Saturday, April 30, 2011

Politics, Not Economics, Will Decide Europe's Path

. Saturday, April 30, 2011

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Friday, April 29, 2011

Karl Smith on Fire

. Friday, April 29, 2011


The Masonomic taxonomy is:

- The Chicago school says markets work so lets use markets
- The Cambridge School says markets fail so lets use government
- The George Mason School says markets fail so lets use markets

I have tried to push the notion that sometimes markets and government simultaneously fail, so lets get drunk.


Though, I do enjoy saying “If you are selling Treasuries then what are you buying? Ammunition and Water Purifiers?”

However, that line often doesn’t go over well with a certain class of business folks who are under the mistaken impression that all of them can simultaneously run to gold despite the fact that only 5 billion ounces have ever been mined in all of human history and over half of that is currently being used as jewelry.

Good News


Matt Rognlie is back blogging, at a new site. His mission statement is here. He's an econ grad student at MIT, and has been one of my favorite econo-bloggers over his sporadic career.

There Will Be Austerity


The inestimable Steve Waldman tries to butter me up ("excellent") before smacking down my first post on EU "Hard Keynesian" political economy:

Winecoff makes an important point, but I think he needs to cut his analysis a bit more finely. Economies run two very different kinds of deficits, a government fiscal deficit and an international current account deficit. Although the two deficits are related, there is no mechanical connection between the two. They do not reliably move together. ...

As long as the country, post-default, issues its own currency, and as long as the country’s citizenry is interested in accumulating domestic currency and debt, the government can run a budget deficit after the restructuring. The capacity of a country to run budget deficits post-crisis will depend largely on the citizenry’s confidence in domestic institutions after the fall.

This is all true, as far as it goes, and my example of Iceland as a potential comparable to Greece and Ireland (really Ireland), bears that out, as I noted in a prior post. Iceland's sovereign debt has trebled since the crisis, and presumably most of that hasn't come from foreign finance (excepting the IMF). Iceland's standards of living, from increased import costs since the devaluation, have gone down but they've still been able to borrow. In fact, as Waldman notes, a devaluation can actually increase the amount of domestic savings available for a sovereign to borrow by making consumption relatively more expensive. And a sovereign in need of funds can always make an offer too good for those with savings to refuse: either you loan us the money now and we pay you back with interest in a few years, or we tax the bejeezus out of you. Either way, we're getting the money we need.

But there's a big "as long as" assumption in there. In my original post I said that in the case of default and euro-exits, "[t]he government budget will have to be balanced almost immediately, and unless there’s a full default will likely need to run a primary surplus for many years”. Combined with my sloppy language ("almost immediately" can mean any number of things), Waldman's "as long as" can obfuscate an important point. Iceland's debt-to-GDP is now 115% at least. Ireland's debt is listed at about 100% of GDP, but of course that's a made-up number since they don't know exactly what the banks will cost them. Anyway, there comes a point when the credibility of domestic institutions gets called into question, when that "as long as" doesn't hold any longer. I think that the point of default would be as near to that point as a state can get. Governments will have a difficult time running deficits of 3% of GDP, much less 10% of GDP.

My "almost immediately" might not be instantaneous -- large shifts in government budgets generally aren't, and I shouldn't've implied that they were -- but we're dealing in the short term, not the long term. "Almost immediately" can mean austerity plans are enacted quickly and implemented over a number of years. The exact duration depends on the levels of domestic savings, and whether governments can get funding from the IMF or EFSF. But the shift from fiscal deficit to balance has to happen, and there has to be a credible plan in place in the short run, or that "as long as" won't hold very long. Indeed, in May 2009, "almost immediately" after the crisis, Iceland committed to a balanced budget by 2013, which they are on track to meet and exceed, running a primary surplus this year (pdf). That's just two years after the default. They also plan to run an overall surplus (net of interest) of at least 2.5% of GDP for at least 5 years, beginning in 2013.

All in all, I think the Iceland experience matches pretty well with my description of things. Maybe Iceland's move to fiscal balance wasn't quite as sharp as Argentina2002 or Russia1998, as Waldman points out, but it's still fairly sharp.

(An aside: Waldman claims that the EU crisis has been slow-moving enough for Irish savers to move their savings out of the country if they wish. But a huge proportion of Irish GDP, and thus tax revenue, comes from foreign banks using Ireland as a tax haven. If all those firms left, it would blow an even bigger hole in the budget. Ireland doesn't want that to happen.)

SRW's point about the difference between fiscal deficits and current account deficits is important, but let's not make too much of it. If we think of a country as a large household, then the fiscal account becomes a feeder into the national accounts. The current account reflects the difference between savings and investment, and the fiscal balance is part of that. Both public and private saving will have to go up, and/or investment will have to go down (perhaps via capital flight, but that's perhaps the worst outcome). I know what SRW is going to say: don't confuse an accounting identity for a behavioral relationship. Fine, but the fact remains: in order to balance the current account, consumption has to fall and savings has to rise. This is austerity, no matter how it's distributed. When SRW says "Shifting international accounts from deficit to balance harms citizens in their role of consumers, but serves them in their roles as workers and savers", what he's really saying is "people have to live more poorly than they did before".

Now as SRW notes, there are a number of different mechanisms for achieving this, and not all austerities are equal. I didn't say they were, but maybe I wasn't clear enough. So far, international institutions have stepped up to smooth the landing. Iceland's current account deficit has funded by the IMF, as they work to build up public surpluses. For Ireland and Greece, it's been the EFSF/IMF, as they enact their own austerity plans. Ireland's CA deficit has narrowed back to pre-crises levels, but only because of austerity, and it hasn't paid back any of the debt principal yet. Greece hasn't even gotten to that point yet. But that only smooths out the process; it doesn't revoke it.

So I don't quite buy this:

Undoubtedly, ending an era of persistent current account deficits will prove painful to consumers accustomed to cheap imports. However, that is not ultimately an incremental cost of leaving the Euro. After all, the purpose of staying and suffering austerity would be to pay down indebtedness, which is more costly than a shift to balance. Contrite borrowers have to pay interest on past debt and run (primary) surpluses. Deadbeats just need to pay for what they buy now. Quantities matter. Staying within the Eurozone offers the palliative of stretching the pain out over time, but increases the ultimate burden of the adjustment. Exiting front-loads costs, but reduces their size, as much of the work is done by the act of default. Undoubtedly, jilted creditors would punish “Euro deadbeats”, and exact non-financial costs, so the benefits of debt write-offs would be counterbalanced, at least in part, by new costs. There’d have to be some cost-benefit analysis. But the options are not, as Winecoff suggests, a zero-sum shift in how countries take their lumps. Countries may find they have a lot fewer lumps to take if they repudiate their debt than if they don’t.

It may not be zero-sum, but that doesn't imply that one option is obviously better. If you take your lumps and pay off your debt, you get rewarded by having access to international capital markets. This can boost investment and future growth, smooth future business cycles, etc. In the eurozone, it means a credible exchange rate and lower borrowing costs, as well as unfettered access to the world's biggest market. Over any medium- to long-run horizon, it is certainly possible, perhaps even likely, that you'd be better off. That's why I don't default on my credit card every month. If you default, you lose those benefits. No more external investment. No more smoothing the business cycle. Lower growth. And it takes a very long time to overcome a bad reputation. To say that "deadbeats just need to pay for what they buy now" misses the point: non-deadbeats could do that too, if they wanted. Defaulting removes the option. Everyone would rather have access to a credit stream than not.

Of course this is where we get into the distributional politics, which is where I wanted to be all along and where I got in my subsequent post on the Quiggin/Farrell article. Admittedly, I used some crude econ to get there, which is where SRW's corrections are useful. But what I really wanted to highlight was that this is a political choice, about who is going to bear the brunt of austerity. So I am befuddled when SRW says this:

Lots of countries, obviously emerging Asia but also Germany, seem to prefer the social goods that come with full employment and financial security to the consumer purchasing power gains that accompany current account deficits. The countries of the Eurozone periphery have so far “chosen” the path of excess consumption, but it’s not clear whether that represents a genuine preference or a historical accident.

Those countries, including Germany, have forced savings. Many emerging Asian economies have capital controls and/or unconvertible currencies. They are also poor and usually well below full employment. (Germany is only half-poor... the eastern half, and ran a CA deficit from reunification until recently. They also have high underemployment, and not especially low unemployment: "However, when comparing the rates of unused labour supply between EU countries, Germany (20.1%) ranks only 20th".). Meanwhile, before the crisis, Ireland and Iceland had full employment and high standards of living and (perceived) financial security.

So any way you strike it, default/devalue is a major step down. How far down, and who pays, is the only question remaining. But let's not kid ourselves... there's no technocratic solution to this. I'd put it much nearer to "catastrophe" than "bows and flows of angel's hair".

Thursday, April 28, 2011

The Politics of Hard Keynesianism in the E.U., Part Two

. Thursday, April 28, 2011

I posted yesterday on how I see the short-run political dynamics of the EU political economy, and why specifically why a holding pattern until 2013 makes some sense for EU leaders. At some point the EU will likely need to decide whether to contract membership or expand its political reach, but that decision doesn't have to be made immediately, and won't be due to local political pressures in member states.

This was all in response to an article by Henry Farrell and John Quiggin in Foreign Affairs that proposed a "Hard Keynesian" legal-institutional overhaul to the eurozone Stability and Growth Pact, that forces a build-up of surpluses during expansions so that states have necessary fiscal flexibility during downturns. That, in turn, should prevent the huge debt pressures that now threaten the integrity of the monetary union. (Note: As usual at Crooked Timber, the comments are well worth reading. Daniel Davies corrects some misconceptions I had about the Irish banking sector, and others responded with some points about the Irish economy that I'm drawing from here.)

What I didn't get around to yesterday was discussing the political feasibility of the Farrell/Quiggin proposal itself. It's certainly an attractive technocratic solution, at least in some ways, but that doesn't necessarily mean that the necessary commitment from member states is credible, which means that a first-best technocratic solution may not be feasible. The Stability and Growth Pact, which intended to serve much the same purpose, certainly wasn't. Farrell and Quiggin admit that monitoring and enforcement capabilities will be necessary, but they're light on specifics. But before getting into the necessary institutional design, I think it's worth asking what is meant by Hard Keynesianism.

As I understand it, Hard Keynesianism (aka "Keynesianism") argues that states should build up "rainy day funds" that can be drawn down when economies are stressed. Essentially, this requires a counter-cyclical fiscal policy to match a counter-cyclical monetary policy. This is similar to the budget requirements of U.S. states, many of which have constitutional mandates to maintain balanced budgets. Since maintaining a balanced budget is very painful during recessions, states often try to build surpluses during expansions. For national governments, this will often mean paying down debt during expansions, and expanding debt during recessions.

The graphic at the top of this post shows the Irish debt-to-GDP ratio, as reported by Ireland's National Treasury. From 1993-2007, Ireland slashed its debt as a percentage of GDP by 70 percentage points. From 1999, when Ireland joined the euro, to 2007 Ireland's debt-to-GDP ratio nearly halved. That's a huge reduction in a short period of time, and any EU "Hard Keynesian" rule would surely consider a debt-to-GDP ratio of 25% to be acceptable. (And if it didn't, of the EU27 only Bulgaria, Estonia, and Luxembourg would be in compliance as of the most recent EU data.) Moreover, this report (linked to by Quiggin in comments at CT) indicates that as of 2007, Ireland ran government surpluses in 10 of the previous 11 years. Quiggin argues that this Keynesianism isn't hard enough, but then what would be? Until the bust, Ireland was the shining example of fiscal rectitude in the EU. How could Ireland's leaders have persuaded voters in 2005 that following all that debt reduction, what was really needed for economic health was to raise taxes and cut spending? Especially considering that much of Ireland's debt reduction came from high growth rates, which were attributed at the time to supply-side factors, not Keynesian counter-cyclical policies.

Also in comments at CT, Farrell linked to this discussion of former Irish Finance Minister Charlie McGreevey's famous maxim: "When I have it I spend it, and when I don't, I don't". The conclusion of the article is that this "negligence" and "madness" was embedded into the culture of Ireland during the Celtic Tiger days:

In the space of a generation the Irish had gone from a people that saved before they bought, questioned any extravagance, and were wary of debt, to a nation only too happy to blow their paycheque on nights out, put the bills on the credit card, and become sodden in debt to buy their dream home and all the trimmings in one go. For a long time the Irish had been a people who simply didn’t have it to spend. Now that we had it, by god we were going to spend it.

The author, Cian O’Callaghan, attributes this shift in mentality to some sort of neoliberal voodoo, but I imagine the Irish citizens didn't need a lot of persuading. After all, other countries went through the same thing. The U.S. shifted from decades of budget deficits to a brief moment of surplus after following a classic counter-cyclical Keynesian policy in the 1990s. It raised taxes on the rich, cut some welfare programs and defense spending, and didn't reinvest the tax proceeds that came from robust growth. It was the height of center-left technocratic management, in the U.S. at least, and it wasn't very popular. Those that were created those policies were first impeached, and then voted out of office in 2000, in favor of the candidate who promised to blow through that surplus by cutting taxes. Arguably this was the proper Keynesian choice too, considering the US was in recession, but the move back to balance (much less surplus) never happened.

I don't think this has much to do with neoliberalism per se. To the contrary, neoliberals have generally been perjoratively accused of forcing balanced budgets (or at least reduced deficits) on others, through the IMF or otherwise. I think it has more to do with the fact that the politics of surpluses is very bad for the technocrats. There is no constituency built around "surpluses in good times". There are plenty of constituencies built around "lower taxes" or "more generous pensions" or "smaller class sizes" or "more funding for alternative energies" or "more aid to the developing world" or ______________.

Viewed in a certain way, we can think of the maintenance of a budget as a common pool resource: we'd be collectively better off in the long run if everyone could commit to maintaining balance (or surplus) in good times as insurance, but we're all individually better off in the short run by defecting. In democracies, the incentives for legislators will always be to appease their constituents via tax cuts or spending increases. So this could be viewed as a collective action problem of sorts*.

Of course it's possible that a major crisis could shake that political equilibrium long enough to erect legal and institutional reforms that lock in the technocratic solution. Perhaps the debt crisis is such an event. If ever there was one this would probably be it. The Germans want to ensure they won't always be on the hook for bailouts in the periphery. The indebted in the periphery need funds to such a great extent that they may accept significant restraints on their future sovereignty in exchange. It's not clear that the Germans want such a Hard Keynesian rule, much less that they'd have much leverage over the EMU17 legislatures that *aren't* in need of bailout, but let's just pretend that interests are sufficiently aligned for this to happen.

Obviously such a rule needs an enforcement mechanism that doesn't require collective action, or else we're right back where we started. This was the problem with the Stability and Growth Pact. But what sort of mechanism would that be? The power to sanction? To levy tariffs? Fines? The best bet would seemingly be the withholding of Structural/Cohesion funds, but those apply to the whole EU27, not just the EMU17. And why would the legislators in periphery states not receiving EFSF funds agree to this? That could have worked

There is one final issue I wanted to cover, and that is that this particular crisis was so severe that no prior Hard Keynesian arrangement could possibly have contained it, so any technocratic mechanism runs the risk of being anachronistic: observed when it's not needed, and neglected when it is. But this is already too long, so I'll have to save that for another day.

*I tend to not like this sort of framing of distributional issues, but I'm trying to present a technocratic objection to a situation that was mostly presented as a technocratic problem.

Wednesday, April 27, 2011

UNC Everywhere

. Wednesday, April 27, 2011

UNC Poli Sci Prof Graeme Robertson has a nice article in FP on the politics of dictatorship and revolutions. I have a few minor quibbles, but in general it's very good (and he knows much more about this than me, so my quibbles are likely wrong). Those interested in the Mideast revolutions, or the politics of authoritarianism, will likely learn a thing or two from it. For more depth, see his recent book (but maybe wait for the cheaper paperback release).

Nye on Power


Joe Nye, interviewed at decent length on AJE. Some of the questions aren't great and some of the answers are trite, but in general it's a pretty good overview of where Nye is at. Apparently there is no embed, so follow the link.

Future of power - Riz Khan - Al Jazeera English

The Politics of Hard Keynesianism in the E.U.


Henry Farrell and John Quiggin have a new Foreign Affairs article (ungated) arguing that the E.U. should pursue "Hard Keynesianism" in response to its recent crisis. What does that entail? In a nutshell, run surpluses and/or pay down debt during expansions, then deficit-spend during downturns. They argue that this policy needs to be firmly embedded in E.U. law, and there has to be a credible enforcement mechanism in order for it to be more successful than the Stability and Growth Pact. Here's a few snippets, but of course you should read the whole thing:

If the EU is to survive, it will have to craft a solution to the eurozone crisis that is politically as well as economically sustainable. It will need to create long-term institutions that both minimize the risk of future economic crises and refrain from adopting politically unsustainable forms of austerity when crises do hit. They must offer the EU countries that are the worst hit a viable path to economic stability while reassuring Germany, the state currently driving economic debates within the union, that it will not be asked to bail out weaker states indefinitely. ...

Hard Keynesianism would not solve all of the EU’s economic and political problems. But it would steer the union away from the disaster toward which it is now sleepwalking. A new set of rules based on this approach could form the basis of a solution that is politically viable for both Germany and its European partners most suffering from the crisis. With only limited fiscal transfers allowed, Germany could be further assured that it would not have to continually bail out its profligate partners. Such an approach would maximize the fiscal room that states in distress need in order to deal with economic shocks while ensuring the eurozone’s long-term fiscal sustainability. In the short term, hard Keynesianism, like enforced austerity, would impose real adjustment costs on the eurozone’s weaker economies; there is no cost-free path to fiscal balance. But if the costs were shared with bondholders and were alleviated by a one-off loosening of monetary policy, they could be politically acceptable.

By concentrating on its economic problems but ignoring their political consequences, the EU is setting itself up for failure. The case for austerity does not make sense. And if the EU fails to deal with the political fallout of its own institutional weaknesses, it is going to collapse. No political body can force voters to repeatedly shoulder the costs of adjustment on their own and expect to remain legitimate. During the gold standard, nation-states tried this and failed—and they had considerably more authority than the EU has today. Hard Keynesianism offers a means to combine fiscal discipline with flexibility in order to cushion the political costs of adjustment in times of economic stress. EU leaders must institute it in a hurry.

I think I agree with their general take that the Eurozone cannot muddle on as it is, although I frequently waver. Things often persist longer than they probably should, and something as slow-moving as this debt crisis lends itself to that approach. In fact, "muddling through" seems to be the default position of the EU leadership right now, and there are very good reasons for that, which I'll return to in a minute. For now let's take for granted that the EU must either move towards deeper political and economic integration, including some form of fiscal union as well as a broadening of the ECB's mandate, or it must contract membership. Neither option is especially appealing to the leadership of the EU countries, but increasing integration appears to be especially unpopular with the voting publics, so of the two I still think an exit of at least one or two of the PIGS is most likely in the short run.

I disagree that "the case for austerity does not make sense". Short of debt forgiveness, which won't happen, austerity must occur. It's only a matter of how it occurs. The alternative to an internal devaluation through wage cuts, tax increases, and reduction of social services is external devaluation (exit from euro) and default. Call it the Iceland Alternative (Iceland was never in the euro, but it did devalue/default, which is what we're talking about). In that scenario, the new drachma and Irish pound will collapse in value and the government will be unable to borrow from international capital markets. This is austerity too. The government budget will have to be balanced almost immediately, and unless there's a full default will likely need to run a primary surplus for many years.

Moreover, small open economies like Greece and Ireland are heavily reliant on imports to maintain standards of living. Ireland imported about 40% of its GDP in 2009; Greece about 1/3. For comparison, the U.S. imported about 14% of its GDP. If the post-euro currencies drop 50% in those countries (as Iceland's did, and it was never attached to the euro), then those imports become 100% more expensive. That's a big price increase. True, there will be some substitution into domestically-produced goods, but such a large adjustment will take time and cause pain. These are not large, diversified economies and there's a reason domestic production wasn't being consumed before; overall standards of living will have to drop if there's a currency devaluation. And while exporting industries may benefit from a cheaper currency, boosting employment in those sectors, the importing industries will suffer, contracting employment in those sectors. Even if overall employment goes up, it will be at much lower relative wages. This is why Iceland is applying for EU membership, including adoption of the currency, despite the sacrifice of policymaking autonomy that entails.

In other words, there will be austerity. The only question is how it's distributed.

Meanwhile, a debt writedown would have a large adverse impact on banks in the EU core (as well as the US). The banks are already undergoing stress tests -- which have been defined down, well below the bank obligations under Basel III -- that reveal potentially critical exposure to peripheral debt. Banks are quickly trying to recapitalize in order to be able to absorb some losses on these loans, and are also trying to reduce their exposure, but that process takes time. If the PIGS defaulted today, Germany and France would have to bail out their banks anyway, so why not do so indirectly by extending loans to the PIGS? In this way, the EU debt crisis is a lot like the Latin American debt crisis in the 1980s.

This is why, unlike Megan McArdle, I'm not convinced that probability of a euro split-up is better than 50%. The peripheral economies will have to suffer austerity in either case, but by staying in the union they can still get the benefits of the common market. The core economies will have to continue to support their banks in either case, so they may as well keep the peripheral economies in.

Here's where the muddling through comes in. The current bailout scheme only runs until 2013. That's not enough time for Ireland and Greece to get completely out of their straits, but it is enough time for EU banks to recapitalize. It may be enough for the PIGS to stabilize, and pass credible enough reforms that their bond rates fall a bit. With some luck, the confidence fairies might even show up. So that leaves us with an equilibrium whereby the current policy of muddling through is a best response in the short run, and there are three possibilities in the medium run: If, in 2013, the banks can handle it and the PIGS haven't credibly reformed, there will be defaults and exits from the eurozone. If, in 2013, credible domestic reforms have been made in the PIGS then there will likely be political space for the sort of EU reforms Quiggin and Farrell describe and the eurozone will remain intact. If, in 2013, the banks aren't fine, then replay until 2015.

Anyway, that's how I see it, and this holding pattern until 2013 seems to be the default position of the EU governments. It's certainly possible that domestic polities force their governments' hand before then, but considering that default isn't good for anyone I'm not sure that's especially likely either.

Tuesday, April 26, 2011

What Libya Tells Us About American Hegemony

. Tuesday, April 26, 2011

Lawrence Kaplan has a nice short piece in TNR that speaks to the debate between John Quiggin and I regarding America's power. There are lots of quotable bits, but you should read the whole thing so I'll only offer one:

Regardless of his own inclinations, President Obama has been presented with successive crises to which he has been obliged, kicking and screaming, to respond. The United Nations has not been able to. Europe has not been able to. Either the United States will respond, or no one will.

A Presidential Reading List


Like everyone else, Dan Drezner picks up on the fact that Obama's early foreign policy reading list, erm, leaves something to be desired. He seems to have pulled a couple of FP-related books off the NY Times best seller list -- Zakaria and Friedman -- and that's it. So Drezner lays down a challenge:

This raises an interesting question, however -- if a newly-minted U.S. Senator did want to seriously bone up on foreign affairs, what books should he or she read?

[I]f you're educating a politician from scratch, you need something relatively pithy, accessible, relevant to current events, and America-centric. Given those criteria, Friedman's oeuvre makes some kind of inuitive sense, no matter how wrong or ripe for satire it is. I mean, what's the alternative -- Three Cups of Tea?

Aspiring leaders of America can and should do better than Friedman, however. I therefore call upon the readers of this blog to proffer up their suggestions -- if you had to pick three books for an ambitious U.S. politician to read in order to bone up on foreign affairs, what would they be?

In more recent years I'm sure Obama's read Samantha Power and Anne-Marie Slaughter, or has at least been exposed to their ideas sufficiently to bring them into his administration, so we should probably cross them off the list. Drezner's commenters tended toward the obvious: Khanna, Mearsheimer/Walt, Kaplan, Brzezinski, Kissinger, and Drezner. Excepting the last (of course), I think I'd rather him read Zakaria and Friedman.

I'd like to put a little meat on those bones, but I understand that heavily formal theory and complicated quantitative stuff is off the table, so I'd lean towards stuff that emphasizes history, but with a bent for theoretical explanations -- rather than descriptions -- of phenomena.

My three:

1. After Victory, by John Ikenberry. It gives a good account of the how the world we live in today was shaped by World War II, the importance of institutions and multilateralism in maintaining order, and the difficulties that power transitions present. All of these seem to be very relevant today. The historical narrative in engaging but rich in both theory and evidence.

2. The Strategy of Conflict, by Thomas Schelling. The previous administration seemed to think that many world leaders were crazy, undeterrable, or otherwise worth not engaging in any strategic way. This book (and most IR scholarship) forcefully argues otherwise. I think a foreign policy leader should have some exposure to rationalism as a paradigm of thought, and this book provides that without being technical. Schelling was a master at communicating counter-intuitive ideas in a clear way. For a game theorist, he's amazingly readable.

3. Global Capitalism: Its Fall and Rise in the 20th Century, Jeffry Frieden. Something on the economy, suitable for the times. This book not only covers various 20th century crises, but also has a longer-run view of the broader threats to economic stability and growth. In my opinion, a lack of global economic policy has been Obama's biggest presidential weakness so far, and it was predictable. His campaign rhetoric skewed protectionist, and while that stance has softened since he's been in office, the U.S. Federal Reserve has arguably been the most important global economic institution since 2007. It has coordinated with other central banks, extended liquidity to foreign firms, refused to engage in competitive currency devaluations, and otherwise helped stabilize a teetering the global financial system and broader economy. How has Obama responded? By leaving numerous Fed chairs unfilled (and also under-staffing Treasury). Many have criticized the Fed for not doing enough (some have criticized it for doing too much), but part of that may be due to Obama's unwillingness to get the needed personnel into the right spots. Obama seems to have little grasp of the interworkings of the global economy, and this book can help with that.

UPDATE: Stephanie Carvin has her own list here, and Phil Arena whines about how stupid this all is before offering up a suggestion here.

Monday, April 25, 2011

The Indirect Effects of the Dollar As Reserve Currency

. Monday, April 25, 2011

Paul Krugman has a post on how holding the world's reserve currency gives the U.S. economy no great advantage. As I've written before, I think he's right on the economics (it seems to be the consensus view), but there's a few points worth adding:

1. While it may not be especially important for the world's reserve currency to be the dollar, it is important that there is some global reserve currency. And it is important that it be controlled by a central bank that is willing to inject liquidity into the global economy during periods of stress, and serve as an international lender of last resort. Call this Kindleberger's Law. Right now, the U.S. Fed seems to be the only central bank that is able and willing to serve that role.

2. More broadly, I wonder if international monetary economists are asking the wrong question. Rather than trying to quantify how much the "exorbitant privilege" is worth to the U.S., why not look at how other countries respond to policy changes in the U.S.? Putin says the "dollar zone" includes the entire globe, and so the whole globe has ideas about how the U.S. should conduct its monetary policy. Brazil imposes capital controls when the U.S. pursues monetary easing, China holds $1tn or more in reserves and has oriented its entire macroeconomic policy to respond to the U.S., South Korea put exchange rates at the top of its G20 agenda, etc. This suggests that the effects of U.S. policy choices are much more important than getting a few billion from seniorage and foreign holdings of dead presidents.

3. This foreign reliance on the U.S. gives us quite a lot of domestic policy flexibility. We're not constrained by the "small open economy" models in the ways that South Korea is, for example. If our major trading partners are pegging to the dollar, then we're not constrained by the trilemma, either. We can pursue expansionary monetary policy when and how we like. We have essentially no currency risk, S&P downgrade notwithstanding. This policy flexibility is worth much more than the $25 billion a year that Krugman estimates.

4. It also reinforces the centrality of the U.S. in the international economic system, which not only provides the U.S. with cheap capital when we need it ("flight to safety"), but also gives us a lot of leverage in global governance negotiations. In other words, it allows us to skew the rules to suit our preferences to a greater degree than other states. This is obviously not an absolute power, but neither is it negligible (to the extent that global governance is not negligible, that is). South Korea was not able to get an exchange rate agreement at the G20, because the U.S. has no reason to comply. The U.S. has a large impact on global real exchange rates, so when it wants to devalue it can, even when other countries maintain nominal pegs.

These are mostly indirect effects that a simple analysis of "value of having the reserve currency" would likely miss. And it may be impossible to accurately measure. But these factors should not be ignored. They shape the politics that shapes the broader global macroeconomy. And we've seen plenty of evidence that this effect is not small. The world's emerging markets have been upfront in their desire to move to a multilateral reserve currency, such as the IMF SDR, that would give them more influence in managing the international monetary systems. They've also pressured the IMF to concede that capital controls can be a legitimate policy response to U.S. monetary easing, and have built massive piles of reserves. This indicates how important U.S. monetary policy is to the world, which should give us some indication of how important it is for us.

Friday, April 22, 2011

Elasticity of Morals, con.

. Friday, April 22, 2011

Tyler Cowen notes the decline in "green" brands. He suggests that the trend is over. But I think it's just another data point demonstrating the income elasticity of public morals. Note that the earlier posts at that link have a more detailed discussion. I'm sure people have written about this at length before, but my education hasn't covered it and people seem to not generally talk in those terms. But why not?

An alternative theory is that it's about partisanship, not income. For example, we know that anti-war demonstrators, who often couch their protests in moral terms, tend to stay home when their preferred candidate in office. Since most environmentalists are on the left, perhaps the face that Obama is in office has led some to be less willing to spend extra on green goods, which has then led to fewer green brands making it onto the market.

That may be part of it, but I don't think it's all of it. High income countries tend to promote all kinds of civic virtues that are not shared by lower income countries. High income regions within high income countries do too. Public virtue appears to be a normal good, to at least some extent: people want more of it as their incomes increase.

Policy Research and Stats


In the past I bashed on Andrew Exum for being too dismissive of stats work in IR, so it's only fair that I praise him for running this guest-post on his to do policy-relevant conflict stats analysis. I haven't read the paper Charlie Simpson is criticizing, but as a general lesson the post is good. Some of them may be less relevant for academics than policy folks -- "Moneyball that shit and find the COIN version of on-base percentage or WHIP" is about exploiting arbitrage opportunities and snapping up under-valued assets at basement prices... not really what academic work is about -- but that's a good lesson too. Methodological approaches that are valid in some contexts are not appropriate in all contexts. Knowing the difference is half the battle. Maybe the most important half.

A few caveats to Simpson's post:

- #3 applies to regression as much as cross-tabs or whatever. I think her point is that multivariate analysis is what is needed, but that's not what she actually says so I can't be too sure.

- #4 is a very good point. Which is why...

- ...It sucks that #5 is wrong. Well, wrong at the end. Not all variables need to be measured at the same level of analysis. That's what HLMs are for. I'm becoming an HLM advocate more and more all the time, so I'd like to see this get out there more.

Thursday, April 21, 2011

Fighting Grade Inflation at UNC

. Thursday, April 21, 2011

UNC will institute a new policy to combat grade inflation, beginning in 2012. The plan hinges on qualifying grades based on contextual factors, so transcripts will now contain summary course statistics alongside grades, and a "scheduled point average" will replace the traditional GPA. In other words, an 'A' in a class where 50% of students receive 'A's will now be worth less than an 'A' in a class where 15% of students receive 'A's.

This plan has been in discussion for quite some time. See, for example, this December NY Times article about a UNC sociology professor Andrew Perrin's push for such a system. And Michael Bérubé wrote an op-ed back in 2004 proposing something similar. I am in full support of this plan, and I hope more colleges and universities adopt a comparable scheme.

But there is one thing that I disagree with. Perrin says:

“I don’t think it’s fair to say it punishes or undermines students,” he said.

“For every student that it seems to harm because it shows their high GPA was earned in relatively easy classes, it helps another student whose low GPA was earned in relatively difficult classes.”

This isn't really true. Some students will benefit from this, yes, but if the problem is grade inflation rather than grade inconsistency, more students will suffer than will benefit. That's because the new "contextual" grades will send a clearer signal of a student's ability (or, at least, her performance in classes). This will help strong students, but it is unlikely that they needed the help: they likely had high GPAs under the traditional grade-inflated system. It will hurt mediocre students, who previously benefitted from the extra noise. A clear signal reveals their mediocrity, where the previous noisy signal masked it. A low GPA in difficult classes will become a mediocre GPA, but will still sort those students into a lower tier than the strongest students.

As I understand it, that's the whole point: rewarding good students for their good work. Like Perrin, I don't think of this as "punishing" mediocre students, but as removing rents. In other words, if the system works the way it's intended, it should hurt some students on the job market*. Which means parents are going to complain. Which means the system might not stay intact for very long. Of course, if this sort of practice becomes widely-adopted, then that pressure will go away. So I hope that's what happens. But there are reasons for schools to not participate: a noisy signal is better for the majority of their students than a clear signal would be.

*Unless it raises the status of a UNC degree at any GPA sufficiently high that a "contextual B" at UNC is equivalent to a "likely-inflated A" at UVA, or wherever. But because the 'A' is a noisy signal while the 'B' is a clear signal, I doubt that will happen.

UPDATE: See Phil's thoughts on how he, as a professor at a different university, would respond to this type of system. He likes it, and would change teaching strategies, but the students are likely to be angry.

The Lesson of Iceland


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

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

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

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

Wednesday, April 20, 2011

Some Politics of U.S. "Hooliganism"

. Wednesday, April 20, 2011

Paul Krugman sends us to Vlad "the Destroyer" Putin:

“Look at their trade balance, their debt, and budget. They turn on the printing press and flood the entire dollar zone — in other words, the whole world — with government bonds. There is no way we will act this way anytime soon. We don’t have the luxury of such hooliganism,” he said.

As Krugman notes, it takes two to tango. A big reason the U.S. has such a large trade deficit is because emerging markets have undervalued their currencies relative to the dollar*. And the big reason the U.S. has engaged in so much monetary stimulus is to boost employment, some of which would could have happened through the nominal exchange rate if so many other countries weren't actively managing their currencies. But adjustment still needs to happen, so now we're seeing pressures on the real exchange rate rather than the nominal exchange rate. In other words, inflation in emerging economies will rise until things become more into balance. And now Russia, and China, and Brazil, and others are complaining about the inflationary pressures that U.S. monetary policy is putting on their economies. But they can't have it both ways: while the U.S. economy is depressed, adjustment has to coming through the nominal exchange rate or the real exchange rate.

This isn't hooliganism. This is using monetary policy in textbook ways. As it happens, U.S. monetary policy has a great effect on external economies, which is why Putin calls the whole world the "dollar zone", but let's be clear: those countries want the U.S. to pursue less expansionary monetary policy so they can free-ride on it. It's fine for them to have that preference, and as I've argued before, I think the U.S. should allow some free-riding. But the U.S. government has citizens to satisfy as well, so those countries can't very well expect the U.S. to pursue a contractionary policies while the economy is so weak.

Krugman explains this as "capital wants to go South". I actually don't think that's right. I think capital "wants" to go North: witness the flight to safety, the historically low U.S. bond rates, the fact that the S&P downgrade warning had no effect on those rates, the rallying U.S. equity markets. Look at how developed countries increased their holdings in U.S. banks immediately following the banking crisis (clear in the animation here).

There's nothing preventing capital flight from the U.S., and yet that hasn't happened. Likely because while the U.S. has some problems, compared to many other large economies they are manageable. They aren't trying to stave off the collapse of a currency union, or a nuclear meltdown, or all the things China has to deal with. There's a high demand for safe, liquid assets, and the U.S. public and private sectors can provide more of those anyone else. The U.S. is at the center of the global financial network, which appears to behave in some ways according to a preferential attachment decision rule. Remember the Leontief paradox: factor-price equalization is not always the norm.

The U.S. government, on the other hand, wants some capital to go South. In other words, it doesn't want deflation, and it does want some dollar depreciation to boost employment via exports. The South, on the other hand, doesn't want capital inflows. Brazil has put currency controls in place, China has a closed capital account and fixed exchange rates, etc. The U.S. is trying to force adjustment through the real exchange rate, meaning higher inflation in exporting economies with managed exchange rates. These choices are political, not responsive to some economic natural laws.

*There's a lot of moving pieces here: budget deficits are a result of tax cuts + spending hikes (Medicare Part D plus wars), and then the recession. This also feeds into the national accounts. And while that is an accounting identity, not a behavioral relationship, I don't think it's a stretch to say that deficit spending is encouraged by low borrowing costs. Indeed this is what the Keynesians are arguing now, and it's one reason why Dick Cheney said that "deficits don't matter". During Bretton Woods II, there's been a huge rightward shift in the supply curve of funds available for the U.S. (either as sovereign, or as businesses and individuals) to borrow. When that happens, we'd expect the quantity demanded and thus equilibrium debt levels of the U.S. to also go up.

Tuesday, April 19, 2011

Explaining the Financial Crisis, Assuming No Prior Knowledge

. Tuesday, April 19, 2011

I was a guest lecturer in a large undergrad lecture class yesterday, for Intro to International Politics. It was the first time I've gotten to speak for 50 minutes to an audience of several hundred, so good practice/preparation for me. I gave a talk on the financial crisis. Before that, I'd done an informal survey of some students to find out what they knew about the crisis, and the consensus was that some of them had some vague idea that a crisis had occurred, and a very small minority of those knew that it had something to do with housing, but that's it. The majority have no economics training at all. So the lecture was very much geared towards explaining to them why this was important, and how and why we can think about it in political terms, in ways they could understand.

I had to cover a lot of ground pretty quickly, but I think I covered my bases fairly well, given the constraints. I would've liked to spend more time on the politics than the brush-clearing, but I just couldn't assume enough prior knowledge to make that happen. Ideally, this would be split into two or three lectures, at minimum. Anyway, the students didn't complain to my face, so it couldn't've been too bad.

No video/audio, unfortunately, but here are the slides. Since I had so much to cover in 50 minutes, I made the slides pretty detailed, and gave them to the students so they'd be able to just listen to me rather than furiously scribble notes.


Note1: In the pdf version of the slides, there's a time series animation of banking integration embedded in slide 18 that probably won't show up in Scribd. That can be found here. The students seemed to like that part especially.

Note2: The gorgeous Beamer template was created by the excellent Skyler Cranmer. Technically, I think I'm using it without his permission -- I got it from a grad student who got it from a grad student who got it from a grad student who got it from him, or something -- so credit to him, and hopefully he doesn't mind my free-riding. Whenever he gets back from Europe I'll ask him if there's a favor I can trade in exchange.

Monday, April 18, 2011

Germany's EU Policy Is Not Charity

. Monday, April 18, 2011

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.

Friday, April 15, 2011

The EU Crisis In One Picture

. Friday, April 15, 2011

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.

Thursday, April 14, 2011

Congratulations, Henry Farrell

. Thursday, April 14, 2011

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.

Wednesday, April 13, 2011

Interests and Cognitive Dissonance

. Wednesday, April 13, 2011

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

Monday, April 11, 2011

More on Hegemony, Stability, and Changes to the System

. Monday, April 11, 2011

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.

International Political Economy at the University of North Carolina: April 2011




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