austerity" bandwagon. Look at the Toronto Summit Declaration that Drezner mentions. No seriously, read it. There's a lot of language like "Unprecedented and globally coordinated fiscal and monetary stimulus is playing a major role in helping to restore private demand and lending" and "To sustain recovery, we need to follow through on delivering existing stimulus plans". Here's the first thing it says about budget deficits (emph added): "At the same time, recent events highlight the importance of sustainable public finances and the need for our countries to put in place credible, properly phased and growth-friendly plans to deliver fiscal sustainability, differentiated for and tailored to national circumstances."

To be fair, the next sentence advocates "consolidation" for countries with "serious fiscal challenges", but does that sound like doctrinaire Treasury View economics? Not to me, and certainly not for anyone outside of Club Med. And while Obama started talking about cutting government spending as Drezner notes -- not sure "slashing" is at all the right word -- other than token cuts all of the significant stuff was reserved for a few years down the road when the recovery was expected to well in progress. The Obama administration also thought in 2010 that growth was taking off; remember "Recovery Summer"? If they'd been right, it would be time to start thinking about cuts in the shortish-run future.

As for European views, it's possible that some people thought Greece's short run growth potential would benefit from austerity, but I don't remember much of that. After all, austerity is called austerity for a reason. All the talk I heard was about austerity as a sufficiently strong commitment mechanism that donors from the EFSF and IMF could be convinced that their transfers to Greece wouldn't be squandered, nor that they would be embedding moral hazard into the EMU that would encourage future profligacy. Now that may not be the best possible economic strategy, but this is a political game not an optimization problem, and in any case it doesn't follow from this observation that anyone believed that austerity would lead to expansion. The Germans cared about getting their money back, not generating growth in Greece, except to the extent that the two are related (and maybe not even that much). My recollection of the early discussions was that if European leaders believed in any of Krugman's oft-mentioned myths it was the "Confidence Fairy", not expansionary austerity.

And, while we're on the subject, the most recent proposal is for lots more austerity for Greece, with Germany taking over Greece's political system if they can't manage that themselves. It doesn't sound like the austerity consensus is at risk of breaking.

Regarding Great Britain and the United States, I'm not sure that the "austerity has failed" line is all that accurate. Here's Scott Sumner:

Here are the three biggest budget deficits of 2011: 

1. Egypt 10% of GDP 

2. Greece: 9.5% of GDP 

3. Britain: 8.8% of GDP 

A slightly more respectable argument is that the current deficit is slightly smaller than in 2010 (when it was 10.1% of GDP.) But that shouldn’t cause a recession. Think about the Keynesian model you studied in school. If you are three years into a recession, and you slightly reduce the deficit to still astronomical levels, is that supposed to cause another recession? That’s not the model I studied. ...

To get a sense of just how expansionary UK fiscal policy really is, compare it to France (5.8% of GDP), Germany (1.0% of GDP), or Italy (4.0% of GDP). Lots of people blame ECB policies for the recession, but Britain is not in the eurozone. Outside the eurozone you have Denmark (3.9% of GDP), Sweden (zero), Switzerland (1% surplus).

In other words, any "cuts" in spending have to be considered in context. Britain's cuts were from an insanely-high (and completely unsustainable) level to an exceptionally-high (and completely unsustainable) level. You can call that "austerity" if you like, and blame the lack of recovery on it if you like, or you could say that Britain has run historically high deficits in each of the last few years. Which is, pretty much, the opposite of austerity. (In any case, Cameron's administration knew that these cuts would not be expansionary, estimating that they'd cost more than a million jobs over five years.)

Similarly, with regards to the United States, Kevin Grier notes that "Federal spending is still [sic] than 30% higher than it was in January of 2007. State and Local spending is still around 12% higher than it was in January 2007. Is this really austerity? ... Can we really run a trillion dollar deficit and bemoan austerity simultaneously?"

I would tend to answer that question with a loud "No".* "Austerity" does not mean "not spending more on infrastructure". "Austerity" does not mean "not enacting a major jobs program". The U.S. did not continue to use fiscal stimulus at the same rate as the emergency measures taken in 2009, but that doesn't mean there's been all that much retrenchment. We haven't stopped mailing the food stamps. We haven't cut off Social Security payments. We haven't raised any taxes, and have cut quite a few. How is that austerity? Maybe that's not enough for Krugman's your taste -- and in fact I'd support higher deficits right now -- but fiscal transfers are political choices, subject to political pressures. Doing more now implies a greater burden for certain segments of the population later, and Obama's continued pursuit of a "millionaire's tax" and "Buffett rule" and "TBTF tax" and corporate tax reform and international corporate minimum tax just drives that point home.

So upper-income Americans don't have to believe in expansionary austerity to oppose further deficit spending; they just have to realize that when the bill does come due they'll be the ones paying it. They couldn't care less whether the fiscal multiplier is greater than 1 or not, because they won't be getting most of the benefit but will be paying almost all of the cost. Substitute "Germans" for "Upper-income Americans" and you're describing the Euro-crisis as well.

Drezner refers to an austerity "gospel", but I'm not seeing all that many true believers. I see it more as a competition between interests.

*Perhaps ironically, so does Krugman. From the article Drezner links: "True, the federal government has avoided all-out austerity" although he contradicts Grier by saying right after "But state and local governments, which must run more or less balanced budgets, have slashed spending and employment as federal aid runs out — and this has been a major drag on the overall economy". Grier provides data, so I'd tend to believe that he's more right, but Krugman usually doesn't make that sort of error so maybe a more nuanced perspective is needed.

Global Financial Markets FOTD

Major U.S. banks have about $80bn in exposure to troubled European sovereigns, about $30bn of which is protected via CDS. Think $50-80bn is a lot? It is. But remember that TARP was a $700bn program. Remember that the Fed will hold interest rates at zero percent through 2014. Remember that these same five banks control over $9tn (with a 't') in assets. $50-80bn isn't very much for these companies.

Yes, there is still secondary risk from a sovereign default tipping over European banks, which then hold up U.S. banks. That's not nothing at all, but isn't everything either: unless it's a huge event, large enough to take down all the big banks in Europe, then I wouldn't be exceptionally worried about it. And if it's that big then there's likely nothing you can do about it anyway.

The European mess is mostly a European mess. We're not nearly as susceptible to them as they were/are to us.

(ht: @EconOfContempt)

Baking Banking Instability into the European Cake

Apologies for the long absence. The past few weeks have been extraordinarily busy on several fronts. I think I'll be able to get this place back into fighting shape pretty quickly.

The decision of S&P to downgrade more or less the whole of Europe has made a lot of headlines, but I'm not sure how much it matters. The plan for Europe before that happened isn't much affected by the downgrade: the ECB prints money and gives it to the banks, accepting EMU sovereign debt as collateral. The banks use the funds to buy sovereign debt. The banks get financing for sure, and if all goes well so do the governments. As far as I can tell, for regulatory purposes all OECD sovereign debt still counts as "risk-less" -- meaning that banks are not forced to hold any capital against it -- under the Basel accords, so there is a regulatory incentive for banks to buy some of this stuff.

There's something absurd about all of this... every step in the chain is an attempt to hear no evil by sticking fingers in one's ear. But if the eurozone is going to survive the European banking system has to stand upright and be able to finance governments. That requires ECB support.

JP MorganChase CEO Jamie Dimon, who often says things in public that are more revealing than he perhaps realizes, recently claimed to believe that there is no banking problem in Europe:

“It eliminates bank liquidity or funding problems for at least the next year, that’s a pretty powerful statement,” Dimon said today after his company reported a drop in fourth-quarter net income. “That was the biggest single risk of an uncontrollable surprise right there, so if that’s taken off the table, that’s a good thing.” ... 

“Europe is trying mightily to solve its problems. I still think the likely outcome is they will muddle through,” Dimon said. “The longer you wait, the higher you run the risk of something disorderly that you can’t really control. I think the ECB took off the worst outcome, i.e. a bank failure.”

Dimon might be right about Europe being able to muddle through, although I still have my doubts. He might even be right that a bank failure is the "worst outcome" in Europe, although I can think of some worse outcomes. But what he doesn't say, indeed what no one has much talked about, are the negative effects this will likely have in the European banking sector if the plan works.

The problem that the new ECB policy is supposed to resolve is this: banks won't lend to needy European governments except at punitive rates. Why? Because those governments are highly likely to default. This is exactly what we want a responsible, healthy banking sector to do.* What we don't want is what we're now hoping to get, which is to say that we don't want a banking sector whose investment behavior is skewed by political institutions pursuing dubious policy goals. We don't want a banking sector that has an expectation of future support if their investments go bad, and we don't want a banking sector that cannot discipline either itself or those to whom it lends.**

We don't, in short, want a situation in which government interventions make Jamie Dimon smile. (Or interventions that make him rich.)

Is this road less bad than the one Europe was on previously? In short run, surely. In the medium-to-long run it's hard to say. Perhaps we think that once the crisis is resolved the ECB can make a credible future commitment to be more standoffish towards the European banking sector. Perhaps we think that we can rein in banks and national governments in other ways, via strict capital standards for the banks and "Hard Keynesianism" for the governments. But I have little confidence that those things are likely. They cut against almost every identifiable political current.

The only way it works is if this crisis really scares everybody so much that a significant (and durable) shift is made in the regulatory and fiscal infrastructure of Europe. While not impossible, I remain highly skeptical that that will happen. I believe it's more likely that policymakers will conclude that the institutions in place are pretty resilient already -- "How else could we have pulled through this crisis?" -- particularly when coupled with a more activist ECB that will support the banking sector when needed.  I believe the banks will conclude that the ECB is their friend, and will therefore count on support when needed, particularly if the cause of the trouble are the member nations of the EMU. That is a recipe for a lot of future financial instability.

The ECB cannot, and should not, be in the business of resolving Europe's political problems. Forcing it into that role is likely to make things worse in the long run.

*The "we" here being an imagined societal consensus in possession of the general will, which reflects more-or-less center-left neoliberal technocratic principles. Yes, I know this "we" does not exist in nature.

**I have a paper, currently R&R, that argues that when banks expect preferential policies from governments they act less prudently. Simple argument, I know, but it's not in the literature yet. I find statistical support. I'll post it if/when it gets accepted somewhere; if someone wants it sooner e-mail me.

More US Debt Needed?

So says David Andolfatto (via Mark Thoma):

I believe that the decline in real rates on U.S. treasuries reflects a steady change in how agents and agencies around the world want to structure their wealth portfolios. There has been a massive substitution away from many asset classes into U.S. treasuries; and it is this fundamental market force that is driving real interest rates lower. 

The phenomenon began in the early 1990s, with the collapse of the Japanese stock market. Then Mexico in 1994, the Asian crisis 1997-98, Russia in 1998, and Brazil in 1999; see Bernanke (2005). Investors became rationally pessimistic about the returns to investing in these countries, as well as similar countries that had not yet experienced crisis. The natural effect of this would be capital outflows from these countries into relative safe havens, like the United States.

The basic thesis here is very much related to what Ricardo Caballero calls a "global asset shortage."

I wrote about this over a year ago, in response to a similar argument by Brad DeLong. You can read that post for more details, but the gist is that Kindleberger argued that in a crisis a hegemon is needed to stabilize the international system by providing five public goods: a market for distress (unsalable) goods, lender of last resort and provider of liquidity into the global financial system, a stable system of exchange rates, macroeconomic coordination, and countercyclical lending.

But what if there's a 6th? What if the hegemon should also create large amounts of highly-rated financial assets that firms can keep on their books without worrying about default?

In a sense, such a role is already encapsulated in Kindleberger's five. It would, in a sense, provide a market for distress goods, which in this case is speculative finance. If these assets are heavily-traded enough an increase in their supply could also constitute a form of liquidity. And they could be used to fund a program of countercyclical lending, by borrowing funds from skittish investors and channeling them to needy borrowers.

As Mark Blyth and Matthias Matthijs argue in a recent issue of Foreign Affairs, Germany is either incapable or unwilling to play this role in Europe. (I'd argue both.) In which case the U.S. should step in and be more aggressive. The Federal Reserve has taken some steps in that direction, opening up swap lines with most major central banks worldwide, and lending directly to foreign banks. But many of those programs have ended. It's not clear that the Fed is doing much to stabilize Europe now. Meanwhile, the federal government has no appetite for such a role.

Put all this together and it's hard to escape the belief that things are going to get worse before they get better. The U.S. may be relatively insulated from a European collapse, but that doesn't mean we're perfectly insulated. And plenty of other places are much more exposed. As the systems level, then, unless the U.S. steps up instability is likely to worsen.

Why Is the US Doing So Well?

So asks Ezra Klein:

Not in absolute terms, of course. Unemployment remains high. Growth remains anemic. Markets remain shaky. But Europe has been doing something very close to imploding for months now. So just as our financial crisis sent Europe into a tailspin three years ago, you might expect that the possibility of a partial or complete break-up of the Eurozone would have American businesses taking a chainsaw to their workforces and households stuffing their paychecks under the mattress in the expectation that 2012 will be a lot like 2009. And yet none of that is happening.

He then runs down some data and has some quotes from macroeconomists. I think the answer is given by this interactive graph from the BBC. In short, Europe is much more highly exposed to weakness in the US (Above picture) than the US is exposed to weakness from Europe. Click on a few of those European countries; almost none of them expose the US. The ones that do -- mostly the UK -- are in decent enough shape. Even the biggest exposures, from France and Germany, are much smaller than exposures of European countries to the US, and of course the US has a much larger economy and banking system than any one of those countries.

Thomas, Sarah, Andy, and I have some joint research that we've posted about before that visualizes the same data in a different way. Ours includes more countries as well as cross-time developments, shown in an animation. (We posted it nine months ago, so the BBC is way behind.) The point is the same: the world is much more susceptible to contagion emanating from the US than the US is to contagion from the rest of the world. This includes even Europe.

In other words, it's not enough to simply say that interlinkages in the global economy are important, and conclude from that developments in the EU will automatically determine the US's economic performance. The patterns of interdependence are even more important, and these give us reasons to be optimistic that the US may be relatively okay even if Europe goes belly-up.

The Great Crash 2008, Part Three

In the last chapter of The Great Crash 1929, "Cause and Consequences", JK Galbraith offers his explanation for why the Great Depression rather than a typical recession followed from the stock market collapse. Or, as he put it, why the economy was "fundamentally unsound" in the run-up to the stock market crash. There are five reasons given (beginning on pg. 177 of the 2009 Mariner paperback, for those wishing to follow at home), and it's worth thinking about each to see how they may or may not relate to today. I'm going to do them in a series for the sake of brevity. This is the third.


The third cause Galbraith gives for the length and depth of the 1930s depression was that there was a bad banking structure. His words: 

[M]any of these [banking] practices were made ludicrous only by the depression. Loans which would have been perfectly good were made perfectly foolish by the collapse of the borrower's prices or the markets for his goods or the value of the collateral he had posted. The most responsible bankers -- those who saw that their debtors were victims of circumstances far beyond their control and sought to help -- were often made to look the worst. The banks yielded, as did others, to the blithe, optimistic, and immoral mood of times but probably not more so. ...

However, although the bankers were not unusually foolish in 1929, the banking structure was inherently weak. The weakness was implicit in the large numbers of independent units. When one bank failed, the assets of others were frozen while depositors elsewhere had a pregnant warning to go and ask for their money. Thus one failure led to other failures, and these spread with a domino effect.

The banking structure in 2008 is often characterized as being dominated by the concentration of market share in a few "too big to fail" firms that were able to exploit an implicit government guarantee and thus secure rents. This led these firms to engage in more risk-taking than they would have done absent a guarantee, so the best way to promote future financial stability is to reduce the size of these firms, thus eliminating the implicit government guarantee, thus forcing firms to internalize their risk-taking, thus leading to less risk-taking and more stability. But this was more or less the state of affairs in 1929, according to Galbraith. There were many small firms and no government guarantee. But that led to instability for the opposite reason as 2008: market share was too dispersed throughout the banking sector, with no financial institutions large enough to halt the spread of contagion.

I've blogged similar arguments to Galbraith's before (and before having read the book). A big part of the resolution of the 2008 crisis involved selling illiquid and/or insolvent firms (Bear Stearns, Merrill Lynch, Washington Mutual, Lehman Brothers, Countrywide, etc.). The only possible buyers for firms that large and with that many problems on their balance sheets was to find other large firms that could absorb them, like JP Morgan and Bank of America. This option was mostly not available in 1907 or 1929 but, combined with strong action from the Fed and Treasury, allowed the resolution of the financial crisis much more quickly and comfortably than in those previous crises. Indeed, the actual financial shock in 2008 was worse than in 1929, and possible worse than any in previous history. The fact that since that shock we've merely had a period of slowed growth and a fairly moderate increase in unemployment rather than a Great Depression is perhaps partially attributable to the fact that we dealt with this crisis much better than previous crises.

This line of thinking should give us pause when we consider whether having more small banks rather than fewer large banks would really be a good idea*. One way we might conceptualize this is to think in terms of patterns of financial integration. A financial system in which a relatively small number of firms are central to the system will generally react differently to crises than a system in which the distribution of links is more dispersed. Specifically, according to research on the spread of viruses and other crises through networks, highly-unequal systems are "robust but fragile": they are resilient to shocks in the periphery of the network, but fragile to shocks in the core. In 2008 we had a shock to the core, so the gut reaction is to reduce the importance of the institutions that comprise the core to the broader system. But that may only leave us susceptible to shocks anywhere in the financial system. This, warns Galbraith, is a very real possibility.

That doesn't seem to leave us with many good options. But here we may take some good news from the 2008 crisis: despite being a more severe financial crisis than 1929, the fallout was much less severe. This is obviously due to a number of reasons including the safety net and automatic stabilizers, as well as pretty drastic actions taken by the Fed and other central banks. But the Fed's actions were likely made more effective by the fact that they had to concentrate their efforts towards only a handful of firms at the center of the system. Once those firms were stabilized, the entire system was stabilized. The 1929 Fed didn't have that option.

This "solution" isn't much of one, admittedly. For one thing, it means that we may remain susceptible to types of crises similar to the one in 2008. That's little comfort. Additionally, it maintains the system of rents that these large firms are able to exploit, and that's unfortunate. But there may be ways of using the regulatory code, tax code, or criminal code to eliminate these rents in other ways. It may be possible to use the same tools or others to promote financial stability in other ways. In any case, it isn't obviously clear that a more decentralized financial system would be any more stable. It wasn't in 1929.

*Keep in mind that a stated goal of regulatory policy at both the domestic and international levels is to reduce the size and number of "systemically important financial institutions". These firms are likely to have higher capital requirements under Basel III, and Obama proposed a special tax for these firms. As far as I can tell these policies have had no effect at all on bank behaviors.

"Macroeconomic Events Have Macroeconomic Causes"

That's D^2, saying we need to do better than "the bankers are all bastards" as an explanation of the state we're in. In my view he doesn't talk enough about the political causes of the recession, nor the international dynamics at play, but a good post nonetheless.

The Great Crash 2008, Part Two

In the last chapter of The Great Crash 1929, "Cause and Consequences", JK Galbraith offers his explanation for why the Great Depression rather than a typical recession followed from the stock market collapse. Or, as he put it, why the economy was "fundamentally unsound" in the run-up to the stock market crash. There are five reasons given (beginning on pg. 177 of the 2009 Mariner paperback, for those wishing to follow at home), and it's worth thinking about each to see how they may or may not relate to today. I'm going to do them in a series for the sake of brevity. This is the second.

Galbraith's second possible reason for why the 1930s depression was so great was that the corporate structure in the US economy was poor:

The fact was that American enterprise in the twenties had opened its hospitable arms to an exceptional number of promoters, grafters, swindlers, impostors, and frauds. This, in the long history of such activities, was a kind of flood tide of corporate larceny. 

The most important corporate weakness was inherent in the vast new structure of holding companies and investment trusts. ... dividends from the operating companies paid the interest on the bonds of the upstream holding companies. The interruption of the dividends meant default on the bonds, bankruptcy, and the collapse of the structure.

There are really two things here. First, Galbraith claims that the 1920s were prone to a widespread prevalence of fraud. Second, that corporations were structured in such a way that a disruption in finance would batter the real economy because financial firms owned many of the most important firms in the real economy. Throughout the book he offers a lot of evidence that fraud and other shenanigans were prevalent in the 1920s, although he does nothing to establish the claim that the 1920s were somehow worse in this regard than decades before or since. He does more throughout the book to show how the corporate structure was organized with productive firms downstream that were owned by financial firms upstream. The two were tightly linked, so that a major perturbation to one sector could have adverse effects on the others.

Some of these charges have been levied about the corporate system in the run-up to the 2008 crash. While I think claims that the financial crisis is a result of fraud or other criminal activity are generally over-stated, and I know of no reason to believe that criminal activity in the financial sector was more prevalent during the 2000s than other periods, there certainly was some of that going on. Perhaps more plausible is the argument that compensation schemes in major financial firms were skewed towards excessive risk-taking and boosting the short-run value of firms, not long-run stability. That may be true as well, although the only piece of research I've seen that directly examines that question finds the opposite (although another study shows that executives of large banks sold their companies stock more than they bought it, perhaps indicating that they didn't have much confidence in their firms' activities).

The second part of Galbraith's claim is more interesting to me, and potentially much more important. Was there was a shift in the underlying structure of the economy that altered the pattern of corporate organization? I don't know of any research showing the specific dynamic that Galbraith describes -- dividends from downstream productive firms paying for activities of upstream financial holding companies -- but something else happened:

From this analysis came two striking figures. The first is a map [above; click for larger version] of links between companies in five key economic sectors: technology, oil, other basic materials, finance linked to real estate and other finance. As of 2003, the sectors are relatively distinct, with real estate isolated. By 2008, they’re a tightly linked jumble, with finance at the center. 

I wrote about this research last year:

To me, there are two ways of looking at this. The first is the conclusion reached by Keim, that interdependence on its own can be stabilizing, until it reaches a critical mass, at which point increased interdependence destabilizes the system. Interdependence obviously went up throughout the 2000s. But another way to look at it is to examine the pattern of interdependence, rather than the occurrence of interdependence. 

It is clear that the financial sector became much more central to the economy, so the economy as a whole became much more susceptible to trouble in the financial sector. In this way, the U.S. economy appears to display a feature of non-random, hierarchical networks, which is that they are robust to shocks in peripheral parts of the network, but fragile to shocks at the center. In other words, if a shock had hit the peripheral oil sector (as happened, in fact, in the middle part of the decade), the increased interlinkages with finance would make the economy more resilient. But once a shock hit finance, the central sector, everything else was prone to collapse as well.

In other words, the major American industries -- tech, energy, real estate, etc. -- all became very strongly linked to finance. This generated lots of profits during the 2000s, but also left the entire economy more susceptible to a shock to the financial system. So the tightly-linked corporate structure that emerged in the 2000s may indeed have had quite a lot to do with why the financial panic had such a devastating (and persistent) effect on the real economy.

Banks Too Weak for Basel III?

It looks like many might be, especially in Europe:

Banking regulators are preparing to relax the new rules requiring banks to hold more liquid assets to be prepared for a new funding crisis, writes the Financial Times. ... 

A new report by JPMorgan estimates that 28 European banks showed a liquidity deficit of 493 billion euro billion at the end of last year. 

Only seven of the 28 banks tested comply with the  new standards, French banks being among the least prepared. In fact, JPMorgan analysts concluded that the requirements of liquidity for the banks must hold sufficient assets, easily sold to meet a 30-day-long funding crisis, will affect most sectors, and will cost about 12% of the average European banks earnings of 2012.

We've written a lot about the competitive nature of Basel III, and especially how American banks tend to have higher capital and liquidity ratios than many of their European counterparts. Basel III was really hard on European (and Japanese) banks, and it looks like many of them won't be able to meet their obligations in a timely manner, especially if the European debt situation deteriorates. And, of course, if European banks are allowed to defect from their Basel obligations then pressure will be placed on the US and other governments to allow their banks to do the same.

This is worth keeping an eye on.

EU Fiscal Union Is Highly Unlikely

Phil Arena was fishing for a post from me on Europe in response to this:

Europe appears to be inching closer to a more centralized fiscal union that would eventually turn the euro zone into something resembling a United States of Europe.

Today we have news that a German court has ruled that Merkel's actions to bailout other European countries were not illegal -- good news for Merkel -- but that any new funding must be approved by the German legislature -- very bad news for Merkel. And yet even Merkel does not approve of the sort of measures that would create a "more centralized fiscal union" in Europe. Her joint statement with Sarkozy on August 16 repudiated eurobonds, as well as an extension for the European bailout mechanism, the EFSF. Meanwhile voters in Finland (and other countries) are starting to assert themselves by demanding increased collateral from Euroborrowers before they approve of new funding. Any one of the 17 EMU members can veto any agreement, and it looks increasingly likely that one or more of them will. And not just the creditors... the debtors are angry too. (Most recently Italian workers went on strike to protest a new austerity package, following similar protests in Greece, Portugal, and Spain.) The EU banking crisis looks like it's spreading, placing even greater burdens on public sector balance sheets and economic growth rates.

Meanwhile, where is the constituency for a greater fiscal union? Perhaps Sarkozy wants that, but Merkel does not. Voters in the Eurocore do not, and it's not even clear that voters in the Europeriphery do either, at least if that comes with supranational authority to set budgets and intervene into macroeconomic policymaking. Which it surely would.

So I just don't see how a fiscal union is politically possible. And I don't even see why it's desirable. Or more precisely, I don't see who would desire it. So I don't see it happening.

The Great Crash 2008, Part One

In "Cause and Consequences", the last chapter of The Great Crash 1929, JK Galbraith offers his explanation for why the Great Depression rather than a typical recession followed the stock market collapse. Or, as he put it, why the economy was "fundamentally unsound" in the run-up to the stock market crash that led to a prolonged slump. There are five reasons given (beginning on pg. 177 of the 2009 Mariner paperback, for those wishing to follow at home), and it's worth thinking about each to see how they may or may not relate to today. I'm going to do them in a series for the sake of brevity. This is the first.

Galbraith's first reason given for why the stock market collapse plunged the real economy into deep depression is the large amount of income inequality. Galbraith writes:

This highly unequal income distribution meant that the economy was dependent on a high level of investment or a high level of luxury consumer spending or both. The rich cannot buy great quantities of bread. ... Both investment and luxury spending are subject, inevitably, to more erratic influences and to wider fluctuations that the bread and rent outlays of the $25-a-week workman. This high-bracket spending and investment was especially susceptible, one may assume, to the crushing news from the stock market in October of 1929.

It's well-established that US income inequality increased dramatically over the two decades prior to the 2008 crash. Here's a snapshot of the share of national income going to the top 10% of income earners from the famous Piketty/Saez historical study of the American income distribution (labelled and discussed by Krugman here)



The graph ends a few years before 2008 but the trend didn't reverse in that time. What I like about Galbraith's explanation of the role of income inequality in the Great Depression is that there is a plausible causal story: with increased inequality the economy becomes more dependent on the fortunes of the high-bracket folks to maintain demand and investment; a shock to their finances via a financial crash thus hurts more than it otherwise would. This can link up with demand-side and structural explanations of the sclerotic US recovery. Too often discussions of contemporary income inequality lacks such a mechanism, and are much more normatively framed and politically charged. That's fine, but it doesn't really help us understand how income distribution affects the broader economy.

The question is whether Gailbaith's causal story matches the present. Let's look at some data on private investment. We know that there was a slump in housing, so let's check that first:




It drops off a cliff, but notice that that begins in late-2005. This is in line with the usual story that the housing collapse preceded and perhaps caused the financial collapse by deteriorating the value of the underlying assets on which securities were backed. For Galbraith's story to be true, we'd need to see investment drop off after the financial collapse destroyed the wealth of those at the top of the income distribution. And we do:



Note that in percentage terms, the dropoff post-2008 is more severe than what occurred during the 2001 recession. My back of the envelope estimate is that investment at the trough post-2001 was ~ 88% of the pre-2001 peak; In 2008 it was 78%. Moreover, investment fell more steeply more quickly post-2008 than post-2001. But it also rebounded in a sharper V-pattern than in 2001. If Galbraith's logic held, we might expect to see the opposite: a deeper, longer investment drought. Sometime like an 'L'- or 'U'-shaped pattern of recovery.

Let's look at some consumption data:



Here we see a much bigger dropoff post-2008 than post-2001, and it persists for much longer. While we've gotten back to pre-2008 levels, we haven't yet caught back up to trend. But is this slack enough to explain the persistent malaise in labor and financial markets? And is the slack in spending and investment attributable to income inequality rather than high unemployment? Is high unemployment attributable to income inequality? There's no obvious mechanism that explains it. At least not that I can think of.

It may be that increased inequality was a symptom of structural shifts in the global economy that pre-dated the crash. An effect rather than a cause. Post-crash inequality becomes a cause of ongoing economic weakness. However as a first explanation for the Lesser Depression I'd look elsewhere.

In any case, the major political battles in the US since the financial crisis have been on issues related to income distribution: health care, financial regulation, and progressive taxation vs. expenditure austerity. Maybe we could add classic Phillips-curve battles over unemployment/inflation tradeoffs.* This suggests that the cleavages in the economy break down along at least some of these lines. But this could be a consequence of the weak economy rather than a cause of it, especially since the political scene has shifted from fire-fighting to deficit-cutting.

*Krugman and others argue that right now there isn't much of a tradeoff and I tend to agree, but neither the political leadership of the GOP nor most pundits seem to believe him.

On Michael Lewis on Germany

Michael Lewis continues his Euro-crisis tour, this time popping up in Germany. Like previous installments in Iceland and Ireland, Lewis has found a curious (and probably grossly exaggerated) cultural trait that -- whaddyaknow? -- has surprising relevance for the crisis. In Iceland it was fear of underground elves; in Ireland it was fairies. In Germany? The duality of scheisse. (I'll let those of you that have forgotten your foreign curse words from middle school look it up.) Also Hitler.

As always with Lewis it's a very interesting piece. Also as always, I'm not sure he gets to the true center of his subject. Actually, that's not true. He does, but usually very briefly and with a key component left out. He mentions Germany's willingness to accept the eurozone as a sort of penance for the Holocaust, but not that it was related to European reticence over reunification. He mentions that other countries used Germany's credit rating to borrow more than they should, but chalks up Germany's frugality to some inherent character trait, perhaps related to long memories of the 1920s hyperinflation. Humorously, he allows his translator/chauffeur to blow apart his thesis midway through -- "How do you generalize about 80 million people? You can say they are all the same, but why would they be this way? -- but then continues on with it anyway.

But a few things come out from the article anyway. First is the unsophistication of German bankers, at least relative to their American counterparts. This, too, is a common thread running through Lewis' discussions of Iceland and Ireland. Second is the fact that German bankers took AAA ratings at face value. Of course so did lots of other investors, including American bankers, which undercuts his "German unsophistication" argument, but whatever. Third is the politics, which he barely touches on but which is obviously the most important aspect of the creation of the crisis and the responses to it.

In Lewis' story, Germans are austere and hard-working while Greeks are lavish and lazy. Of course this view is common, but it is also highly questionable. For example, did you know that on average Greeks work later in life than Germans, French, or Italians? Or that a substantial amount of Greek's debt was accumulated by borrowing from France to buy French weapons to deter Turkey? Greece has a major problem with tax collection and productivity, but many of these concerns are caused by or exacerbated by the German dominance of the ECB and Euro economy. Lewis writes that Germany has become Europe's daddy, but don't the parents get some blame when the children misbehave?

Lewis also presents contradictory views of the German political environment. On the one hand, Germans are portrayed as docile and demure, eager to demonstrate their commitment to Europe and the international community, willing to sacrifice quite a lot to those ends, shamed by displays of nationalism, and almost masochistic in the "memorialization" of their own ugly past. On the other hand, they are PISSED OFF at the rest of Europe and aren't going to take any more of this scheisse from the rest of the continent. Well, which is it?

Lewis' essay is fun reading, but I'm not really sure how much can be learned from it. As always there is a bit of financial mechanics for the uninitiated, and some interesting characters that tell interesting stories -- look for the one about Commerzbank, Deutsche Bank, and the urinals in the men's bathroom -- but give no clear sense of why things happened, much less what's going to happen. Lewis is interested in narrative not analysis, and his sense of politics has always been immature. He's much more interested in culture, and especially the culture of Wall Street and the ways in which it differs from other cultures. Which is all fine and good, I guess, but it limits the importance of what Lewis can say.

PS: I now see that Kevin Drum and Felix Salmon had a similar reaction, except more revolted.

Why Hasn't Academic IPE Had Anything to Say About the Crisis?

Thomas Oatley, who started this blog and still contributes every other month or so, has a guest-post at the Duck of Minerva answering Dan Nexon's question of why no articles of relevance to the global financial crisis have been published in International Organization, the flagship IPE journal. Here's his conclusion:

In short, I would argue that no articles directly relevant to the financial crisis have appeared in IO because the field attaches little value to studying the US crisis in isolation, and the banking crises with which it might share common properties are so infrequent that statistical techniques are unlikely to identify general relationships. As a result, an event of supreme global importance gains very little attention from American IPE scholars.

Kate Weaver -- editor at RIPE -- posted Thomas' contribution at DoM and had some good thoughts of her own. Mark Blyth also had a response. Gist:

Others can talk about intellectual hegemony and the like, but as someone who has sat on a board for many years, I can say its the submissions or lack thereof the is the real killer. Why aren't IPE journals publishing crisis work? Possibly because no one is submitting it? Or because its much more bang for the buck and much faster to publish in Foreign Affairs or on line? ...

The fundamental problem is that IPE imagines a world quite unlike the one we actually inhabit much of the time. As a consequence when we are asked to comment on the world we actually inhabit, we have little to say.

My comment on Nexon's original post was basically what Blyth said: according to Louis Pauly, one of IO's editors speaking at this year's ISA meeting, there haven't been any submissions related to the GFC. It's hard to publish on a topic when you don't have any submissions. In comments to Nexon's original post, Len Seabrooke -- also an editor at RIPE -- said that the lack of submissions is self-selection, and that academics interested in influencing policy are unlikely to look for publication in an academic outlet like IO first.

More generally, this is a marked shift from IPE's early days when the field was focused around questions of complex interdependence. The shift away from that sort of research has been mostly pragmatic and for mostly good reasons, but it isn't unreasonable to think that something has been lost. Robert Keohane called this the "suppression of the 'I' in IPE", and views it with a "gnawing sense of dissatisfaction". It seems that a growing number of scholars feel similarly.

The Coming Unnecessary Disaster

I've recently had a few people ask me what the big deal is about the debt ceiling. A little default couldn't be that big of deal, right? And who cares what the ratings agencies think? I've found it distressingly difficult to get across just how serious this is. So let's start with this excellent primer from Ezra Klein:

It all comes back to U.S. Treasury bonds, which are the foundation of almost all other financial products — the base of the global financial pyramid.

If the federal government’s borrowing costs rise, so will everyone else’s. Mortgages rates will jump, car loans will be harder to come by, universities won’t be able to float bonds, cities won’t be able to fund themselves.

Treasuries are supposed to set the rate of “riskless return” — the price of loaning someone money and knowing, with perfect certainty, that they’ll pay you back, with interest. So when lenders decide how much to charge, they start with the riskless rate and then add to it to cover the risk that you won’t pay them back, and the inconvenience of having to wait for you to pay them back.

It’s a practice called benchmarking, and it’s everywhere: in your mortgage, your credit card, your car payments, the loan you took out to hire three new employees at your business. It’s even common internationally. The fact that Brazilian loans tie themselves to the American government’s debt just shows the high esteem in which the world holds us.

The most basic financial pricing formulas, the ones you learn about in Finance 101 like CAPM and Black-Scholes, depend in large part on a riskless, liquid baseline financial asset, which has long been understood to be US Treasuries. In other words, if T-bills are no longer "riskless", then the value of basically every financial instrument in the world comes into question. As I've mentioned previously, a Treasury default will make current financial regulations, which rely on risk-weighting to determine capital requirements where Treasury debt has a 0% risk weight, more or less meaningless. And because all of this is networked together, it can lead to big problems.

“There’s a whole credit structure,” says Pete Davis, president of Davis Capital Investment Ideas. “Think of it as roads and bridges, but it’s finance, it’s all connected, and it’s all on top of Treasuries. . . . So when you shake the basis of it, everything on top of it shakes, too.”

Or let's put this another way. If you thought things were bad when investors became convinced that Lehman Brothers and AIG were not as safe as they'd thought, what do you think will happen when people think the same about the US government? This has the potential to be very devastating. Klein puts it well:

Running in the background of every day’s trading is the accumulated wisdom of an almost endless number of calculations: How much money does J.P. Morgan Chase have? How likely is Des Moines, Iowa, to pay its bills? What will interest rates be next year? How many people will buy homes in 2013?

These calculations undergo incremental updates almost constantly. That’s fine. Occasionally, they need to be dramatically updated. That’s manageable. But if they all need to be updated at once, and if no one really has the information to update them because Treasuries are suddenly unreliable? That’s catastrophe.

And it's a catastrophe that doesn't need to happen. The ratings agencies appear to be more spooked about the US political process than real pressures on sovereign debt. And for good reason. The US government can borrow for the next five years at negative real interest rates. Literally. Other people will pay us to take their money:



Moreover, unlike other countries the US can borrow -- again, at negative real interest rates -- in its own currency. We don't have to worry about exchange rates or some technocrats in Frankfurt. This could be due to the dynamics I discussed earlier, in which there appears to be a shortage in high-quality investment assets. Regardless of the cause, we are flirting with a disaster the severity of which very few people seem to understand for no good reason at all.

The Bond Vigilantes are no longer invisible... they're just in the form of ratings agencies rather than bond markets. And we need to take them seriously. There's a reason why other countries are trying everything, including dispatching riot police to combat thousands of protesters, in order to avoid default. It's a very bad thing. It's a big mistake to treat it so flippantly.

Misc IPE Developments and Research...

... That I won't properly blog.

-- US and Mexico finally reach agreement on cross-border trucking. This issue has been festering since NAFTA's beginning, but came to a head a few years ago when Mexico got fed up and enacted retaliatory tariffs. To be clear: the US has been in the wrong here all along. Via Greg Weeks on Twitter, who also noticed Chomsky criticizing Chavez.

-- US, EU, and Mexico win case against China in the WTO over Chinese restrictions of exports of rare earth metals. China said the restrictions were for environmental reasons, but they were pretty clearly intended to benefit domestic manufacturers by subsidizing the price of an important input into production.

-- Brazil's real continues to rise, and they don't like it. Is this what adjustment looks like? And is it just me, or do all of Latin America's major economies look fairly fragile right now?

-- John Quiggin has an excellent series of posts [1, 2, 3] on what remains of Marxism if we ditch the assumption that revolution is both necessary and sufficient for positive social change. The answer, it seems to me, is very little that we can't get elsewhere. I've been thinking about this a lot lately, prompted by this awful book by Terry Eagleton (and even worse promo essay). I will probably be returning to the topic eventually.

-- Chinn, Eichengreen, and Ito do a "forensic analysis" on global macro imbalances in the run-up to the crisis. They aren't very optimistic about corrections in the near future. And Chinn describes an important-looking paper by Rose and Eichengreen on the effects of abandoning currency pegs for gaining policy flexibility elsewhere.

-- Tim Harford explains what all the fuss about bank capital is about. Excellent intro for those unfamiliar with the topic.

-- An aggravated take on the current US political economy of banking and bailouts.

-- The BIS compares the internationalization of the 2008 banking crisis, as compared to the 1931 banking crisis. The takeaway is that we only got a Great Recession (Little Depression? What are we calling this?) in 2008 because the lack of a gold standard allowed large liquidity injections.

-- Ha-Joon Chang and Jagdish Bhagwati debate the merits of a strong manufacturing base in The Economist. I wonder if the vote tally is a sign of the times? Ryan Avent adds some levity.

-- Cosma Shalizi reviews the new Easley-Kleinberg book on networks in The American Scientist. A free pre-print of the book is still available here (very large pdf).