Is This It?

Der Spiegel says Greece is about to restructure its debt and leave the eurozone:

Greece's economic problems are massive, with protests against the government being held almost daily. Now Prime Minister George Papandreou apparently feels he has no other option: SPIEGEL ONLINE has obtained information from German government sources knowledgeable of the situation in Athens indicating that Papandreou's government is considering abandoning the euro and reintroducing its own currency.

Alarmed by Athens' intentions, the European Commission has called a crisis meeting in Luxembourg on Friday night. In addition to Greece's possible exit from the currency union, a speedy restructuring of the country's debt also features on the agenda. One year after the Greek crisis broke out, the development represents a potentially existential turning point for the European monetary union -- regardless which variant is ultimately decided upon for dealing with Greece's massive troubles.

And here's one political dynamic:

The European Central Bank (ECB) would also feel the effects. The Frankfurt-based institution would be forced to "write down a significant portion of its claims as irrecoverable." In addition to its exposure to the banks, the ECB also owns large amounts of Greek state bonds, which it has purchased in recent months. Officials at the Finance Ministry estimate the total to be worth at least €40 billion ($58 billion) "Given its 27 percent share of ECB capital, Germany would bear the majority of the losses," the paper reads.

In short, a Greek withdrawal from the euro zone and an ensuing national default would be expensive for euro-zone countries and their taxpayers. Together with the International Monetary Fund, the EU member states have already pledged €110 billion ($159.5 billion) in aid to Athens -- half of which has already been paid out.

"Should the country become insolvent," the paper reads, "euro-zone countries would have to renounce a portion of their claims."

In other words, now that Greece has gotten funds from the EFSF there is domestic political pressure from citizens in the Eurocore to keep them in the monetary union, if only to get their money back. Interesting.

I've blogged a lot about this recently; in the past week or so I've written about it here, here, here, and here. Near the end of the most recent of those I summarized some IPE research on fiscal crises, fixed exchange rates, and propensity to devalue/default and concluded:

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.

Not exactly a novel prediction, but one supported by prior research and not just a gut feeling.

The link above is via Ryan Avent, who says:

Even as it does this, it runs a deficit, which means that absent access to capital markets (and it will lack access to markets for the forseeable future) it must continue with austerity. Fearing a potentially ugly restructuring, some depositors have been pulling money from Greek banks, threatening the system with dissollution.

As ugly as this path appears, is departure from the euro zone really going to be better? Much of this pain is unavoidable. A massive devaluation would help Greece's economy, but the short-term impact of a Greek departure is unclear and could be highly destabilising. Over the long-term, it's not certain that Greece is better off outside the euro zone.

This is pretty close to my "there will be austerity" argument that Steve Randy Waldman discussed. Avent suggests that it may be a negotiating tactic, and I've made a similar case before: so long as Europeriphery debt is held by weak financial institutions in the Eurocore, the periphery actually has quite a bit of leverage.

If this is the beginning of a new bargaining round, it opens the window for a "Hard Keynesian" agreement similar to what Farrell and Quiggin propose. The timing for a broad negotiation seems about right: Portugal just had to tap into the EFSF fund for the first time, and pressures on Spain mount. There are many difficulties in getting such an agreement through -- I believe it requires the approval of the legislatures in every EU country, which doesn't seem likely -- but if it were ever going to happen, now is probably the time.

Politics, Not Economics, Will Decide Europe's Path

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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.

Some Politics of Debt, Default, and the EMU

Tyler Cowen notes that Irish (and Portuguese and I'd add Spanish) are not yet out of the clear, and writes:

The first country which can, with no shame, credibly threaten to leave the eurozone or outright default can blackmail Brussels and Berlin into further aid, due to fear of contagion effects. Some are arguing that Portugal is already assuming that strategic stance.

Let's try to tease this out a little bit. One of the first rules of bargaining theory is that the side with the best outside options has quite a lot of negotiating leverage. Eric Voeten has looked at this dynamic in the context of international institutions, where there is an asymmetric power distribution among the members. Specifically, he looked at the UNSC and found that the presence of strong outside options makes multilateral agreements more likely, so long as there is some incentive not to exercise them. But, and this is key, Voeten argues that "the first condition for multilateral action is the [most powerful state] be willing to act alone or with close allies" (p. 856). In other words, thinking only about how the PIGS have leverage over Berlin is probably not the best way to go about it.

Which most needs a Euro that includes Ireland, Greece, and Portugal: those countries, or Germany? Well, departure from the Euro (and ensuing debt restructuring/default) will massively impair those countries' abilities to engage international credit markets for a long while to come. Michael Tomz has written about the reputational effects of debt defaults, and it's not pretty. Defaults not only adversely affect countries access to foreign credit in the short-run, thus making austerity inevitable, but these effects persist. In other words, possible EMU defaulters have two choices: austerity with devaluation (which reduces real wealth but boosts competitiveness) but no external finance, or austerity without devaluation but with external finance (in the form of ECB/EFSF plus continued access to bond markets in at least some form). The question is which benefit is greater: access to foreign finance that can help smooth out the pain from austerity, or the shock treatment of devaluation. So far the answer appears to be the former.

What about Germany? Now that it's in a currency union it's better to keep it. The EMU is very good for German exporters. If the union splits, and peripheral European economies devalue, Germany's exports become much more expensive for those economies. Additionally, if some of the weaker members left the Euro the currency's value would likely increase against other international currencies. That, too, would bad for German exports. So Germany has incentives for keeping the EMU intact, and thus fulfills one of Voeten's criteria. On the other hand, Germany would do fine under a narrower Eurozone. The value of EMU membership that accrues to Germany is significant, but limited. There is a price tag that is simply too high for it to pay. That should give Germany quite a lot of leverage in Voeten's framework.

This is where Cowen's mention of contagion could come in. I'm not sure what he means by that; it could be Asia1997-style currency contagion across the PIGS, or it could be the fact that German (and French) banks are heavily exposed to PIGS' debt, so a sovereign default could have large knock-on effects for the financial systems at the core of the Eurozone. From Germany's perspective, the latter is much more salient. It increases the costs associated with a break-up in the EMU, and thus provides incentives to keep the union intact. But these costs, too, are not infinite. At some point it might be easier to bail out the financial sector than to bail out Europe's periphery, especially if domestic polities in the PIGs revolt against austerity or demand better terms from the EFSF.

So Cowen's right: the PIGS have some blackmail room, but only until the German and French banking sectors recapitalize. Meanwhile, Berlin has the nuclear option. If it comes to blows, Germany will end up in far better shape than the PIGS. So given what we know about the ways that powerful states use international institutions to help them achieve their goals, the most likely outcome seems to be either that the PIGS pay up, or that there is an intermediate period where the ECB/EFSF provides some funding to the periphery basically as a stalling tactic, buying time for the banks, and then pulls out the rug. The former seems to describe Ireland, the latter may end up being the story of Greece and Portugal.

Realism, the EU, and Germany

In response to this post, Stephen Walt writes:

Accordingly, a realist account of the EU would stress that these states agreed to constrain their own autonomy and sovereignty largely in response to an unusual power configuration (i.e., the Cold War), and as much for security reasons as for purely economic ones. The end of the Cold War removed that power configuration, and we have seen the EU both expand and fray ever since. Germany's unwillingness to keep subsidizing profligate countries and European concerns about the implications of Germany's increasingly dominant role (as highlighted in this NYT article) are consistent with that view.

I think this is an especially poor account of both the history of the EU, and what an appropriate realist view of it could be. On the first point, the majority of significant EU integration has happened since the end of the Cold War. Prior to that it was almost exclusively and economic community, not a security community. (That's what NATO was for.) Since then the political and economic ties have grown stronger. True, the move towards the constitutionalization of the federation failed in 2004, but both Maastricht and Lisbon have happened since 1989, as has the Stability and Growth Pact and indeed the creation of the Euro itself. 15 of the 27 EU members have joined since the collapse of the Warsaw Pact. So there's been quite a lot of expansion in membership* and purpose. And to the extent that any fraying has gone on it's not because of power transitions or the dissolution of the USSR, but because the monetary union was built on the false premise that an accompanying fiscal union was unnecessary so long as countries pretended to abide by Maastricht. The fallout from the financial crisis has brought that illogic into sharp focus, but security concerns have absolutely nothing to do with it.

On the second point, it's right to emphasize Germany's dominant role, but wrong to think of it as only becoming salient recently. In fact, the best realist argument is the opposite: that the EU became more institutionalized post-Cold War -- including the establishment of the EMU -- in order to resolve the German question. The process of German reunification which, not coincidentally, corresponds to the period of increasing EU integration tilted power balance even further in Germany's direction. This also at a time when the US might have been assumed to draw down in Europe (Walt, like many others, expected and still expects NATO to dissolve any day now, or at least become a shell of its former self.) In other words, the EU serves a similar role with w/r/t Germany that NATO served with the US: by codifying and institutionalizing the relationships between more and less powerful states, the hope was that security dilemmas (including political economy security dilemmas) would dissipate. Or, as Ikenberry would put it, the EU integration project made Germany's commitment to "strategic restraint" credible.

I assume Walt would reject that argument, because a realist would (generally) argue that institutions are incapable of restraining great powers**, but if so then he has quite a lot left to explain.

*A lot of this is pure selection effect: many of the new entrants to the EU were part of the Warsaw Pact prior to 1991 and thus could not join the EU before. But that doesn't explain Austria, Finland, Sweden, and Cyprus. Nor Turkey's constant flirtations.

**This is why John Ikenberry isn't considered a realist, which is case-in-point of why realism is a dirty word these days.

Euro Economics: Only Half the Story

I found Krugman's NYTimes mag article on the economics of the eurozone to be solid. Of course at this point the economics are well-understood by informed observers. What's not is the politics of the eurozone. And on that point Krugman is no help, as evidenced by his closing:

So will Europe’s strong nations let that happen? Or will they accept the responsibility, and possibly the cost, of being their neighbors’ keepers? The whole world is waiting for the answer.

Well, we've been writing about that a lot over the past year or so. So far it seems clear that the strong nations in the EMU (especially Germany) are not prepared to be their neighbors' keepers. They are not ready to ditch the common currency either. So they've taken (perhaps) the worst option: forced austerity for the periphery in exchange for temporary solvency, in order to give the banks in the core time to get their books in order. That, and allow the ECB to take a more active role than they are (technically) legally allowed.

As of today, I think the ball is actually in the peripheral countries' court. If they do a "full Argentina", as Krugman calls it, or even a milder debt restructuring, it will force Frankfurt's hand. If they are willing to stick it out and go through crushing austerity -- the Baltic option -- then the eurozone will survive on something like its present course. I wouldn't put any money on the latter happening in Greece or Spain, although it could work in Ireland.

The point is that, at this point, the economics is merely the backdrop for the politics.

Has the ECB's Independence Gone Up or Down?

The question in the title refers to the fact that central bank independence usually refers to the isolation from the political process that a central bank has in setting policy. Traditionally, the ECB has been considered to have a lot of independence. But it has also had a very narrow, strict mandate: to promote price stability in the eurozone. It did not have a mandate to promote full employment. It did not regulate the European banking system. It was not a lender of last resort. So the ECB's freedom to pursue the goal of price stability was very high, but pre-crisis its freedom to pursue other goals was very low. Depends on what you mean by independence.

That's all changed over the past few years. The Financial Times' stupid, self-hurting TOS prevent cutting, which means (among other things) that I've been linking to them a lot less frequently than I used to, but this article is worth highlighting. Who would have thought in 2006 that the ECB would be intervening in bond markets to prop up Portugal's debt auction? Portugal says it does not need a bailout, but this is a bailout. It's just a monetary bailout rather than a fiscal bailout. The ECB intervened so the auction wouldn't fail.

At this point the ECB looks like the main thing holding EMU together. And it's able to do it because, unlike national governments, it doesn't have to face an election following a fiscal transfer to the PIGS. It can just intervene when necessary, serving as the "lender of last resort" that it claims not to be. In other words, its scope of authority has been greatly expanded since the crisis began, without (as far as I know) any new statutory authority being given to it.

The ECB is still not pursuing employment-boosting monetary policies, but by buying the debt of needy countries it is in effect subsidizing fiscal policies that could boost employment. The alternative is austerity, either self-imposed or demanded by the EFSF/IMF, which involves major internal contraction. And while the ECB is not regulating banking sectors, it is doing whatever it can to prevent a banking collapse, especially in Spain. If the ECB hadn't overstepped its official mandate back in 2007-8, there is little question that the entire European banking sector would have melted down by now.

So the ECB is now acting more like that Fed than it had pre-crisis. I would consider that an increase in the ECB's independence, because it can act in more ways to promote the economic well-being on Europe. The difference is that the Fed has a political mandate to act the way it does. The ECB does not. By intervening in bond (and other) markets, the ECB is essentially spreading the credit risk of the eurozone's riskiest governments across the entire union. If this were properly understood in Frankfurt it would be deeply unpopular. Perhaps it is; my thumb isn't enough on the pulse of Euro domestic politics to know.

There are political battles on the horizon in the eurozone. It will be interesting to see the fate of the ECB in the coming years. My guess is that Europe's leaders will see that a stronger, more flexible ECB would make fiscal union less necessary; given that, I expect the ECB to retain its new-found authority, and perhaps get some more. We'll have to see.

Saving the EMU or Postponing the Inevitable?

It has been fashionable over the past few years to examine historical events looking for parallels to the current financial crisis. For obvious reasons the most cited periods have been the 1930s in the U.S. and the 1990s in Japan. (I've pushed back a bit on relying too much on historical narratives here.) But if I were a member of the ECB, or any other policymaker responsible for maintaining the EMU, I'd be begging Sebastian Mallaby's publisher for an advance copy of his new book, More Money Than God: Hedge Funds and the Making of a New Elite. The Atlantic has an excerpt, describing how George Soros and others brought down the British pound in 1992 and ruined any chances of the U.K. joining the Euro. Here's how it went down:

Schlesinger had made it obvious that the Bundesbank was not going to help the pound cling onto its position inside the exchange-rate mechanism by cutting German interest rates. The devaluation of sterling was now all but inevitable.

True to form, European leaders have been hesitant to do much to prevent similar devaluations in the eurozone during this crisis. Interest rate cuts at the ECB have mostly been small and late, and the $1tn bailout fund is only enough to buy time for European banks to repair their damage sheets in advance of a default in Greece (and probably elsewhere). Now we see that Germany is planning austerity measures at home, which will make it far less likely to subsidize other EMU members, while concerns about the debt of Spain, Italy, and even France are steadily mounting.

There is a tipping point, and while we may not be there yet we are getting closer to it every day. When markets become convinced that a devaluation is inevitable they "go for the jugular", to use Soros' language, and it becomes a self-fulfilling prophecy. That happened in 1992, but U.K. officials weren't very quick on the uptake; they cost their citizens hundreds of billions by postponing necessary actions. The same thing may be happening right now. As Mallaby concludes in that excerpt:

The markets had won, and the government had at last recognized it.

In terms of recognizing the inevitable, the sooner the better. But has that lesson been learnt?

UPDATE: Tyler Cowen says things are coming to a head in Spain.

Germany Passes Stabilization Package

A while back I commented that the Euro stabilization fund required approval of domestic legislatures, and noted that this might be difficult to achieve in some places. Well Germany passed it, but only just. Germany's signature is the most important, so the stabilization plan is basically operable.

Remember that this is just putting a bandaid on a gunshot wound; Europe still has still decide what it's going to be.

The current debate goes beyond the emergency bailout for indebted nations to questions about the future of economic integration among the countries using the euro currency. The bloc has neither a common fiscal policy nor a consensus of how best to balance stability and growth. Many members, including France, feel that Germany’s historic fear of inflation has led to a monetary policy that has unduly restricted economic growth.

“In terms of ideology, Germany is blind in the deflation eye and France is blind in the inflation eye,” said Ms. Guérot of the European Council on Foreign Relations. “It’s about economic cultures, how you want to organize your societies and your social cohesion. And it’s hard to find the appropriate mechanism because it goes right to the heart of how your society is structured.”

Warning Signs in Europe

Once, I apologize for the light posting. Hopefully things will pick up soon. And by "soon", I mean probably not until the end of the semester in early May. On the plus side... well, so far there is no plus side but hopefully about a month from now Sarah, Alex, and I will be able to add another degree under our names on our CVs.

I do want to take a break from paper writing to take note of what is going on in the eurozone. By now it's old news that Greece will receive a 30mn euro credit line from other euro economies, with perhaps another 10-15mn en route from the IMF. Boone and Johnson at Baseline Scenario argue, rightly I think, this is a temporary fix not a permanent one. But at this point the more interesting question to me is not what happens to Greece, but what happens to Europe. And by Europe I don't mean Europe-the-continent, but "Europe"-the-ideal. The frictions that have always existed between Germany and France on this point have come to quite a head, as this NYT article notes:

Germany, long the financier of the European Union, has made it clear that it will no longer pay for the mistakes and frauds of others.

France has put a much stronger emphasis on European unity and pride, trying to avoid involving multilateral institutions like the International Monetary Fund in the future of the euro, a prominent symbol of Europe’s challenge to the supremacy of the United States.

The problem is that while France is clear in what it wants, Germany can't seem to decide:

Germany always acted in its interests, Ms. Guérot said, but those were perceived as sublimated within the European Union and NATO, the two postwar multilateral institutions that both protected the new democratic Germany and kept its ambitions in check. Now Germany is turning more obviously to Russia for energy and commercial interests, she said, making its European and American partners uneasy.

“We sublimated hegemony,” said Ms. Guérot, a German who is working on a paper called “Germany Unbound.” “But we’re dropping the sublimation now.” She laughed, then said: “Of course, this doesn’t sound nice to others.”

If it's true that Germany wishes to ascend to regional hegemony, then abandoning the rest of Europe in its time of need is not the way to go about it. In fact, Germany is acting in the opposite way that a hegemon would:

Germany also reacted angrily and defensively to a modest French suggestion by Finance Minister Christine Lagarde that the German export model had to change in the interests of other, less competitive euro zone countries, and that Germans should spend more buying the goods of their less fortunate neighbors.

Germans, who have already undergone a wrenching structural reform and paid a huge bill to integrate the former eastern Germany, say they feel that “they’re paying a significant personal price,” Mr. Klau said. “Poverty has increased considerably in Germany and is now a social reality. And it makes Germany more inward-looking than the old West Germany, and a more defensive country.” ...

Germans feel they have paid both their reparations and their dues, “and many times over,” said Ms. Stelzenmüller, especially in an uncertain time of globalization and financial crisis. “People want to be normal, in the sense that other people don’t come to us first and say, ‘You have to pay.’ And it doesn’t have much to do with political orientation. All of us are huddling with our backs against the storm.”

No hyperbole intended, but using Kindleberger's typology of hegemony this sort of inward-focus in the midst of an international economic crisis has many more parallels with the refusal of the U.S. to assume international leadership during the interwar period than its postwar acceptance of it. So I think the NYT has the general framing of this issue all wrong. In fact, there is one paragraph in it that gives the game up:

At the heart of the dispute is the euro. The French see it as the currency of a new, united Europe; the Germans see it as the direct descendant of the mark, and the European Central Bank as retaining the DNA of the Bundesbank, whose main task was to keep inflation down. The French favor a kind of European economic government, with easier rules on deficits; the Germans have no intention of giving up economic sovereignty to anyone, let alone to the French.

Ah, so it is the French who seek to preserve their regional influence, but they can't do it alone. Germany wants to minimize its exposure to Europe -- especially the low-income countries, and the less-trustworthy PIIGS -- and it always has. There is much more that could be said, but this is getting long already. I'll try to revisit this soon, but I am not optimistic about Europe: the bailout arrangement for Greece indicates that Germany's tolerance for bailouts is weak and weakening, without Germany there is no Europe, and the other PIIGS are on deck.

Sovereign Debt As Social Contract

The Economist blogger Charlamagne has written an insightful post on Greece:

The Greek civil war, and the bloody score-settling that followed, is a living memory for many Greeks. Any consideration of Greek nepotism or clientelism needs to be seen in that light. So for example, it is not enough to say that Greek civil servants enjoy jobs for life, and that is a big problem. (Though it is a big problem, not least because many Greek civil servants are paid pitiful wages—partly because there are so many of them. That means they will resist austerity measures all the harder, because they feel like victims in this crisis, not fat cats.) But the bloated public sector is also a function of history. ...

Newspapers here in Belgium talk all the time about the government needing to "buy social peace" by paying off some interest group or other. In Belgium, the alternative to "paix sociale" is a strike. In Greece, plenty of grown-ups remember when the alternative to social peace was their neighbour, or their loved-one, vanishing in the night into a jail cell or worse. The current clientelist truce between right and left is the price (albeit a horrible, wasteful price) established for the current version of social peace enjoyed in Greece.

Douglas Muir adds to it:

I’ve always had a very low opinion of Papandreou pere; it hadn’t occurred to me to think of him as a post-conflict figure, trying to restore social comity to a country still riven by its past. I’m still not sure that was really the case, but it’s an interesting perspective. ...

Here’s a random thought: this blog has seen a lot of posts recently talking about economic problems in Greece, Spain and the Baltic States. All of these are countries that were, within living memory, governed by brutal non-democratic authoritarian regimes. Accident? Or is there something else at work here?

It is an interesting question and maybe there's something to it. On the other hand, almost all of Europe and much of the rest of the world has been governed by brutal non-democratic regimes within living memory, yet not all countries are at risk of sovereign debt default. It seems like there's a missing variable somewhere, and I think it's incentives built into the EMU.

More generally I think it's worth thinking about how the evolution of the concept of "liberal democracy" since the end of World War II has left many states in difficult positions. All democratic states have embedded liberalism in a web of social welfare institutions in order to build consensus and maintain social stability, but the price of those compromises has varied cross-nationally. As I've argued before, democracies are exceptionally prone to the sort of time inconsistency problems that lead to things like debt crises. As such, there is a huge potential for moral hazard built in if states are able to escape their debt obligations without pain. Just ask California. It's an internal contradiction of democracy, if you like.

I have empathy for the citizens of Greece and other states that find themselves in difficult positions. But I have even more empathy for the future citizens of Greece and other states who will surely suffer more if their governments cannot get their house in order. I'm not quite sure how to escape this trap without austerity.

A Little Light Game Theory (Greek Sovereign Debt Edition)

A few days ago I saw Jeffrey Friedman extend his "Basel thesis" -- in which the risk-weighting scheme in the Basel Accords created the incentive structure that led to the subprime financial crisis -- to Greece's debt crisis:

So why did the bursting of the asset bubble in housing cause a banking crisis, freezing interbank lending and then bank lending into the "real" economy?

Because, according to the Basel thesis, Basel I bank-capital regulations, enhanced in 2001 in the United States by the Recourse Rule, encouraged banks worldwide and especially in the United States to leverage into asset-backed securities, including mortgage-backed securities, that were either government guaranteed (by Fan or Fred) or were privately issued but had an AA or AAA rating. How did the Basel rules encourage this? By giving such securities a 20 percent risk weight.

Translation: An AAA-rated mortgage backed security worth $100 required only $2 in bank capital at the 8 percent Basel rate for adequately capitalized banks. $100 x .08 x .20 (the 20 percent risk weight assigned to asset-backed securities by the Recourse Rule) = $2. By contrast, a commercial loan of $100 required $8 of bank capital, because Basel gave such loans a 100 percent risk weight. $100 x 8 percent x 1.00 = $8. Similarly, a $100 whole mortgage retained by the bank required $4 of capital, because the Basel risk weight for unsecuritized mortgages was 50 percent. With these risk weightings, securitized mortgage-backed debt offered significant capital relief.

Today's FT brings the news that "European financial institutions have $235 billion worth of claims on Greek debt, most of which is thought to be in government bonds." Why do they hold so much Greek government debt? Because the only category of bank asset treated more kindly by the Basel rules than asset-backed securities is government debt, which has a zero risk weight. I.e., no bank capital need be used to buy a government bond.

So today I was interested to read that some major banks are fanning the flames engulfing Greece:

Bets by some of the same banks that helped Greece shroud its mounting debts may actually now be pushing the nation closer to the brink of financial ruin. ...

As Greece’s financial condition has worsened, undermining the euro, the role of Goldman Sachs and other major banks in masking the true extent of the country’s problems has drawn criticism from European leaders. But even before that issue became apparent, a little-known company backed by Goldman, JP Morgan Chase and about a dozen other banks had created an index that enabled market players to bet on whether Greece and other European nations would go bust.

Last September, the company, the Markit Group of London, introduced the iTraxx SovX Western Europe index, which is based on such swaps and let traders gamble on Greece shortly before the crisis. Such derivatives have assumed an outsize role in Europe’s debt crisis, as traders focus on their daily gyrations. ...

A result, some traders say, is a vicious circle. As banks and others rush into these swaps, the cost of insuring Greece’s debt rises. Alarmed by that bearish signal, bond investors then shun Greek bonds, making it harder for the country to borrow. That, in turn, adds to the anxiety — and the whole thing starts over again.

How can we square this circle? If Friedman is right, then banks are highly leveraged in the sovereign debt of Greece (and other countries). Basel rules required a 0% right weight for any OECD sovereign debt, but not all sovereign debt paid the same yield. Some states, like Greece, are relatively more risky than others, like the U.S., but they all had the same risk weight. So banks looking for a bigger profit would plow funds into the riskier countries at a higher interest rate because yields were higher.

Why, then, would many of the same banks now do their best to increase the risk of a Greek default? If that happens, and Friedman is correct that many banks are leveraged to the hilt on Greek debt, then they lose a lot of money. They can't be trading on moral hazard, since if they believed that Greece will eventually be bailed out and their debts made whole they wouldn't waste money purchasing insurance (a.k.a. credit default swaps). So what's going on?

One explanation is that a need for hedging has created the equivalent of a bank run in CDS markets, and this is creating a self-fulfilling prophecy. Another is that this represents a classic Prisoner's Dilemma: in aggregate all banks would be better off if none of them bid up the prices of CDS on Greek debt and thus relaxed the credit constraints on Greece, but each individual bank is incentivized to defect and insure themselves against potential default. Banks in competition against each other cannot credibly commit to cooperate, so (Defect, Defect) is a dominant strategy for all banks exposed to Greek debt. This creates a run, which manifests itself in CDS markets, and leads to a sub-optimal outcome for all involved.

If this is the appropriate model, then there would seemingly be a role for outside players to influence the game. Germany, or the ECB, or the IMF, or even the US could step in and provide financing for Greece to roll over their debt, meet counterparty obligations, and loosen the constraints that Greece faces in credit markets. But this simply raises another Prisoner's Dilemma: how could a third party guarantor be sure that Greece will not defect from that agreement and continue in its fiscal profligacy? Again, the dominant strategy seems to be (Defect, Defect) unless Greece can somehow credibly commit to austerity in order to meet its obligations. Unfortunately, it doesn't appear that they can.

Maybe the EMU should play a Grim Trigger strategy: they'll provide financing for Greece in exchange for austerity. If Greece defects, then the EMU boots Greece out of the monetary union and they're on their own. That threat might be significant enough to escape the Prisoner's Dilemma if it's perceived as being credible.

Or maybe not. It's a mess. As Carlo Bastasin says over at Baseline Scenario: "You cannot imagine really solving the Greek imbalance without – at least somewhat – correcting the German imbalance." Germany does not want to correct its imbalance. So Greece is probably screwed.

(edited for correct attribution, 8:41)

UPDATE: Felix Salmon sees this as a simple hedge. He's probably right.

Paul Krugman on the Recession in the EU

The Guardian has a good interview with Paul Krugman on macroeconomic conditions in the EU.

"Britain's looking the best among the major European economies ... Britain actually may have stopped contracting - that's the most positive thing one can say." Elsewhere, PK attributes this to a devalued pound and a generally aggressive monetary policy. I think Britain should be quite pleased to not be constrained by EMU.

He also takes up the German puzzle: "How is it possible that Germany, which did not have a house price bubble, is having a steeper GDP fall than anyone else in the major economies?

His Answer: Germany depended upon exporting to the bubble regions of Europe, so they actually got side-swiped by the loss of those exports worse than the bubble regions themselves got hit.

His Concern Moving Forward: "We worry about the drag on world demand from the global savings coming out of east Asia and the Middle East, but within Europe there's a European savings glut which is coming out of Germany. And it's much bigger relative to the size of the economy."

Why is the German government so resistant to an aggressive response? It all seems so very Mellonesque.

Update: Scott Sumner concurs with PK's analysis of the UK.

Eurozone Update

"The politicians in Italy and Spain do not seem to realise how deep-rooted their problems are. We think the markets will force them to take action. They may have to cut real wages, and this could be unpleasant," said Mr Redeker. "These countries will want higher inflation in Germany to get them off the hook, but I doubt Germany is ready to do that. This is going to create friction within the eurozone. Euro weakness will be the inevitable result."

The ECB, Asymmetric Shocks, and Monetary Policy Dilemmas

Standard theories of monetary union suggest that they work best when the participating countries experience the same shocks. They work least well when they experience asymmetric shocks. I have always found it difficult to teach this, because until now the EU's monetary union has not really had to deal with a big shock. The fall out from the US sub-prime crisis is imposing an asymmetric shock on euroland. Consequently, we now begin to see the dilemma that EMU creates for its members and its single central bank.

The core problem is that the ECB must choose between inconsistent objectives. As the Telegraph summarizes, "Mr Trichet has to tread a delicate path between the eurozone's Germanic and Latin blocs, pulling ever further apart. The credit and housing booms have begun to deflate in the Club Med region. The Bank of France's governor, Christian Noyer, said this week that Europe was facing a "huge shock" as contagion spread from the US sub-prime crisis...Spain in particular is now in serious trouble, with a "staggering" current account deficit of 9pc of GDP and a huge overhang of unsold property from the housing bubble."

Germany, in contrast, is struggling with rising inflation: "The hard-line bloc [is] led by the two German council members, Bundesbank chief Axel Weber and the ECB's chief economist Jurgen Stark. The latest spike in oil and food costs has pushed German inflation to 3pc, the highest since the launch of the euro and fast approaching the level where it may erode popular support for the currency."

Thus, one monetary policy but divergent economic developments across euroland. Someone has to accept a monetary policy that not only fails to address their current needs but will actually further worsen their situation. The dilemma is complicated by uncertainty; the more German unions question whether the ECB will use policy to keep inflation down in Germany (i.e., the more they believe that monetary policy will target Spain and the Med) the larger the nominal wage increases they will seek. Hence, to keep inflation down in Germany, the ECB must be hard line and build a reputation. But, being willing to raise interest rates to build this reputation risks making things even worse for "club med."

Not surprisingly, this "technical decision" is spilling over into politics, as French and Italian politicians have chastened Trichet for the hard line he is adopting.

It is precisely this problem that caused me to write, more than ten years ago, that EMU is not obviously a very good idea.