On Michael Lewis on Germany

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

S&P and Exorbitant Privilege

Layna Mosley, one of my professors here at UNC, has a guest-post at the Monkey Cage on the sovereign debt downgrade. I'm not going to excerpt much as it's worth reading in full, but I want to highlight a few things. First:

[O]n the basis of just its fiscal statistics, the U.S. would have been under pressure to accept an IMF program long ago. Of course, there are many differences between the US and the typical IMF borrower; the broader point is that the US can’t necessarily expect its “special” status vis-à-vis markets to persist indefinitely.

I think the "many differences" part is really key here, as Layna gets to a bit further down:

In the U.S. case, the fact remains that Treasury securities are a favored “flight to safety” instrument for investors worldwide. When risk acceptance and global liquidity is high, investors look for high-risk, high-return assets – equity offerings in emerging or frontier markets, for instance. But when risk aversion is high, investors seek out safe havens. Treasury bonds have long been such a haven, both for domestic and foreign investors. Many holders of U.S. government securities are official entities (such as foreign central banks), while others are private investors.

What other options do these safety-seeking investors have? There’s the Swiss franc. And there’s gold. Both have experienced surges in prices that come from the search for safe investments. But where else might investors go? Certainly not into euro-denominated instruments, given the continuing crisis in the euro-zone. And probably not into renminbi-denominated instruments; for all of the speculation that the dollar’s “exorbitant privilege” is reaching its end, don’t expect it just yet.

The US is different from other countries that might go on to a IMF program in a lot of ways, but most importantly because it can create the most important store of value in the world, and it can do so whenever it pleases. Ireland, for example, cannot. Neither can Greece or Thailand or Malaysia or even Japan. Gold is limited by quantity, which is why prices are through the roof. Swiss francs are limited by the small size of the Swiss economy and its lack of centrality in the global economic system. The dollar is not only the most-used and most-traded currency in the world, it is also embedded in the global economy in ways that other currencies are not.

The graph above was constructed with BIS data. (Just ignore the isolates like "OtherEMS" and "FRF", which aren't actually in the currency system anymore; I was too lazy to take them out before making the graph.) Node size represents the % of total global currency exchange in a country's currency, and tie thickness represents the (bilateral) size of currency exchange between two currencies. The US is obviously the most central node and is also the largest by far; Swiss francs ("CHF") are much smaller and only has ties to Europe and the US. For the rest of the world shifting out of dollars into the Swiss franc isn't even really an option. For that matter, neither is the euro or yen. Only the US dollar has a truly global reach.

Network externalities can be very powerful. If everyone in the world is using dollars as a medium of exchange, it makes sense for you to use dollars as a medium of exchange. And if you use dollars, then your trading partners and counterparty investors benefit from using dollars. This effect reinforces itself as it spreads through the international economic system. Self-reinforcing patterns are path-dependent in complex networks; it usually takes the destruction of the entire system to reverse them.

And since the US is the only country that can create dollars, it has a very important capability that countries on IMF programs do not: the ability to service its debts with paper, with a strong presumption that it will not be punished for doing so as long as network dynamics remain self-reinforcing. So far the lesson from the S&P downgrade is that those externalities are not only still in effect, but are intensifying.

In other words, the US's peers are not Greece and Ireland, or the countries involved in the 1990s Asian flu. The US's peers are not even France and Germany, which are large industrial countries but do not control the printing press. Nor even Japan, which is sustaining a debt/GDP of nearly 200%. The US has no peers, and this shows up in the bond market data (to be discussed in a future post).

Several times in her post Layna explicitly or implicitly references Barry Eichengreen, who has written a lot on capital, debt, and currency. In a recent column, Eichengreen argues two things. First, that the argument of his recent book Exorbitant Privilege is essentially wrong: the global currency system will not move to a USD/euro condominium in the near term, because "a pox has been cast on both their houses". Second, that there are no other viable alternatives in the form of national currencies -- he explicitly mentions the Swiss franc, Canadian dollar, Chinese RMB, and Australian dollar as being insufficient, despite being the main contenders -- and international baskets like the IMF's SDRs suffer from a lack of liquidity and over-exposure to the USD and euro. So he suggests moving to global GDP-indexed bonds. But this ignores politics. If Europe can't even issue Euro-bonds, and if SDRs are unattractive for a number of reasons, why should we think that a global effort will be more successful?

So I agree with Layna: the era of "exorbitant privilege" is not only not over, but this crisis has seemingly reinforced it. You don't hear much talk about "decoupling" these days.

Catching Up

Apologies for the light posting. I've had fairly severe computer problems that necessitated the purchase of a new one, then an epic struggle with FedEx to actually get the damn thing in my hands. Obviously the past week has been a bad one for an IPE blogger to go missing, but I'm back in business now. So a few rapid-fire thoughts on the week that was.

1. S&P: This is clearly an attack on the US political system, not the fundamentals in the US economy. (The fact that the GOP hasn't internalized this lesson is bad news for them, methinks.) Nothing changed with the US's debt situation, and the solvency of the US is not under question by anyone in the market (more on this in a later post). For this reason the sloppy math in the initial S&P report doesn't matter... it's not about the math. It's about the legislative process. S&P prefers a cleaner one. I guess it's fine to have that preference, which I share but do not expect, but if this downgrade is about political risk than S&P really should have consulted some political risk experts, legislative affairs experts, or political scientists more generally. They also should have talked to folks who study global political economy, since rapping the US's knuckles can have far-reaching effects if done wrongly.

All said, the actual downgrade wasn't too significant, because the US didn't actually default. US bonds are still investment grade, and yields are at historic lows. The credibility of S&P, not the US, is what was severely damaged with this decision.

2. Europe: How long can this go on? The sovereign debt trouble is spilling over into the banking sector more rapidly. The biggest worries now are about Société Générale, and with good reason: it's the second-largest bank in France and the eighth-largest in the eurozone. It was already helped indirectly by the AIG bailout and directly by the Fed's international activities through TAF, but pressures mount and SocGen is definitely systemically important. Tyler Cowen and others have written about the silent bank run in Greece, and how an exit from the eurozone would affect Greek banks, but it would also affect banks in the Euro core.

The ECB is finally starting to act like a central bank, but either way the game has irrevocably changed. As far as I can tell the ECB's current actions are illegal under Article 123 of the Lisbon Treaty, but I'm no EU legal scholar so I could be wrong about that. In any case it seems to me that the eurozone must change somehow. Either by contracting members, dissolving into a two-track union, or centralizing more authority in a federal system.

3. Fed: It now appears clear to me that Ben Bernanke has been hamstrung by a Board that doesn't understand how or why the Fed should be more active. There were three dissents from the most recent, tepid, statement that interest rates would remain low for two years -- a statement that will be interesting to track, as it has credible commitment issues -- and there is no sign of further action. This is a shame. It's also a shame that Obama has left key Fed spots empty for so long. It seems like he'll be nominating Jeremy Stein and Richard Clarida for two empty Board spots, and Daniel Tarullo to the vice-chair spot that heads the regulatory apparatus of the Fed. I'm familiar with Stein's and Tarullo's academic work, and it is very good in both cases.

But this is not enough. The Fed needs to much more active in changing expectations about the path of the nominal economy. It needs to make much more credible commitments to boosting economic activity. It needs to play a greater role in the international banking system to avoid another panic at a crucial time in the "recovery". It, in short, is the most powerful economic agency in the world, and it needs to start acting like it. It has great capabilities, but also great responsibilities.

4. Equity markets: A lot of people are saying that this is like 2008. This is not like 2008. In 2008 credit markets had frozen up entirely, the whole system lacked liquidity, and every major financial institution was in the process of realizing very large losses. That's not the problem today. The problem today is that economic growth has been weak and will remain so for the foreseeable future, and governments are either unwilling (US) or unable (EU) to do much of anything about it. These are the countries that drive global demand, so if they slip up it hurts production in the developing world as well.

Bigger May Be Different

“It is the irony of the downgrade,” says Lou Crandall at Wrightson Icap. “What do you do if the US is downgraded? The answer is, buy more Treasuries.” Two and three-year Treasuries hit record lows of .23 and .48 percent. 10-year notes fell to 2.33%, their lowest yield since January 2009.

Do we really close this loop by asserting that the downgrade caused the sell off?

Dedicated

Why We (Sometimes) Shouldn't Internalize Externalities

At the end of my previous post, I suggested that we might not always want to force people to internalize externalities. This is anathema to most economists and indeed believers in the market as the most efficient allocator of resources. After all, if the market allocates efficiently, and externalities are market failures, then externalities should be corrected. In many cases this will be true, but not, I think in all.

First the argument in favor of internalizing externalities. In the case of positive externalities, if the people generating the benefits are not able to capture the value of those benefits, then they will tend to not produce those goods. Even if these are not public goods, wealth creation is good for its own sake as people will tend to enrich others' lives with their innovations as well as use their wealth to employ other people*. In other words, we want people who are capable of creating new things to create those things, ceteris paribus. If people are not compensated for doing so, they will tend not to bother, or so the argument goes. In the case of negative externalities, if people are not forced to internalize those costs they will tend to over-produce those goods. That's bad for society as well.

To see where this can go wrong, let's take an extreme example. Bill Gates has been the world's richest man, although he's currently #2 behind Carlos Slim. What's more, no one believes that Gates has secured his wealth illegitimately. However, the benefits to the economy of Microsoft's products have not all been captured by Gates. As intermediate goods, Microsoft products allow people to produce other products, and to do so more efficiently than they otherwise might. Though I can't find the study now, a few years back someone estimated that Microsoft had generated hundreds of billions of surplus value to the economy, mostly by reducing transaction costs, improving efficiency in a number of business environments, and generating network externalities. These innovations have literally benefitted hundreds of millions, if not billions, of people all over the world.

You can probably see where I'm going with this. The fact that Gates has not been able to internalize all of the benefits from his products has not stopped him from creating and distributing them. On the contrary: in order for Gates to be as wealthy as he is he has to make sure his products are broadly dispersed, which is why he gives some of them away for free. He has been rewarded very well, but no utilitarian calculus that I'm aware of would suggest that we should redistribute away from ordinary people who have benefitted from Microsoft to Gates. He has more than enough. So we should modify the common claim at the beginning: internalizing (positive) externalities only needs to be done when we're operating near the margin where innovators might choose not to innovate without more compensation. And if we think in those terms, it isn't immediately obvious that we're usually operating at that margin. It is well-known, for example, that popular live music events are generally "inefficient" in that they usually sell out quickly, which indicates that there is quite a lot of surplus that is being captured by consumers rather than producers (or other consumers, who might be willing to pay more for a ticket in an auction setting). Economists generally think this is puzzling, but from a utilitarian perspective it's arguably a very good thing.

How about negative externalities? Arguably this is a more difficult case, but if we keep using the same utilitarian logic I've presented it isn't hard to argue that poorer people should be given some license to push negative externalities onto richer people. People have used this sort of argument to suggest that developing countries should not have to adhere to the same climate change restrictions that richer countries should adhere to. The question is where the margin that tips over into inefficiency lies. I admit that these cases will be much more in the eye of the beholder than the case in which Gates' positive externalities are broadly shared, but there isn't any ex ante reason to discard the idea.

*You don't have to be a believer in strong-form trickle down economics to generally accept this point.

Negative Externalities and the Tragedy of the Commons

In a classic example of a tragedy of the commons, a field is used by several farmers to graze their cattle. None of the farmers have the right to restrict access to other farmers. The field can support a certain number of cattle, say ten, without being depleted. But any additional cattle added to the field beyond ten will deplete the field and everyone will suffer. In this case, every farmer has an incentive to add the eleventh cow, as the benefit from doing so will accrue only to that farmer, while the costs will be shared by all. Therefore, the owner of the eleventh cow has imposed a negative externality on the owners of the ten when he brings the cow to the field. The tragedy is that because individual incentives deviate from collective incentives, and there is no external enforcement, everyone is bound to suffer.

This example, or one like it, is used to illustrate many problems in the world. Pollution, overpopulation (as in the original Garrett Hardin article that I believe remains the most-cited in the history of the journal Science), climate change, financial regulation, etc. In many cases, we focus on the ability of institutions like government, property rights, or bargained contracts to overcome this tragedy and ensure a more efficient outcome.

The problem is that it makes no sense. At least, it makes no sense when translated into the language of externalities, which nowhere appear in Hardin's original article. To see why, remember this: there are no property rights in the commons. So while the eleventh cow is the one that puts the commons over the edge, this is only true because of its cumulative effect with cows one thru ten. Were any of of those ten absent (i.e. not just the eleventh), the presence of the eleventh would be no problem. Since no farmer has any more or less right to access the commons than any other, all the farmers are equally culpable when the commons becomes depleted. The owner of cow #11 is doing no more (or less) damage than the owner of cow #4. Since all are culpable and all share the cost, there is no externality. All the farmers are contributing equally to the problem, all are equally suffering the cost. The removal of any of the cows would solve the problem, and there is no established reason for the claim that the eleventh cow is the one that should be removed.

The logic of externalities requires an established property right that is being infringed upon. It also requires that someone is forced to pay the costs of an action without accruing the benefits from it. When we realize this, we also realize that the problem of externalities is a much smaller one than we first thought. It does extend to manufacturers that pollute a river that makes fishing impossible downstream, but only if the fisherman has a claim to the river and does no polluting on her own. It does not extend to a financial crisis that culminates in some people being unemployed or losing wealth via asset depreciation, unless (perhaps) the crisis was caused by fraud.

The question that remains: what about climate change? Is this an externalities problem? Every society that has the capability to pollute does so, albeit at differential rates. While the infamous Summers memo was obviously sarcastic, there is a kernel of truth embedded in it: pollution is a by-product of economic activity, all of which generates waste, and the lack of which is a greater threat to human well-being in the developing than climate change. The pollution levels of even low-polluting industrial countries like Japan would be more than enough to warm the planet if all countries polluted at that rate. This is analogous to the owner of the eleventh cow: whenever anyone comes into possession of this cow, they will add it to the commons and everyone suffers. We don't fault the owner of the eleventh cow for ownership, we fault the structure of the interaction. If the only difference between the culpable and non-culpable is opportunity, can we really feel comfortable ascribing blame?

Secondly, is it really clear that people in Bangladesh (say) have a rights claim to an climate environment that is not two or three degrees warmer than it is right now? How did they acquire this right? This is an important point when considering the politics. Some countries, such as Russia and Canada, will likely benefit from a warmer climate. Some countries will suffer. Some countries, like the United States, will probably not be greatly affected in aggregate, but within the country some groups will benefit while others will suffer. Similarly, taking large efforts to prevent or mitigate climate change will benefit some and harm others. How do we resolve this without some sense of who has what claim to what type of climate?

None of which is to deny that even if climate change does not represent an externalities problem, it nevertheless may constitute a human problem. And really I'm less interested in climate change per se as I am in the fact that the tragedy of the commons is not necessarily an externalities problem as we usually think.

I'm planning to follow this post with another post on why we might not want to force people to internalize externalities in all contexts.

Regulatory Politics

The EU is working to implement Basel III:

New European Union rules designed to make the financial system safer would require banks operating in Europe to raise an estimated €460bn in capital by 2019 or substantially reduce their risk and balance sheets.

The draft proposals unveiled on Wednesday – which still need approval from the 27 member states and the European parliament – make the EU the first jurisdiction to start implementing the global Basel III capital and liquidity guidelines that were adopted last year.

The new Basel capital definitions hurt EU banks more than US banks, as they focus on improving capital quality by mandating more equity and less debt. As a result, EU banks -- still suffering from the crisis and recession, and on edge over sovereign debt holdings -- have to raise more capital than many of their foreign competitors. Predictably, they don't like that:

Industry groups in the UK and Germany warned that if the EU moves too far ahead of the rest of the world, its banks could lose out to international competitors and cut lending to the real economy. The projected capital shortfall, equivalent to 2.9 per cent of all the EU banks’ risk weighted assets, goes a long way towards explaining why EU banks are among the fiercest critics of the Basel III proposals.

Banks and some other groups argue that this will have an adverse effect on economic growth at a time when the EU can had afford it; while there might be some truth to that some new research shows that too much finance can actually retard growth, and that this is currently the case in some EU countries.

But the competitiveness argument seems to be undercut by this:

The EU’s draft proposals are likely to unleash months of heated debate, as member states and banking institutions haggle over the details. Some countries – including the UK – are still fighting for the flexibility to introduce national requirements that are higher than the EU minimums.

If competitiveness is such a big worry then why would any states have stricter requirements than required by international agreement? Note that this is nothing new; the US had stricter capital requirements than Basel I and II in order for firms to be considered "well capitalized" by the FDIC. And World Bank surveys conducted in 1999, 2003, and 2006 showed that 40-50% of countries had capital standards stricter than the Basel minima even before the financial crisis. The above heat map shows those results in 2006*. Since the crisis many countries have proposed or enacted new regulations that are tighter than their international obligations.

Most existing literature on regulation in finance, economics, or political science does not expect this type of behavior by governments**. Episodes like this suggest that we need to complicate our expectations about the ways that domestic and international politics interact, and the process by which governments set policy in a competitive global economy. It isn't unidirectional neoliberalism, even before the crisis. This is the focus of my dissertation research, so I'm sure you'll all be hearing plenty more about it in coming months. For now let's just say that this type of behavior follows the precedent of previous periods of crisis and regulatory reform.

*Darker colors indicate higher capital requirements. White is missing data. The Basel minimum of 8% is the light orange, as in the US. Note that much of the variation on this variable is in the developing world.

**Or the equivalent behavior of firms, which "over-comply" with capital regulations as a rule, albeit at different spreads.

Touche

DD:

I just realised that plenty of mainstream US Democrats, having spent the last however long castigating people to the left of them for perceiving some progressive tendencies in the government of Fidel Castro, are now reduced to supporting the re-election of a President who imprisons people without human rights in Cuba, but who has made excellent advances in the field of bringing healthcare to the poor.

Well...