Germany's EU Policy Is Not Charity

The other day I pointed out this Economist article, which wins this year's "Most Rhetorical Subtitle Ever" contest: "Is Germany bailing out euro-area countries to save its own banks?" Yes. Yes it is. That fact alters the EU political economy quite a bit. But one bit I didn't mention the other, and the article does a good job of highlighting, is just how important this dynamic is:

Calculations by the Bank of England on losses that would arise from haircuts to Greek, Irish, Portuguese and Spanish debt suggests that a 50% haircut would wipe out 70% of the equity in Greek banks, almost half of it in Portuguese and Spanish banks and about 10% of the equity in German and French banks.

In other words, the periphery is most exposed to the periphery. But that's a lot of exposure from German and French banks as well. Enough for those governments to figure out how to lessen their banks' exposure. Right now, the solution appears to be: provide funding until 2013 -- thus giving the banks adequate time to recapitalize -- then pull the plug. Or, as Tyler Cowen puts it:

For instance, taking this approach, the Merkel government in Germany might acknowledge the status quo isn’t working and speedily recapitalize the German banking system, while letting Ireland, Portugal and others off the hook for some of the money. It’s easy to see why this policy isn’t popular in Germany, and indeed, for years German politicians promised to their voters that such an outcome would never happen.

Right, but the question isn't "Will there be a bailout?" It's "Who's going to get it?"

Summers, Salmon, DeLong, and the Underpants Gnomes

Felix Salmon says Larry Summers is stupid for not thinking that the financial crisis was caused by new-fangled financial instruments. Brad DeLong leaps to Summers' defense, arguing that Summers said no such thing. Instead, Summer said that other notable financial crises -- the Japanese, Nordic, and EU debt crises -- did not arise from new-fangled financial instruments.

I think that Salmon is right about this: I think Summers was implying that new-fangled financial instruments did not cause this crisis, or at least there is no overwhelmingly-convincing evidence that they did. After all, Summers says "I am in less of a hurry to condemn the [financial] innovation as the cause of the crisis than many." I think Salmon is wrong, however, in saying that Summers should be scoffed at for saying such a thing.

Rather than denying that Summers said what he said, DeLong should have said that Summer is right: we did not have a financial crisis because of new-fangled financial instruments. We had a financial crisis because home prices rose by more than 100% from 1999-2006 (pic above), and then dropped 35% from 2006-2008 (pic below). Indeed, given the size of that bubble and the quickness of the correction, a financial crisis was inevitable.



So the question should be: why did we have a such a large bubble? One answer could be "new-fangled financial instruments created a bubble". But that is not obviously true, which is Summers' point. Other countries have had real estate bubbles without new-fangled financial instruments recently, and the U.S. has had real estate bubbles without new-fangled financial instruments in the past, so there is no a priori reason to think that new-fangled financial instruments were responsible for this particular bubble. More precisely, there is no causal mechanism that links new-fangled financial instruments to the housing bubble, much less the crash*.

(I would argue that the same is true of regulation: there is no causal mechanism that links deregulation, or more precisely "unregulation", to the crisis. But then I'm weird that way.)

Plausible causal mechanisms are important if we are to improve future outcomes. Thomas provided a pretty good one recently. Without them, we are in Underpants Gnomes territory:

1. New-fangled financial instruments

2. ?????

3. Crisis

That isn't helpful.

* Jeffrey Friedman has tried to make such a case -- that securitization that could be highly-rated was rewarded by the Basel Accords, which then led banks to do more lending that could be turned into highly-rated securities -- but I don't think Salmon had this in mind.

The EU Crisis In One Picture

The Economist has it on their cool "Daily Chart" blog. The full article is sub-titled "Is Germany bailing out euro-area countries to save its own banks?" The answer, of course, is "yes". This is why Germany is insisting on austerity throughout the union. This is why the ECB is intervening in bond markets. This is why the EFSF is providing loans until 2013, but not after. This is why Ireland, Greece, and Portugal are so unhappy. The entire EU response to the debt crisis is to construct policies that protect German -- and to a lesser extent French -- banks.

We've written about this before. When folks like Krugman are bewildered that the ECB's monetary policies are "one size fits one", they're absolutely right. But that's because this policy is about distribution, and about appeasing powerful domestic interests. Those are the banks.

The Coming Chinese Collapse

Nouriel Roubini is pessimistic. Okay, that's not news, but this time the U.S. isn't his subject. Apparently Project Syndicate doesn't allow cutting of their articles, so I won't, but here's the gist:

China is involved in an enormous fixed investment bubble. At this point a very large part of this is malinvestment, and will eventually lead to deflation and a sharp drop in growth. More than likely it will trigger a financial crisis as well. Right now China is investing nearly 50% of its GDP in capital stock, which is an astounding figure. Inevitably, this leads to many bridges to nowhere, ghost cities, unused high speed rail, and empty airports. Roubini notes that all previous recent examples of over-investment, particularly the East Asian economies in 1990s, ended up with financial crises and slow growth.

Why is this going on? Roubini argues that the causes are structural, embedded in the domestic political economy. High savings is a result of a poor safety net. Households only receive 50% of GDP, with the rest going to politically-influential firms, most of which are exporters. Provincial governments are mini-kleptocracies. There is an enormous patronage/rent-seeking industry in China that feeds off itself.

In other words, the ever-wise and politically-liberated Chinese leaders are actually quite constrained, and that's leading to some very poor choices. At some point, Roubini says 2013 or so (but I think perhaps a bit later), a crash or major slowdown is very likely. And then, politically, what happens in anyone's guess. Let's just say that China's leadership isn't feeling especially comfortable right now, and their position won't be helped by a slowdown.

We've written a decent amount here about how China's rise is not likely to be a strictly linear process. Drezner's also covered it a lot, and Michael Pettis has sounded similar notes. China has very real problems, economically and politically, and most of the actions they've recently taken have reiterated just how strong those vulnerabilities really are.

Of course, if China does slow down that raises a potential problem for the U.S.: servicing our debt potentially gets more expensive. Which is one reason why, even if the Invisible Bond Vigilantes haven't appeared yet, closing the medium-run deficit is pretty important.

Congratulations, Henry Farrell

He is now a U.S. citizen. I say "congratulations" but perhaps I should say "welcome". The polity is better now than it was before; he's pulled the mean up.

He is befuddled about the distinction between "states' rights" and slavery as causes of the civil war, but let him be reassured: he has the right interpretation -- "states' rights" was the right of states to allow slavery -- and the right spirit.

Gaming Immigration

Gary Becker thinks we should charge immigrants $50k (on loan, if necessary) to come to this country. Via Adam Ozimek, who loves it. This baffles me. Becker is obviously a brilliant guy -- winner of both the John Bates Clark medal and the Nobel Prize -- and Ozimek's no slouch. So why don't they understand that the political opposition to increased immigration is centered on "illegal" immigrants? These immigrants are highly price-sensitive, do not earn high wages, are not deterred by formal requirements and have little problem avoiding them. Becker argues that many illegal immigrants will become normalized if given this path, but why should they? Under the status quo they can usually stay for free, and getting here costs much less than $50k. So who do they think is going to pay this $50k?

Perhaps highly-skilled workers, but they are more likely to have access to normal (read: free) immigration mechanisms anyway. Yes, we issue far too few H1B visas, but skilled labor will generally be more abundant in the US than where many of the immigrants come from; making the scarce factor (in their home country) pay to face more competition is generally going to be a self-defeating policy. Arguably we should be subsidizing these immigrants rather than the other way around.

This strikes me as a first-best-world policy recommendation that simply cannot work. Moreover, the prerequisites for it to work would be suboptimal relative to the status quo. It would require a tighter control on immigration than we have at present, and the tighter control is suboptimal on egalitarian and probably efficiency grounds, and so negates any possible benefits from the immigration-license system Becker proposes. On the fiscal side these benefits would be negligible at best. As a deterrent they would be detrimental.

The best (realistic) course of action from the perspective of the immigration advocate -- which Ozimek is, as I am and I believe Becker is -- seems to be a policy of benign neglect. We don't explicitly encourage illegal immigration, but we don't do much to stop it. We let demagogues make political noise about keeping the illegals out, but don't let them follow through. That doesn't work when Arizona goes nuts, but it does when we need to knock down the immigrant-bashing bill du jour.

Chait FTW

This beats every attempt at Friedman parody that I've ever tried. And I've tried. But Chait wins.

Interests and Cognitive Dissonance

In my mind, one of the biggest challenges facing IPE research is how to accurately model the link between interest formation and interest aggregation. (SBD said something about this in conversation the other day, and i've been mulling it over since.) Quite often in IPE we infer interests from economic models. E.g., the scarce factor/sector of production should prefer trade protectionism, while the abundant factor/sector should prefer openness. Or we infer "government" preferences based on the partisan composition of the ruling coalition or executive. I think we all know that these are shortcuts that can't be justified in all circumstances, but as a first cut these types of assumptions often make sense.

But sociologist Fabio Rojas has some newish research (with Michael Heaney) arguing that political mobilization is highly dependent on contextual factors, even if political preferences remain constant. They produce the above graph showing that Democrats stopped showing up to anti-war rallies after Obama became president, and conclude:

Social movements and parties rely on each other. Movements benefit when partisans appear because they can bolster their numbers. Parties use movements as platform for partisan grievances. But there’s a drawback, electoral victories mean that the rank and file will stop showing up.

People don't want to mobilize against their own side.

Some have been perplexed by the Obama administration's foreign policies. Not only has he not reversed some of the Bush administration's detainee policies as he promised he would during the campaign, but he's escalated in Afghanistan and Yemen, and now gotten involved in Libya. This research suggests that one of the reasons he's taken these actions is because he is not constrained by partisans from either party: Democrats will tend to stand by their man, and Republicans tend to favor (or not oppose) military action in general. As the researchers say:

“What’s left in the antiwar movement today is the hardcore,” Heaney said in the interview, “the people who are more or less professional activists. It’s just a small group of people that’s left.”

In other words, this is not the median Democratic voter, much less the median voter in the general population.

This research was just picked up by ABC News, and for good reason. It suggests that we may need to complicate our inference-based models of interest formation and aggregation. It also suggests that if we do, we have an opportunity to get a handle on many substantive questions of interest.

The World Is Still Not Flat

In fact the competitive playing field is highly tilted. Rorden Wilkinson looks at the history of the GATT/WTO at concludes:

The article argues that if WTO performance is measured as the institution’s capacity to act as a strategic device to maintain and exacerbate the advantages of a group of industrial states over their less powerful and developing counterparts (an aim that is much closer to the institution’s intended purpose), then it has actually been quite successful, albeit undesirably so.

I.e., if you think of the WTO as an egalitarian, technocratic institution seeking Pareto-improving bargains, then you'll be disappointed. But if you think that politics actually matters, and by politics I mean power and interests in competition, then this is not surprising at all. Powerful states, particularly the US, have used GATT/WTO to lock in trade relationships that suited their domestic political economies. Specifically, to reference crude trade econ models, the US pushed for liberalization where it had a comparative advantage (industry first, then technology), and protectionism where it did not (agriculture). It got both. These patterns persist in WTO rules to this day. Wilkinson's account is another reminder of how US power and influence has not only shaped the development of the international system since WWII, but how it continues to matter today.

Wilkinson concludes that this is bad on normative grounds, as it does not level the playing field for developing countries, and he is correct. But remember that the international institutional arrangements stemmed from the domestic political environment in powerful democracies, especially the US. Given that, the alternative to a global trading system that is organized around powerful domestic interests in industrialized states is a closed (or more closed) system. It's not obvious that this result would be better for developing countries. Indeed, at Doha it is the developing countries that are pushing for more liberalization from the developed countries, particularly in agriculture and intellectual property, and not the other way around. Given the growth in countries that have integrated into the global trading system, it seems that the some liberalization is better than none for both developed and developing. Pushing too hard for more equal patterns of liberalization could undermine the political consensus in favor of open trade in more developed economies. That wouldn't be good for developing countries.

Via Emmanuel

More on Hegemony, Stability, and Changes to the System

Phil Arena also commented on John Quiggin's post that I remarked on yesterday. Quiggin showed up in comments here and there, and raised a few issues that I want to address in a second. I'm putting them into a new post rather than a comment for three reasons: first, I think the points I'm addressing will be interesting to some who might miss them if buried in comments; second, because I want to post some graphs; and third, because I don't have anything else to blog about today. In general I think this conversation has taken a productive turn, partially because we're starting to talk in terms of hypotheses rather than normative impressions. Phil, for example, built a toy model to tease out whether Quiggin or I was making any sense. Please check that out first.

In comments here Quiggin wrote:

I agree with your observations on the fact that the US was never omnipotent, but would say (in agreement with Phil) that the US was relatively more powerful at the beginning of the Cold War than it is now, which implies a gradual decline over time on this measure.

By contrast, at the end of the Cold War and continuing until the Iraq War went sour, there was a great deal of talk of the US as a hyperpower, empire, a Pax Americana and so on. I've been reacting against that ever since I started blogging...

If we are in agreement on the wrongness of these claims, we can narrow the discussion to a more precise focus on hegemony.

We are in partial agreement. I agree that the US was relatively more powerful at the beginning of the Cold War than it is now in many ways. Those were obviously extraordinary circumstances, in which nearly every other industrialized country had been decimated by war, and the US was the only nuclear power. So in terms of relative hard power gap there's no question that the gap is narrower now than then. In terms of global politics I'm not so sure. In 1946 there was no WTO to regulate trade in ways beneficial to the US. There was no IMF that extended American influence into the periphery. There was no UN disseminating norms of self-determination. Indeed, the empire structure that dominated global politics up until that point had not been entirely disassembled yet. Europe was imperiled by Soviet expansionism, the deterrence of which cost the US quite a lot of resources. The US did not yet have powerful regional allies like Japan and Saudi Arabia to further economic interests globally. The US did not have major military bases on every continent. Yes, the US had larger military advantages then than now, but it had far fewer institutional and structural advantages in place to secure major interests.

How about 1972? The US was in the middle of a much larger military quagmire then than now, the Soviet Union had solidified its control over Eastern Europe and parts of Central Asia throughout the 1960s, the nuclear advantage was long gone, and the US economy was in rough shape. Nixon imposed price controls and tariffs in the face of high inflation, and the Bretton Woods monetary system had just collapsed. The country was emerging from a decade of high internal turmoil (race riots, anti-war protest movements, domestic terrorists, and political assassinations), was in the beginnings of the Watergate scandal, and the legitimacy of the government and indeed superiority of the capitalist system was being questioned in many corners.

Fast forward to today. The US has no major rivals in security. Its major economic rivals are interdependent in (mostly) mutually beneficial ways. Market openness is not only a strong international norm, but is embedded in law and governance by the WTO on terms broadly favorable to the US. Democracy has continued to diffuse throughout the system, and the old imperial structure shows no signs of returning. The US still controls much of the international monetary system, or at least is not constrained by others in this regard. All of the world's major powers are US allies in some form or fashion, or at least are not antagonistic. The largest security threat to the US appears to be a few dozen outcasts hiding out in caves in Pakistan, trying to avoid the US's robot bombs. The largest state threat to American interests is probably Iran, which is in the middle of trying to suppress domestic civil unrest and is watching its only allies -- Syria and Lebanon -- perhaps descend into chaos. Its only other real security rival -- N. Korea -- is isolated to the point that it is derisively referred to as the "Hermit Kingdom".

In both political and economic terms, the world is much more to the US's liking now than in 1946 or 1972. Maybe that's not power as Quiggin means it, but it's got to count for something.

In terms of Quiggin's claim about a post-Cold War Pax Americana, well that strikes me as a hypothesis, so let's look at some data. First the number of battle deaths -- including civilian deaths such as those in Iraq, and intrastate conflicts -- over time:



Graph taken from here. According to two different data sets (for part of the series) it looks to me like a fairly strong drop-off from the height of the Cold War to post-Cold War. The difference is more stark comparing now to immediately following WWII. If these figures were adjusted as population shares there would be an even greater disparity, since overall world population has more than doubled over that time period.

Or we could look at trends in global conflicts since WWII:



Graph taken from here. "Societal warfare" is intrastate wars. Again, we see that in the post-Cold War era there has been a steep drop off in war overall, and there have been almost no interstate conflicts at all during that period.

Maybe that doesn't count as a "Pax Americana", but again, it's gotta count for something.

These leave out other major instances of international cooperation, such as the re-integration of Central and Eastern Europe into strong relationships with the West, the institutionalization of European cooperation more generally, the rise of ASEAN and other regional cooperative institutions, the expansion of the WTO, etc. All of which have happened since the end of the Cold War. It leaves out the large increases in global GDP/capita, trade, and technology.

That doesn't prove anything about the U.S.'s causal role in all of this, but if Kindleberger is right that the international system requires a hegemon in order to be stable, and the world has gotten more stable since the end of the Cold War, then what does that tell you? Maybe this has nothing at all to do with the fact that there has only been one superpower during this time, but then that would be some coincidence wouldn't it. In fact, if we look at the reverse we see much the same pattern: the biggest instabilities in the system over the past twenty years have hinged on US actions -- the military interventions in the Middle East and removal of support for authoritarian regimes, and the subprime crisis -- or inactions where the US has the least global reach -- sub-Saharan Africa, mostly. This is not to say that other actors or factors aren't important. Just that the US plays a much greater role in global developments than any other state, and it's not even particularly close.

(Another IPE scholar is working on a paper suggesting that US monetary policy led somewhat-directly to the revolutions in N. Africa. Basically, the argument is that QE1 and QE2 led to depreciations in US real interest rates, which drove up commodity prices, which are in turn highly correlated with civil unrest. The timing of QE2 in particular maps onto the N. Africa unrest pretty well. Not sure how it will hold up to strong scrutiny, but he has some suggestive early results.)

None of this is to suggest that America is omnipotent; far from it. It's just to say that it isn't as obvious as it might appear that America is, or has been, in steep decline.