Local Austerity

The Wall Street Journal had a really heart-warming article, Europe's Recession Sparks Grass-Roots Political Push  about groups taking over local governments in southern Europe, and cleaning out years of mismanagement. An excerpt

At her inauguration Ms. Biurrun [the new mayor of Torroledones, Spain] choked up before a jubilant crowd.

Then she began slashing away. She lowered the mayor's salary by 21%, to €49,500 a year, trimmed council members' salaries and eliminated four paid advisory positions.

She got rid of the police escort and the leased car, and gave the chauffeur a different job. She returned a carpet, emblazoned with the town seal, that had cost nearly €300 a month to clean. She ordered council members to pay for their own meals at work events instead of billing the town.

"I was so indignant seeing what these people had been doing with everyone's money as if it were their own," Ms. Biurrun said.

Those cuts, combined with savings achieved by renegotiating contracts for garbage pickup and other services, helped give a million-euro boost to the city treasury in her first year in office.

Great, no?

But wait, isn't this all "austerity?" Isn't cutting spending  exactly the kind of thing that Keynesian macroeconomists, as well as the reigning IMF-style policy consensus decries, saying we need stimulus now, austerity later?

Keynesian, and especially new-Keynesian economics wants more government spending, even if completely wasted. Those trimmed salaries, fired "advisers," cleaning bills, restaurant spending, overpaid contracts are, in the standard mindset, all crucial for "demand" and goosing GDP.  If stimulus advocates were at all honest, they would be writing blog posts decrying Ms. Birrun and her kind.

Of course they don't. Abstract "spending" sounds good, and touting abstract "topsy-turvy" model predictions sounds fine.  But when it is concrete, it's so patently absurd that you don't hear it.

The Greek city of Thessaloniki cut costs after Yannis Boutaris, a businessman-turned-politician, took office in late 2010 and ended City Hall's relationship with a few selected providers. Competitive bidding has saved the city 80% of its previous spending on accounting, 25% on waste disposal trucks and 20% on printer paper. The savings have allowed Mr. Boutaris to spend more on social services, even while cutting taxes and paying down City Hall's debt to suppliers.

How sad. So much "demand"-destroying "austerity."

(Of course, the main point of the articles is about a political realignment, in which local governments are becoming responsive to local voters, transparent, and efficient, rather than being cronyist machines of national political parties. I can't imagine anyone not feeling warm about that!)

Update: Courtesy Marginal Revolution, I found this nice story about the new Spanish $680 million submarine that will sink if put in water.  MR snarkily asks "did this help Spain or hurt Spain." $680 million of government spending raises Spanish GDP by nearly $1 billion, so this is great, right?

Cyprus and Resolution Authority

Holman Jenkins has a revealing Cyprus update in today's Wall Street Jounal. For those of you who haven't been following the news, Cyprus' banks failed, borrowing huge amounts of money and investing it in Greek debt (yes).  Cyprus was bailed out by the EU after a chaotic week, including an agreement that large depositors would lose some money, called a "bail-in."


Since us economists have been saying that unsecured creditors and uninsured depositors should lose money when banks fail, it was sort of a watershed moment. I expressed some reservations at the political, discretionary, and chaotic nature of the bail-in. It turns out I underestimated that nature.

From Holman:

A few weeks ago, the Central Bank of Cyprus published a curious set of "clarifications for the better understanding of the resolution measures." The principle of a bail-in—that uninsured creditors should suffer losses before taxpayers are on the hook—turns out to contain a few lacunae. "Financial institutions, the government, municipalities, municipal councils and other public entities, insurance companies, charities, schools, and educational institutions" will be excused from contributing to the depositor haircuts, though insurers later were removed from the exempt list.

There will be no haircut on the €9 billion ($11.8 billion) the European Central Bank injected, for political reasons, in 2012 to keep Cyprus's Laiki Bank temporarily afloat—€9 billion that has now somehow become a liability of Bank of Cyprus depositors, whose losses are bigger as a result.
...
We should mention another possible offense, in a sense, against creditor priority in reports that certain connected customers withdrew funds just before the haircuts. A daughter and son-in-law of Cyprus's president seem to make a good case that their transfer of €10.5 million to a London bank was a coincidence, but then they proffered a "voluntary haircut" anyway via a donation to a church fund for the poor. Hmm
...
we have to chuckle when legislators on Capitol Hill talk about ending "too big to fail"—as if there is any chance of stopping politicians from bailing out whatever institutions politicians decide their own interests require bailing out, or any chance of imposing legal order on what are invariably chaotic, highly politicized decisions in the heat of crisis.
...
Cyprus turns out to be a good template after all. Modern financial systems may be incompatible with the rule of law that mankind has labored so mightily to build over the centuries.

This all matters for our financial "reform." Recall, lots of financial institutions were bailed out in 2008-2009, meaning really that their creditors were bailed out. (Normally, when an institution fails, who gets what is determined by bankruptcy law; the creditors become the new owners, the institution is suddenly recapitalized, and either continues or is carved up depending on what makes more sense to the new owners.)

On the theory that "bankruptcy doesn't work for big banks" the Dodd-Frank law posits a "Resolution Authority," composed of Administration officials, that will sit in the place of bankruptcy court and decide who loses money, with pretty much discretion to do what they want. To get paid off, make sure you persuade the "authority" that you losing money would be a "systemic" danger. It might help to have your campaign contributions up to date. I wrote about that danger in a Regulation article here.

The GM bankruptcy here is a small template. As Holman points out,  when politicians and political appointees have great power to decide who gets money and who doesn't, watch out. Oh, no, I forgot; our political appointees are so much more uncorruptible than the Eurocrats that sort of thing can't happen here. (That was a joke)

His last two paragraphs are better than anything I can write. Go read them again. My one disagreement: Modern financial systems are fine. Modern political systems have abandoned rule of law in favor of a monarchic rule by discretion of appointed bureaucrats. That is incompatible with any financial system.

ECB dilemma

It was announced yesterday that  Europe will have a new, central bank supervisor run by the ECB, much as our Fed combines monetary policy and bank supervision. Be careful what you wish for, you just might get it.

One big unified central agency always sounds like a good idea until you think harder about it. This one faces an intractable dilemma.

Here's the problem. Why not just let Greece default?" is usually answered with "because then all the banks fail and Greece goes even further down the toilet." (And Spain, and Italy).

So, what should a European Bank Regulator do? Well, it should protect the banking system from sovereign default. It should declare that  sovereign debt is risky, require marking it to market, require large capital against it, and it should force banks to reduce sovereign exposure  to get rid of this obviously "systemic" "correlated risk" to their balance sheets. (They can just require banks to buy CDS, they don't have to require them to dump bonds on the market. This is just about not wanting to pay insurance premiums.) It should do for the obvious risky elephant in the room exactly what bank regulators failed to do for mortgage backed securities in 2006.


Moreover, it should encourage a truly European market. Greek, Spanish, Italian banks failing is no problem if large international banks can swoop in, pick up the assets, and open the doors the next day. Bankruptcy is recapitalization.  Greece needs a national banking system as much as Chicago (same population) does.

All well and good. And all diametrically opposed to the ECB's "crisis-fighting" agenda. The right arm of the ECB should be protecting the banking system in this way. But the left arm of the ECB is using banks as sponges for sovereign debt.

In trying to manage the sovereign debt crisis, the ECB has bought huge amounts of sovereign debt. It has lent  euros to banks that in turn have bought large amounts of sovereign debt (often, I gather, with not so subtle pressure from their governments).  It has lent more euros to the same banks to replace deposits that are quite wisely fleeing out of those banks.

How can the right arm protect the banking system from sovereign default, while the left arm wants to stuff the banking system with sovereign debt?

Converesely, how can the left arm do anything but print euros like mad, now that the right arm has responsibility for the banking system?  Lending to banks who buy sovereign debt was always excused by the idea that the bank shareholders bear the credit risk and national supervisors take care of that problem. Now it's in the ECB's lap. Politically, can the ECB really shut down national banks, stiff the creditors, and let them be taken over by big pan-european banks?

I bet on the outcome: print euros like mad, keep pretending sovereign debt is risk free, and prop up existing banks. Let's hope I'm too cynical. For once.

Experimental evidence on the effect of taxes

Much of our "fiscal cliff" debate revolves around the incentive effects of raising marginal taxes on high incomes. High tax advocates used to say that taxes won't hurt growth that much, and advocated them for other reasons.  Now they are advocating that even a 91% federal income tax rate, on top of state, sales, etc, as we had in the 1950s, (not counting all the loopholes!) will actually be good for the economy and also raise lots of revenue.

This seems to me like magical thinking, and a great testament to how people can persuade themselves of anything if it suits the partisan passion of the moment.  But wouldn't it be nice if someone would run an experiment for us?

Fortunately, Europe has been running a very useful set of experiments on what happens if you address yawning deficits with high income, wealth and property taxes. Which brings me to a report from the Telegraph

Almost two-thirds of the country’s million-pound earners disappeared from Britain after the introduction of the 50p (percent) top rate of tax, figures have disclosed.

In the 2009-10 tax year, more than 16,000 people declared an annual income of more than £1 million to HM Revenue and Customs.

This number fell to just 6,000 after Gordon Brown introduced the new 50p top rate of income tax shortly before the last general election....

It is believed that rich Britons moved abroad or took steps to avoid paying the new levy by reducing their taxable incomes.

George Osborne, the Chancellor, announced in the Budget earlier this year that the 50p top rate will be reduced to 45p from next April.

Since the announcement, the number of people declaring annual incomes of more than £1 million has risen to 10,000.

However, the number of million-pound earners is still far below the level recorded even at the height of the recession and financial crisis....

Far from raising funds, it actually cost the UK £7 billion in lost tax revenue

That's just one year. Usually, we think that it takes a while for high taxes to have effects. It takes a while for people to move, shelter income, close down businesses, not start businesses, not go to school, etc. Hitting the Laffer limit in one year is pretty impressive.

Update: Thanks to JM Pinder below I went back to the HMRC report which is indeed more detailed. Some highlights:

The 50 per cent additional rate of income tax was introduced on 6 April 2010. It was the first increase in the highest rate of tax in the UK for over 30 years, and was expected to yield around £2.5 billion...

This report provides the first comprehensive ex-post assessment of the additional rate yield using a range of evidence including the 2010-11 Self Assessment returns. The analysis shows that there was a considerable behavioural response to the rate change, including a substantial amount of forestalling: around £16 billion to £18 billion of income is estimated to have been brought forward to 2009-10 to avoid the introduction of the additional rate of tax. ...[This is a suggestion that it's a one time loss. We'll see]
...
The modelling suggests the underlying behavioural response was greater than estimated previously in Budget 2009 and in March Budget 2010, decreasing the pre-behavioural yield by at least 83 per cent. This result is also consistent with that contained in the Mirrlees review, and suggests the additional rate is a highly distortionary form of taxation.

Don't miss the bigger point here. The US discussion harks back to the great old 1950s, ignoring the much more relevant evidence right before us from Europe: Want to try cutting deficits (very slightly) with high marginal taxes, especially on investment, along with minor "cuts" (declines in growth rates) of spending, but no substantial change in the welfare state? Hey, they just tried it! Their economies sink, and they don't get much revenue.

Unraveling the Mysteries of Money

Harald Uhlig and I did a fun interview run by Gideon Magnus (Chicago PhD) at Morningstar. We talk about the foundations of money, fiscal theory, monetary policy, European debt problems, etc. Gideon framed it well, and Harald is really sharp. Somebody combed my hair. A cleaned up version of the interview appeared in the Morningstar Advisor Magazine (html) (A prettier pdf)



A link in case the video doesn't work or doesn't embed well (if you see "server application unavailable" the link usually still works), or if you want the original source.

The video starts a little abruptly, as it left out Gideon's thoughtful introduction (it's in the Magazine) and framing question:

Gideon Magnus: I want to discuss the value of money and the idea that money is valued similarly to any other asset. Are there really assets backing money? If so, what are they? John, please explain.

The future of central banks

A WSJ Op-Ed. Here is a pdf for non subscribers:

Momentous changes are under way in what central banks are and what they do. We are used to thinking that central banks' main task is to guide the economy by setting interest rates. Central banks' main tools used to be "open-market" operations, i.e. purchasing short-term Treasury debt, and short-term lending to banks.

Since the 2008 financial crisis, however, the Federal Reserve has intervened in a wide variety of markets, including commercial paper, mortgages and long-term Treasury debt. At the height of the crisis, the Fed lent directly to teetering nonbank institutions, such as insurance giant AIG, and participated in several shotgun marriages, most notably between Bank of America and Merrill Lynch.

These "nontraditional" interventions are not going away anytime soon.

Many Fed officials, including Fed Chairman Ben Bernanke, see "credit constraints" and "segmented markets" throughout the economy, which the Fed's standard tools don't address. Moreover, interest rates near zero have rendered those tools nearly powerless, so the Fed will naturally search for bigger guns. In his speech Friday in Jackson Hole, Wyo., Mr. Bernanke made it clear that "we should not rule out the further use of such [nontraditional] policies if economic conditions warrant."

But the Fed has crossed a bright line. Open-market operations do not have direct fiscal consequences, or directly allocate credit. That was the price of the Fed's independence, allowing it to do one thing—conduct monetary policy—without short-term political pressure. But an agency that allocates credit to specific markets and institutions, or buys assets that expose taxpayers to risks, cannot stay independent of elected, and accountable, officials.

In addition, the Fed is now a gargantuan financial regulator. Its inspectors examine too-big-to-fail banks, come up with creative "stress tests" for them to pass, and haggle over thousands of pages of regulation. When we think of the Fed 10 years from now, on current trends, we're likely to think of it as financial czar first, with monetary policy the boring backwater.

A revealing example of where we are going emerged last spring, admirably documented on the Fed's website. Using its bank-regulation authority, the Fed declared that the banks that had robo-signed foreclosure documents were guilty of "unsafe and unsound processes and practices"—though robo-signing has nothing to do with the banks taking too much risk.

The Fed then commanded that the banks provide $25 billion in "mortgage relief," a simple transfer from bank shareholders to mortgage borrowers—though none of these borrowers was a victim of robo-signing.

The Fed even commanded that the banks give money to "nonprofit housing counseling organizations, approved by the U.S. Department of Housing and Urban Development." Why? Many at the Fed see mortgage write-downs as an effective tool to stimulate the economy. The Fed simply used its regulatory power to help meet that policy goal.

Even if you think it's a good idea (I don't), a forced transfer from shareholders to borrowers in pursuit of economic policy is the province of the executive branch and Congress, subject to reproof from angry voters if it's a bad idea.

The Fed said candidly that it was acting "in conjunction" with the state attorneys general and the Justice Department. So much for an apolitical, independent Fed.

True, $25 billion is couch change in today's Washington. But you can see where we are going: Hey, nice bank you've got there. It would be a shame if the Consumer Financial Protection Bureau decided your credit cards were "abusive," or if tomorrow's "stress test" didn't look so good for you. You know, we've really hoped you would lend more to support construction in the depressed parts of your home state.

Conversely, when the time comes to raise interest rates, how can the Fed not consider that doing so will hurt the profits of the too-big-to-fail banks now under its protection?

This is not a criticism of personalities. It is the inevitable result of investing vast discretionary power in a single institution, expecting it to guide the economy, determine the price level, regulate banks and direct the financial system. Of course it will use its regulatory power to advance policy goals. Of course, propping up the financial system will affect monetary policy. If we don't like this sort of outcome, we have to break up the Fed into smaller agencies with narrowly defined mandates.

The European Central Bank's political power is, paradoxically, even greater. The ECB was set up to do less—price stability is its only mandate, and it is not a financial regulator. But the ECB holds the key to the euro-zone's central fiscal-policy question. It has bought the debts of Greece, Italy, Spain and Portugal, and it is lending hundreds of billions of euros to banks, which in turn buy more of those sovereign debts.

Eventually, the ECB will have to suck up this volcano of euros, by selling back the bonds it has accumulated. If it can't—if the bonds have defaulted, or if selling them will drive up interest rates more than the ECB wishes to accept—then the ECB will need massive funds from German taxpayers to prevent a large euro inflation. It might ask for a gift of German bonds it can sell, as "recapitalization," or it might ask for a bond swap of salable German bonds for unsalable southern bonds. Either way, German taxes end up soaking up excess euros.

Our views of central banks have changed every generation or so for centuries. The idea that central banks are centrally responsible for inflation and macroeconomic stability only dates from Milton Friedman's work in the 1960s. It's happening again, and it would be better to think clearly about what we want central banks to do ahead of time.

Mr. Cochrane is a professor of finance at the University of Chicago Booth School of Business, a senior fellow at the Hoover Institution, and an adjunct scholar at the Cato Institute.

A good Greek story

Matt Jacobs sent along a link to a great story from Greece on Reuters,  "Lessons in a shrimp farm's travails." The whole article is worth reading, but here are a few tidbits:

Just over a decade ago, Napoleon Tsanis set out from Sydney with 11 million euros and a dream to build a shrimp farm in his ancestral homeland... What he got was years of wrestling Greek bureaucracy and a court battle with a civil servant...

it's the civil servants that are throwing you into this labyrinth on purpose," Tsanis, 44, said. "The law gives them the latitude to delay you or punish you."

...A process that would take just two or three months to complete in Australia got stuck in a maze of official opinions and permits across several ministries. Greek politicians assured him that the paperwork would be done in 18 months, but that date came and went with no progress.

... then, though, another law change that sought to keep aquaculture projects small meant Tsanis had to break up his farm into sections to go ahead.

...One of the main obstacles to more investment is the legal jumble that dictates how Greek businesses work. Even government officials admit the lack of clear laws and the endless requests for opinions, studies and permits are there to give work to unionized specialists.

"There are whole businesses and technical offices employing engineers and experts specifically for the purpose of licensing," said Tsakanikas at the IOBE think tank.

Red tape often leads to corruption.

Tsanis said he steadfastly refused to bribe anyone. In one incident, in 2005, he appealed to a minister in Athens to get a permit unstuck. "The minister called in the public servant who was refusing to give us the permit and ordered him to issue it the next morning," he said, declining to specify the minister or ministry involved. "When we went back to get it, the civil servant told me: 'Australian, that guy is a politician and he'll be gone tomorrow, but I'll be here waiting for you.

The only European Union country not to have a fully functioning land registry - despite collecting EU funds to set it up and then paying penalties when it failed to do so - Greece still lacks a comprehensive zoning law and building rules.

"Several interests prefer a fuzzy system they can manipulate," Papaconstantinou said. "We must simplify building permits, which are a hub of corruption."

After his shrimp farm opened, Tsanis had hoped to build a 120 million euro golf resort. But when the local authorities decided they didn't want it, he opted not to fight.

This story rings with several of the themes on this blog, and I can't resist hitting you over the head a bit.

The nature of "regulation." In the popular discussion "regulation" means a wise system of rules that keep order in markets. Here is regulation in action.

There are different kinds of regulation. This is "regulation" by a deliberately vague forest of laws and rules, which give great discretionary power to the functionaries who administer those regulations. And clearly, they and their cronies like to keep it that way.

This is not "regulation" by clear rules, which you can quickly appeal in court if they are misapplied. The lack of title, zoning, and property rights falls in the same bucket.



Let us not feel superior, fellow Americans. This is the system of regulation to which we are crashing. Dodd Frank and Obamacare look a lot like Greek zoning laws, as far as the power of appointed officials vs. the rule of law are concerned.


Currency. Many of my macroeconomics colleagues think the main problem with the Greek economy is an "overvalued" exchange rate and thus too high wages. Rather than see high unemployment drive down wages that are "sticky" by some magic mechanism (even Paul Krugman admits he doesn't really know why wages are "sticky"), they would like to see Greece have a Drachma to devalue, or what the heck, devalue the whole euorozone, as even Anil Kashyap and Martin Feldstein have recently argued, along with Austan Goolsbee and more reliable liberals.

How much of Mr. Tsanis' troubles does this analysis describe? Not zero, in fact. The article says

He survived, he said, thanks to the 30 percent appreciation of the Australian dollar versus the euro in recent years

He doesn't even mention wages. I guess you have to open a factory before you have to start paying people.

You assign a percentage. Add up whether, faced with this story, the first thing you want to do is devalue the currency, or maybe if as economists we should be writing opeds about "shock liberalization" instead. Decide if this economy will liberalize on its own, given time, and "breathing space" by more German subsidies.

Micro vs. macro. In Greece's slump, as in ours, how much is this, "microeconomic" problems solveable only by micro liberalization, and how much is "macroeconomic," solveable by central banks, "stimulus" programs and the like?

Common sense from France

Today's WSJ has a lovely editorial from Pascal Salin, professor emeritus of economics at the Université Paris-Dauphine. It echoes many of the things I've said about the euro crisis, but with deeper political insight....and it's from France.

A few tidbits with comment

Contrary to what is claimed daily in the media by politicians and many economists, there is no "euro crisis." The single currency doesn't have to be "saved" or else explode.

The present crisis is not a European monetary problem at all, but rather a debt problem in some countries—Greece, Spain and some others—that happen to be members of the euro zone. ... there is no logical link between these countries' fiscal situations and the functioning of the euro system.

A currency union can work just fine without fiscal union.

..the deficits now plaguing these countries were, in large part, justified only a few years ago as necessary to initiate so-called "recovery policies."  But it is always an illusion to believe that governments could increase total demand and thereby induce producers to produce more....The present state of affairs in countries that engaged in stimulus blowouts in 2008 and 2009 should serve as proof of the failure of the Keynesian model.

A letter from Europe that rejects the confusion between common currency and sovereign default, and  sees the abject failure of stimulus? There is still hope. 

I found Prof. Salin's view of the political situation most interesting:

The "euro crisis" is a pure political construction without any economic content. It could even be said that the crisis is a splendid opportunity for many politicians to impose some of their longstanding goals on everyone else. For instance, before the introduction of the euro, many politicians who called themselves Europeans considered monetary union a stepping stone to political union....

So, in Prof. Salin's view, the Euro worthies are deliberately linking sovereign default to breaking up the euro zone in a deliberate effort to scare wary voters into accepting fiscal union. 

This process has begun and continues to develop. Politicians now argue that "saving the euro" will require not only propping up Europe's irresponsible governments, but also reinforcing and centralizing decision-making. This is now the dominant opinion of politicians in Europe, France in particular.

It's really the "centralizing decision-making" that is the problem not "political union." The US at least historically had a political union without requiring the rules on provenance of prosciutto to be written by bureacrats in Brussels.

There are a few reasons why politicians in Paris might take that view. They might see themselves as being in a similar situation as Greece in the near future, so all the schemes to "save the euro" could also be helpful to them shortly....

Yeah, but the Germans may not have any money left by then!

What to do instead? Someone else likes "shock liberalization:"

The real solutions to Europe's debt problems lie in tax cuts and deregulation, and it's here that national politicians should turn their attention. Pan-European cooperation won't deliver any government from its fiscal or economic crises. Only national governments, each working independently to implement the best possible policies, can hope to achieve that.

What a breath of fresh air.

I can't wait to read Prof. Salin's next letter on France's 75% tax -- especially in the face of the UK's disastrous and quickly repealed experience with a 50% tax.  (16 billion pounds forecast revenue turned in to two.) 

The Devaluation Chorus Sings again

The chorus to devalue (and then inflate) the euro as the key to solving Europe's ills is singing again.

Ken Griffin and my colleague Anil Kashyap have a big OpEd on the Euro in the New York Times. They want Germany to leave the Euro, followed by quick euro depreciation relative to the Mark and Dollar.

Martin Feldstein, writing in the Wall Street Journal, echoes this faith in devaluation

The only way to prevent the dissolution of the euro zone might be a sharp decline in the value of the euro relative to the dollar and to other currencies

As you might have guessed, I think it's a terrible idea.

The biggest reason is the vanity that you can do it just once. "Devalue and inflate the currency" is hardly a new idea. Portugal, Italy, Spain, and Greece lived on a cycle of continual devaluation and inflation until they joined the Euro.  Going on the Euro was a hard won transformation to precommit to get off this cycle.

Imagine that  your brother in law had been drinking too much for 40 years, perpetually on and off the sauce, never really able to give it up. He went  through a painful 12 step program and rehab, and finally quits the sauce for 10 years. He threw away all the liquor in the house. Then he loses his job. Is "one more big night out to soothe the pain, and then I'll really really never do it again"  at all a credible plan?  That's exactly what my normally sensible colleagues are advocating.

Kashyap and Griffin make some sharp predictions.

Reintroducing the mark [and devaluing the Euro] would not solve the debt burdens of southern European countries, but it would give them needed breathing room to restructure their economies, reform labor markets, collect more taxes and reassure investors

When in human affairs has "breathing room" ever led to expeditious "reform," especially when such reform meant stepping on the toes of very powerful interests?

Witness: The Germans gave Greece three years of "breathing room" already, repeatedly bailing out and rolling over its debts. And look at the great progress Greece has made on "structural reform." Not. Italy just backed off its effort to repeal its stultifying labor law. Heck, look at the "breathing room" of the forty previous years of perpetual devaluation when all the "structural rigidities" were enacted.

With the "breathing room" of currency depreciation and inflation, won't the unions and other powers arrayed against reform just reassert themselves?

A crisis is indeed a terrible thing to waste. Nobody ever reforms in good times. Heck, look at how well the US is doing -- we have the same entitlement disaster heading our way, we just have a few more years of "breathing room." And we're  really putting the pedal to the metal on tax and entitlement reform, aren't we?  We advocate "structural reform" in Greece, yet where is the deregulation effort here?

Kashyap and Griffin make some more interesting cause-and-effect predictions

 a weaker euro would give a boost in competitiveness to all members of the monetary union, including France and the Netherlands,

A weaker euro would also encourage greater foreign investment. For example, Spain’s distressed real estate market would become far more attractive.

Let's see if they come true. The first: Is there any exchange rate at which France ships Citroens to Stuttgart? Are Europe's "compeititiveness" problems really all about some mysterious exchange rate misalignment and not pervasive sand in the gears? Would Detroit roar back if it could only introduce a Detroit dollar and finagle its monetary policy?

The second: When Germany goes its own way, and Spain has embarked on a let's-all-inflate-our-way-out-of-this-mess along with its neighbors, will this really be the signal of great times to invest?

My prediction -- investment runs to Germany anyway. Even faster, Why? Ken and Anil recognize

Although repeated currency devaluations are not the path to prosperity,

Right. Just this once. But how do you sin just once? How do you devalue once, then convince the rest of the world that the rump euro is now a hard-money area, determined for structural reform, and not back to its  pre-euro history of  repeated and continual devaluations?

Investmet and growth are about expectations, institutions, rules, commitments, not one-time devaluations with empty promises not to do it again. That's what the euro was about. You can't throw out the euro and have anyone believe a devaluation is just this once, and not back to the perpetual stagnation of the 70s and 80s.

Kashyap and Griffin go on twice to argue that devaluation will lead to greater "dignity" for Southern workers. We know a little about how printing money devaules a currency and inflates. We know a tiny bit about whether that effort can give a one time boost to exports, and sets up poor expectations about another bender. This is the first time I've heard serious economists adduce that we know a cause and effect relationship from monetary policy to "dignity," and that depreciating the currency promotes more of the latter.

Doesn't devaluation automatically mean inflation, at least eventually? Kashyap and Griffin are silent. Feldstein goes on to 

Although a decline of the euro would mean higher import prices in euro-zone countries, it need not mean higher inflation or even a higher overall price level. The ECB could in principle continue to aim at a 2% inflation rate with lower prices of domestic goods and services offsetting the higher prices of imports from outside the euro zone. At worst, the ECB could allow a one-time pass-through of the higher import costs but prevent any further increases in inflation rates.

I thought the one thing we all agreed on is that money is neutral in the long run.  Certainly the repeated devaluations of the 70s and 80s were almost perfectly matched with extra inflation. Why would this time be different? We might as well hope that the Physicists at CERN will repeal conservation of energy with the new Higgs Boson.

OK, one point of agreement: 

What is essential is the preservation of the European Union’s greatest accomplishment: the free movement of labor, goods and services.

Yes. Keep the euro, and all its comitments against devaluation and inflation. [Update to clarify in response to comments: the most important commitments are that the South, as part of the euro, does not resort once again to devaluation and then inflation relative to the North. The second most important commitement is that the ECB was once set up as a central bank with a pure inflation target. This is a precommitment against deliberate devaluation and inflation relative to the rest of the world.]   Recognize that a currency union, without fiscal union, works only if you countenance sovereign default and default of banks who invest in sovereign debt.

In the end, the devaulation idea is this: In the warmth of summer, the crickets of Europe voted in laws that you can't fire people, can't lower wages, and they will only work 35 hours, with long paid vacations. Now those structures are no longer tenable. In winter, der ants don't want to buy stuff that crickets are producing with those huge labor costs. What to do? Let's devalue the hour! Pass a law that the hour is 75 minutes.

Really. The euro is the unit of value, as the hour is the unit of time and the meter is the unit of value. You could engineer a one-time boost by fiddling with the hour, the meter, the kilo and the euro. Until people catch on and rewrite contracts. And then they are aware you will do it again, since you throw out all the precommitments not to devaule built in to the current system of units.

Anyone for a drink?

Sand in the gears

Today's Wall Street Journal has a beautifully informative editorial, "Employment, Italian Style." Snippets:

Once you hire employee 11, you must submit an annual self-assessment to the national authorities outlining every possible health and safety hazard to which your employees might be subject. These include stress that is work-related or caused by age, gender and racial differences. You must also note all precautionary and individual measures to prevent risks, procedures to carry them out, the names of employees in charge of safety, as well as the physician whose presence is required for the assessment.


Once you hire your 16th employee, national unions can set up shop. As your company grows, so does the number of required employee representatives, each of whom is entitled to eight hours of paid leave monthly to fulfill union or works-council duties. Management must consult these worker reps on everything from gender equality to the introduction of new technology

Hire No. 16 also means that your next recruit must qualify as disabled. By the time your firm hires its 51st worker, 7% of the payroll must be handicapped in some way,...

Once you hire your 101st employee, you must submit a report every two years on the gender dynamics within the company. This must include a tabulation of the men and women employed in each production unit, their functions and level within the company, details of compensation and benefits, and dates and reasons for recruitments, promotions and transfers, as well as the estimated revenue impact....

This kind of thing is hard to track down. You can't easily find a prepackaged "list of regulatory sand in the gears lowering productivity and employment in Italy," the way we can find (statutory) tax rates, spending numbers, interest rates, and so on.  So like the drunk in the old joke, looking for his car keys under the light even though he knows he dropped them a block a way, much economic discussion focuses on those headline issues ("Stimulus!" "Austerity!" "Bailout!" "Leave the Euro!" "Raise/lower taxes!") and ignores all the sand in the gears.

The journal writes, 

All of these protections and assurances, along with the bureaucracies that oversee them, subtract 47.6% from the average Italian wage, according to the OECD.

I wish the WSJ had footnotes or links, even in its online edition, to make it easier to track down  numbers of this sort. A quick tour through the OECD website provides some horrifying numbers on
 Labor tax wedges of 40-50%, to which we must add “non-tax compulsory payments (NTCPs)” which "represent a strong increase over and above the overall tax burden. E.g., in 2011, the compulsory payment wedge for the average single worker was 50.4% compared with the corresponding tax wedge of 47.6%" And remember, once they give you a euro, you still pay another 21% VAT before you can eat that plate of delicious pasta.  But the WSJ paragraph suggests 47.6% is the effective wedge of regulation on top of explicit taxation. (If readers know where it came from, add a comment.)

Also left out is the effect of this kind of hyper-regulation on corruption. You can imagine when the inspector comes in to see if all the paperwork is up to date how the conversation evolves. (Ask Luigi Zingales)

Cleaning up this mess is what we mean by "structural reform." How to achieve it politically seems like a nightmare to me.  Fighting each of ten thousand regulations one by one seems hopeless. Each one sounds good, each one taken alone seems minor, each one has an entrenched interest backing it and an army of bureaucrats whose jobs depend on its enforcement. And the economy dies the death of a thousand cuts. Can you really abolish it all in one fell swoop or grand bargain?

Certainly not if you don't try. 

The WSJ headline was

Prime Minister Mario Monti has issued a new "growth decree" to revive Italy's moribund economy. Among other initiatives, the 185-page plan proposes discount loans for corporate R&D, tax credits for businesses that hire employees with advanced degrees,.. 

Not to belabor the obvious, but this is incredibly depressing. More special programs are not what Italy needs. I hope there are better ideas in the rest of the 185 pages.

Bloomberg TV link

I did a Bloomberg TV interview this morning on Euro debt crisis. I can't seem to insert the video here, so you'll have to follow the link if you're curious.

Update: I figured out how to embed bloomberg vidoes!

A glimmer of hope?

Weekend Update.

On Monday the Greeks decide whether to vote for the Easter Bunny or Santa Claus to solve their fiscal problems. What is Europe planning to do next?

Sunday's New York Times had an unusually cogent article on European events over the weekend, reporting on events with thoughtful analysis:

The head of the European Central Bank and other euro zone leaders worked on Saturday on a grand vision... the plan will push for countries to remove the regulations and layers of bureaucracy that inhibit competition, keep young people out of the work force or make it difficult to start a new business....

Over the years, countries have repeatedly pledged to clear the rules that hinder competition and led to chronically anemic growth. If the euro zone grew faster, tax receipts would rise and the debts of countries like Spain or Italy would seem less daunting

Halelujah! Growth -- the classical, growth-theory, higher productivity, bend-up-the-trendline, long-run kind of growth, not the quick espresso stimulus kind of growth (if that even works) -- is the only hope for Europe to repay debt rather than face the awful choices of default or inflation. At least we understand this is the central answer and without it, all the rescue plans will fail.

For years the mantra has been, stimulus and crisis management today, and "structural reform program" to be implemented in the vague far off future. They've figured out it won't work. Decades of previous good times did not bring structural reform. 

“There is a long-standing agenda on growth,” Mr. Draghi told a gathering of economists on Friday in Frankfurt. “It is time to implement it.”

---

But..

But it is unclear whether yet more pledges of reform, which would face significant hurdles, will calm financial markets.

The euro zone has no shortage of plans and pacts intended to end years of sluggish growth and impose discipline on its 17 members.

The challenge for Mr. Draghi and the plan’s authors....will be to package their plan in a way that makes investors believe something will get done.

The most difficult task for Mr. Draghi and the other leaders may be to establish a binding timetable, to ensure that political leaders do not drag their feet.

Correct. Quite a challenge, I'd say. How do you establish a "binding timetable?"

The leaders are “only capable of acting at gunpoint” — when markets force them to, Willem H. Buiter, chief economist at Citigroup, said...

But once markets "force them to" act, by a huge bank run, refusing to buy government debt, running from the currency, it will be too late for a structural reform plan to have any chance.

---

What about the immediate problem, the bank run, no longer "imminent" but gaining steam every day?

Under the plan, euro zone leaders will seek to establish the central bank as supreme bank regulator with broad powers, in place of the relatively toothless European Banking Authority.

Countries would also create a deposit insurance program to augment national programs. The goal would be to reassure ordinary depositors and prevent bank runs, an imminent danger in Spain as well as Greece. But any sharing of financial burdens almost automatically encounters opposition in Germany.

Catch 22. We've got a bank run. How to stop it? Ah, deposit insurance! But who is going to pay for that? "Countries" are not credible. The whole problem is that "countries" used their banks as piggy banks, stuffing them with sovereign debt. So, if the countries default on their sovereign debt, the banks go under, and the same "countries" obviously don't have the money to guarantee deposits.

A cross-national deposit insurance scheme, while banks are already stuffed with sovereign debt, is back to Plan A, run for the exit and stiff Germany with the bill. Which "automatically encounters opposition in Germany."

A Supreme Bank Regulator  to stop banks from gorging on sovereign debt in the first place might have been  good idea, perhaps. (The concept "sovereign debt is risky" isn't necessarily beyond the ability of national regulators to comprehend, even with Basel rules denying it.) But it's way too late for that now.

Bottom line: Waffling again. No serious plan to stop the bank run already in place. You can't stop the crisis by saying you'll invent a totally new regulation regime to keep the banks from taking risks.

----

What about looming sovereign defaults?

For now, the most important new tool is a half-dozen rules known as the Six-Pack, which took effect in December. In coming months, the European Commission will be able to impose fines on euro zone countries of up to 0.2 percent of their gross domestic products if they flout rules on public debts and deficits.

Oh yeah, right. The same Spanish government you just lent 100 billion euros to pour down the rathole of its banks, that one. You're going to tell them to pay you a fine of 0.2 pct of GDP because they're borrowing too much money..from you?

The one big lesson to learn from this debacle is that deficit limit rules do not avoid sovereign defaults. A currency union without fiscal union needs to allow sovereign default.

As far as quelling the panic, good luck that "we really mean the deficit targets this time" will have any effect.

---

What are they going to do now, to stop the unraveling that is likely to happen in weeks?

Mario Draghi, the president of the central bank and one of the authors of the plan, said Friday that it would be unveiled within days, ahead of a meeting of European leaders at the end of June.

Well, that's good. I hope there still is a euro at the end of June.

---

Bottom line. Mr. Draghi is saying the right words on growth. But these plans to address bank runs and sovereign defaults are not realistic. And the pace of events is quickening. The time to actually implement a pro-growth policy, and stop financial panic by convincing markets it will really happen, is getting shorter and shorter.

Euro explosion

The European bank run is on, and with it the slow-motion train wreck  will move to high speed.

The Wall Street Journal reports €600 to 900 million  a day are flowing out of Greek banks, and  the outflow may rise above a billion euros per day. At the end of April there were only €166 Billion deposits to flow. Count the days.  And Greeks -- those who can't move money abroad or move themselves abroad -- are "hiding money in jars, under the bed, even burying it in the mountains."

In related news, I read last week say that payments are simply stopping in Greece. If there's a chance to pay in Drachma next month, why pay in euros now? Shipments are stopping -- if your invoice might get paid in drachma, no point in sending goods today. This is simple implosion.  Spain has already lost about € 100 billion of bank deposits and Italy is losing them quickly.
What's going on? Keynesian economists love to talk about how great leaving the euro will be, because then salaries can be cut by depreciation rather than explicitly.

But if you have a bank account, leaving the euro means that you go to bed one night with € 10,000 in your bank account. The next morning, you have 10,000 drachmas. Those drachmas are going to be swiftly devalued to about 1/3 or so of their original value. In addition, it's a good bet there will be capital controls and exchange controls, so you can't get money out of the country or buy things with euros.

People understand this. They get out now.  To an account holder, the country leaving the euro is the same as the government seizing bank accounts. Burglars at least know enough not to advertize their visits in newspapers for two years before they visit.

The run means everything will happen super fast from here on in. The time to dither around and make pronouncements is running out.

------------

How do you stop a bank run?

1. One common prescription is for the government to guarantee deposits. But that won't work, since the whole problem is that the government is out of money and the banks are stuffed full of government debt.

Spain discovered a version of this conundrum last week. Spain borrowed € 100 billion to recapitalize  banks. The result was not only a continued run on the banks, but a sharp rise in Spanish government interest rates.

Why didn't it work? "Recapitalize" means that the Spanish government owns stock in banks. If the banks lose more money, the Spanish government loses money -- but the government still has to repay the 100 billion loan. Unfortunately, the Spanish government is broke. And what do these banks own? Spanish real estate and a lot of Spanish government debt.

...That would raise pressure on the Spanish government, which has come to rely on local banks using ECB funds to buy sovereign debt. According to the latest Spanish Treasury data, while foreign investors have reduced their holdings of Spanish bonds to 32% of the total in March from 36% in December, Spanish banks have raised their holdings to 41% of the total in March from 35% in December

2. The second run-stopping prescription is for the central bank -- the ECB in this case -- to open the spigots. They already are. Ask yourself, where are banks getting the cash to redeem all these deposits anyway? They sure aren't selling assets -- real estate loans and government bonds. The answer is, the ECB is lending them the money.

But wait, isn't the ECB only supposed to lend against collateral? Yes, and that collateral is largely government bonds.  The ECB knows it's taking junk collateral.  If the ECB doesn't stop this massive lending, it understands well that it will essentially end up monetizing all the debt of the southern tier, and a huge inflation will eventually break out. The ECB knows that too. How long will it continue to lend?

If the ECB decides to stop this massive lending, then the game is up. The banks fail, the governments guaranteeing the banks fail, and chaos erupts --whether or not the governments decide to turn the remaining euros in to monopoly money.

3. As in the US "bank holiday," governments can try to shut down the banks, impose capital controls, etc. But if it's not just very temporary illiquidity, the run starts up the moment you reopen the banks. And if you so much as breathe a word you're thinking of doing it, the run starts ahead of time. Whoops, it's too late. Continuing from the journal here

According to the senior [Greek] banker, the current rate of deposit outflows--of €1 billion or less per day–remains "manageable" since the banks keep large cash buffers on hand to deal with the withdrawals. But if those outflows were to grow four- or five-fold, Greece would be forced to impose deposit and other capital controls.

4. The last way to stop this run is to try, even at this late date, to commit fully and forecefully that no country will leave the euro.

That will be hard. Pronouncements at this date have little weight. The only way to do it is to be very clear of the awful things a government will allow rather than leave. It will default on its sovereign debt. It will cut government salaries and entitlements. It will allow bank failures, and it will allow foreign banks to come in and swoop up the assets. All of these things will be awful. But the government has to persuade voters it understands that leaving the euro will be worse.

Even that will not be enough. To a government in fiscal stress, bank accounts look like an ice cream bar to a hungry child. Greece and Italy have already passed wealth and property taxes. "Tax the rich" rhetoric is strong. People with bank accounts fear expropriation and punitive wealth taxation as much as devaluation. Somehow, the government has to persuade them their bank accounts are safe from depredation in the euro.

-----

Why are we here?

I've been writing for two and a half years about mistakes in Europe, and won't repeat all of that now. But there are two central points to make.

1. The euro was explicitly set up as a currency union without a fiscal union. (And it turned in to one without a bank regulatory union.) That can work, a fact which practically all commentators ignore.

The central ingredient is: sovereigns who can't pay their bills default. The European central bank does not print up euros to bail out sovereign creditors, either directly or via the subterfuge of lending to banks who then buy the sovereign debt.

The euro was explicitly set up this way. The main problem is, when the crisis came, nobody bothered to read the instruction manual.

2. As many times in history, strapped governments have forced banks to take on their debts. A sovereign default is manageable. A country-wide banking crisis is much worse.

The liberal consensus wants "more regulation" to stop banks from taking risk. The regulators stuffed the banks with sovereign debts, and treated those debts as riskfree for years. They also confused "the banking system cannot fail" with "no individual bank can fail."

----------

Paul Krugman, writing May 18, wrote a few almost-sensible paragraphs about Europe, echoing many of these points. (His article is for once about economics, not the evil character of Republican politicians, so there is some substance to talk about.) Since I agree so rarely with Krugman, I thought I'd celebrate with a few quotes, though with some quibbles and some interpretations that I'm sure he would disavow.

Mostly, I agree with his main point, that the emerging bank run means the crisis is likely going to move much more quickly now.

Right now, Greece is experiencing what’s being called a “bank jog” — a somewhat slow-motion bank run, as more and more depositors pull out their cash in anticipation of a possible Greek exit from the euro. Europe’s central bank is, in effect, financing this bank run by lending Greece the necessary euros; if and (probably) when the central bank decides it can lend no more, Greece will be forced to abandon the euro and issue its own currency again.

Comment: As above. Change "forced to" to "choose to" and I'm on board. There is an option. Sovereign default. Let banks fail -- meaning their senior debt becomes equity and they are recapitalized. Good banks buy the assets of bad banks.  But the Europeans probably won't have the stomach for it.

This demonstration that the euro is, in fact, reversible would lead, in turn, to runs on Spanish and Italian banks. Once again the European Central Bank would have to choose whether to provide open-ended financing; if it were to say no, the euro as a whole would blow up.

Comment. Right again. The only thing keeping any money in Spanish and Italian banks is the idea that leaving the euro really can't happen. Once it's clear that exit, devaluation -- along with likely currency controls, bank closures, deposit seizures, and sky-high wealth taxes -- are on the table, the run will start in earnest.

Yet financing isn’t enough. Italy and, in particular, Spain must be offered hope — an economic environment in which they have some reasonable prospect of emerging from austerity and depression. Realistically, the only way to provide such an environment would be for the central bank to drop its obsession with price stability, to accept and indeed encourage several years of 3 percent or 4 percent inflation in Europe (and more than that in Germany).

I agree with the first two sentences. But the only hope for such an economic environment is shock liberalization. (Despite Krugman's "savage cuts" these economies still spend half of GDP, with direct intervention, state industries, and other off the books interventions bringing the total even larger.)

Not only is inflation not "the only way" to provide such long-term growth, it isn't a way. When has deliberate, anticipated and announced inflation ever brought long-term prosperity? You must be kidding.

On the other hand, I agree that inflation is the most likely path that Europe will choose. Not because inflation works any Phillips curve magic, but because inflation is the "easy" way to engineer a massive default of government and bank debt.

By arithmetic, here are the options:

1) Government default. (Restructuring, really)  If done right away, this would have meant private-sector losses. Now that so much debt has been rolled in to banks, it means bank failures too.

2) The Germans pay for everything. Not happening. There is not enough taxing power in Germany to repay the entire debt of Portugal, Spain, Italy, and Greece, plus their banks losses and their ongoing deficits.

3) The ECB buys up the sovereign debt, or lends to banks on sovereign "collateral," effectively doing the same. By turning trillions of debt in to money, we get inflation. Inflation engineers the sovereign default and bank debt default implicitly.

4) Shock liberalization, privatization, freeing of markets, selling state assets. Remove the highly distorting taxes of the "austerity" plans, which said loudly "don't start businesses here, don't hire anyone here, and if you have some wealth I suggest you get it to the Bahamas ASAP." Return quickly to strong real growth. Pay back the debt. Fairly radical reform of unsustainable entitlements.

My obvious choice is number 4. The Europeans' most likely choice is number 3. It can be sold as "stimulus" and "liquidity provision," and it kicks the can down the road. The inflation won't happen for several years. Then it will be easy to blame speculators and hoarders and markets and expectations and so on.

But Krugman's wrong on the size of the inflation. Several years of 3-4 percent inflation is nowhere near enough. To write down PIGS debt by half, you have to double the price level. And you have to do it before the debt rolls over. So that means doubling the price level -- 100% inflation -- in under two years or so. If you do it over several years, the overall rise in the price level has to be even higher.

To my mind an inflation so large that it wipes out half of PIGS and bank debt is about the same result as breaking up the euro directly. And the Germans will probably leave before that happens. 

Both the central bankers and the Germans hate this idea, but it’s the only plausible way the euro might be saved. For the past two-and-a-half years, European leaders have responded to crisis with half-measures that buy time, yet they have made no use of that time. Now time has run out.

I'll go with this only because "plausible" includes the chances that European leaders will take it. I agree with the second sentence, though I suspect the "full measures" in my mind -- default, bank restructuring, commitment to euro and open markets, shock liberalization -- are different from what I presume from other writing that Krugman does -- endless stimulus financed by Germany

So will Europe finally rise to the occasion? Let’s hope so — and not just because a euro breakup would have negative ripple effects throughout the world. For the biggest costs of European policy failure would probably be political.

Think of it this way: Failure of the euro would amount to a huge defeat for the broader European project, the attempt to bring peace, prosperity and democracy to a continent with a terrible history. It would also have much the same effect that the failure of austerity is having in Greece, discrediting the political mainstream and empowering extremists.

And now in full-throated agreement. The currency union, without fiscal union, will be a horrible thing to lose.

But what's kicking off the run is that governments are being tempted to leave. I wonder whether Mr. Krugman and his colleagues have any regrets for the many elegies they have written to the wonders of separate currencies and devaluation, the prospect of which is now causing the run.

---------

Bottom line: I'm pretty pessimistic. The run is on and will intensify.  Alternatives exist, but they are so unpalatable to standard views that I think massive intervention by the ECB as the most likely current policy.

The ECB will print euros like mad and lend them to banks, which will continue to buy government debt.  Southerners will take the ECB money and put it in Northern banks. The ECB ends up owning the debt through the banking system. The ECB understands the danger full well, but will give in.

After that, there is a sliver of hope. A shock liberalization could give a return to robust growth and sustainable government finances within a year. Then the debt would not default, and the ECB and its banks could sell back all the sovereign debt they have bought.

But unless that miracle happens, within a year or so the ECB's collateral will evaporate in the inevitable sovereign defaults, the sovereign defaults will mean bank defaults, and the euro will inflate away rather than break up. An immense, and utterly avoidable tragedy.

So, given that there's no way they'd take my radical advice, if I were in charge I would recommend changing the "austerity" conditions on bailouts and ECB financing, with their emphasis on higher distorting taxes and vague promise of structural reform sometime in the next century, to "reform" conditions demanding a tight schedule of structural reforms within months.

Economist's Haiku for Europe

A lovely letter to the Economist says it all.

Sir: 

Leaving the euro zone is no option for Greece (“Fiddling while Athens burns”, May 19th). The new drachma would be valueless, as there would be no demand for it. A country that finds it difficult to run its fiscal affairs cannot manage a national currency. The restored drachma would stay in circulation only if the Greeks were denied access to foreign exchange, preventing the informal use of the euro. That would require draconian exchange controls of the type put in place by Germany after the first world war, which ensured the circulation of the depreciating mark during a period of hyperinflation.

What can Europe do for Greece? It can provide it with a stable monetary unit: the euro. What can Europe not do for Greece? Well, it cannot give it a sound fiscal system. The Greeks have to achieve that themselves if they wish to remain a sovereign country.

Ernst Juerg Weber
Associate professor of economics
University of Western Australia
Perth  

Good news from Europe

This morning's Wall Street Journal article on renewed bank competition in Europe is one little bright spot. Apparently, large healthy international banks are competing for deposits in Greece, Spain and Italy.

Banks from Northern Europe are offering...the safety of having your money parked in large, well-capitalized institutions based outside Europe's danger zone. The campaigns aren't subtle: HSBC Holdings PLC promotes its "safety and security" in Greece...

In Italy, consumer group Altroconsumo has been offering advisory services to jittery depositors since December. As a precautionary measure, the group is recommending that customers consider moving their deposits from domestic Italian banks to foreign banks that operate in Italy...

In Greece, HSBC's local unit is trumpeting "the safety and security of the bank with the greatest capitalization in Europe." The bank, with 16 branches scattered around Greece, is offering depositors 3.5% interest if they lock up their money for at least six month...

Foreign banks are offering competitive prices and the allure of safety. Barclays recently launched its new "depositos solvencia" Spanish savings product

Why is this good news, you may ask? It's just feeding the run away from local banks, which have invested heavily in now-tanking local economies and loaded up on sovereign debt.

Here's the answer. My favorite solution for Europe is sovereign default and keep the common currency. (Actually, that's my second favorite. Free market reforms tomorrow, start growing like China on Monday and pay back the debt is my real favorite, but we can only dream so much.)

The natural rejoinder is, what about the banks? Since the local banks have all loaded up on sovereign debt, then the banks will all go under, and won't that be a disaster?

My response has been to remind people of the difference between existing banks and a functional banking system. Countries need a functional banking system.  They do not need all of the existing banks to continue, nor do they need all of the existing bank's creditors not to lose a cent.

Europe offers a particularly good playground here, because it's supposedly an open market. Greece is about the size of metropolitan Chicago. It can function well as Chicago does, with banking dominated by local branches of diversified international banks. If the local banks fail, that does not mean Greece will not have a banking system. Just transfer the assets and deposits of failed banks to HSBC, put up a new sign on the front window, and open for business.

And this news adds important facts to my scenario. Those large banks are already operating in Greece, Spain, and Italy and ready to take over.

Of course I am guilty of a bit of wishful thinking here. The article also shows how local banks are fighting back to keep their deposits. And it can't be long before local governments intervene to "save our banks from destructive international competition." In fact, the localization of bank regulation is one of the sadder parts of this whole mess. Had Europe really gone for a europe-wide banking system in the first place, that system would be in a lot less mess now. 

Side note: The US discussion is all full of "the financial crisis proves we need more regulation." Europe's banks woes are entirely the product of regulation. What's failing is sovereign debt, debts of the governments that regulate things, not mortgage backed securities put together by greedy wall street bankers. The banks are full of sovereign debt because their regulators told them to do it, not because sneaky financial engineers got them to do it. Here is the fully regulated system on display for us.

Simon Johnson on the Euro

Simon Johnson has a good blog post on the end of the euro. Digging in, the run is on, the end is near, and the chaos will be worse than you thought.T he ECB has also monetized a lot more than you thought.

Still, I do not understand why even Simon cannot imagine the idea of sovereign default while staying in -- and firmly committing to stay in -- the currency union. The picture Simon paints of the euro breakup is a catastrophe. So why not even talk about sovereign default (restructuring) without euro breakup?

It strikes me as really the only way out, and the longer Europe waits, the harder it will be. 

Leaving the Euro again

Yesterday's coverage of the latest European summit seems designed to reinforce my view of basic confusion expressed yesterday pretty clearly.

For example, the Wall Street Journal's "Europe Girds for a Greek Exit" reports that the talk was all about eurobonds, stimulus, or bailout as a way to avoid Greek exit from the Eurozone, repeating the senseless mantra that sovereign default cannot occur in a currency union.

"We want Greece to remain in the euro zone," German Chancellor Angela Merkel told reporters after nearly eight hours of talks. "But the precondition is that Greece upholds the commitments it has made."

I salute Ms. Merkel for not giving in to the camp that wants endless wasted spending disguised as stimulus, to be followed by inflation. But really, why would Greece not "upholding its commitments" mean it has to "leave the eurozone?" Why is it impossible to turn off the bailout spigot, and let Greece default and stop running deficits, while it stays in the euro?


Actually, the article, quotes, and other coverage is deliberately vague on a central question: Are we preparing for Greece to decide to leave the Euro, or are we preparing that the rest of Europe will try to kick it out? The quote reads a lot like the latter!

How do you kick a country out of a currency union? Greece has every right to say "the euro is legal tender in Greece," no matter what the rest of Europe does. Sure banking will be a bit harder if the ECB cuts off the Greek central bank, but unilateral use of another currency is an economic possibility. Kosovo and Montenegro do it.

The mantra continues,

...fears mount that Greece won't be able to carry out the painful surgery to its public finances and its economy needed to stay in the currency zone.

 At least the fact is dawning that a currency switch is the same as default:

In addition, euro-zone members would likely have to take a large hit on governmental and central banks' loans to Greece. There is a risk that some euro-zone commercial banks could face heavy losses on their exposure to the Greek economy. 

Eurobonds

A lot of coverage concerned "eurobonds," an idea that has been stuck for years on just who is going to pay for them.

News flash: eurobonds have already been issued. They are called euros. ECB reserves are just particularly liquid floating-rate debt. The ECB issues reserves in return for sovereign debt and lends reserves to banks who load up on sovereign debt. This action is functionally the same as issuing Eurobonds to buy sovereign debts. What happens of the ECB's holdings of sovereign debt or its bank loans turn out to be worthless? If the ECB needs to be "recapitalized," it has the explicit right to call up the member states and demand funds, which means the member states have to kick in tax revenues. This is exactly a eurobond. For better, or, likely, worse. 

The ECB has propped up Greek banks for months through its lending operations and, increasingly, its emergency-lending program, known as ELA.

Under ELA, banks borrow from their national central bank, in this case the Bank of Greece, with approval of the ECB's governing council. The default risk resides with the Greek central bank and, ultimately, the Greek government.

This is a great case of wishful thinking, I'd say. Oh sure, the ECB doesn't have credit risk...if the banks collapse because the Greek government defaults on its debt, the Greek government will pay us back!

To ease the fallout on Spain and others, the ECB could issue more three-year loans to banks, analysts say. More than €1 trillion in these loans have been doled out since late last year. 

A trillion here, a trillion there, and pretty soon you're talking real money -- real debt. 

Devaluation

A quick response to some emails and comments. Yes, I understand that devaluation can change a trade balance towards exports. (I try to avoid the mercantilist implications of writing "improve the current account" or "raise competitiveness.") 

If the US Fed were to say "we buy and sell Euros at $2 per Euro," US prices and wages would not instantly adjust; our exports would become cheaper and imports more expensive, and we would import less and export more for a while.

The reason is superficially clear: prices and wages are a bit sticky. The precise mechanism of such stickiness is the subject of a huge academic investigation and is, I opine, still a little unclear. But it's not really controversial what would happen in the US.

But nominal prices are not always sticky. For example, when countries joined the euro, nominal prices changed by orders of magnitude, overnight, with no output or trade effects whatsoever.

The challenge for theory -- and for predicting what would happen to Greece if it left the euro -- is to figure out which kind of experience applies.

For a small country to suddenly leave a currency union, adopt its own currency, and instantly devalue that currency,  along with likely capital, exchange, trade, and other controls, is a quite different experiment than for a large country, with a well-established currency to devalue.

Does the price and wage stickiness that applies to a US company with longstanding contracts in dollars apply to Greek contracts that expect 10 euros, suddenly told that's going to be 10 drachmas, which are now worth 5 euros? Or do people in that circumstance focus on the euro value and treat the event exactly as they would being told that they are going to get 5 euros? Just how "sticky" will Greek nominal prices and wages be? Will the political constituencies be who don't want explicit euro cuts be mollified if they are paid in Drachma instead?  It's not obvious!

Here I'm willing to offer my Keynesian colleagues a friendly wager: Let's look at Greece 6 months after Drachma introduction and swift devaluation. I bet it will be a continuing basket case, and that Greece won't be exporting lots of Porsches back to Germany. If return to the Drachma and devaluation produce a swiftly growing Greece based on a hot export sector, well, I'll at least say I was wrong. No, you don't get to say it's awful but it would have been worse otherwise.

Leaving the Euro

I find all the reporting of the Greek (and following Spanish, Italian, etc.) debt crisis unbelievably frustrating.

Why does everyone equate Greece defaulting on its debt with Greece leaving or being kicked out of the euro? The two steps are completely separate. If Illinois defaults on its bonds, it does not have to leave the dollar zone -- and it would be an obvious disaster for it to do so. 

It is precisely the doublespeak confusion of sovereign default with breaking up a currency union which is causing a lot of the run.

It's pretty clear that if Greece leaves the Euro and reintroduces the Drachma, that event will come with capital controls, swift devaluation, effective expropriation of savings, and a disastrous and chaotic rewriting of all private contracts (do I have to pay this bill in Euros or Drachmas? Every contract ends up in court. Greek court.) 

Quiz: If your politicians are even talking about this sort of thing (together with "austerity" which is heavy on higher capital taxation) what do you do? Answer: take your money out of the banks, now.  Take everything that is not bolted down and leave.

Just talking about leaving the Euro is How To Start a Bank Run 101.

The right step is the opposite: firmly announce and commit as much as possible that Greece (and Italy, Spain, etc.) will not leave the euro.

Precommitment is hard, but a good first step is to make it clear you know the action you're trying to commit not to do will hurt you.  Communicating a commitment not to have dessert is hard. Communicating a commitment not to shoot yourself in the foot should be easier. Start by not saying  that shooting yourself in the foot will taste good.

Politicians need to repeat over and over again that they understand a default does not mean euro exit -- that the two steps are completely separate decisions; that a currency union with sovereign default is perfectly possible.

Them they need to articulate just what a disaster leaving the Euro will be. They need to say they will tolerate sovereign default, bank failures, and drastic cuts in government payments rather than breakup.

Yes, cuts. The question for Greece is not whether it will cut payments. Stimulus is off the table, unless the Germans feel like paying for it, which they don't. The question for Greece is whether, having promised 10 euros, it will pay 10 devalued drachmas or 5 actual euros. The supposed benefit of euro exit and swift devaluation is the belief that  people will  be fooled that the 10 Drachmas are not a "cut" like the 5 euros would be. Good luck with that.

Think what would happen if, in order for Illinois or California to solve their debt,  pension and benefits debacles, they decided to leave the dollar zone, institute capital controls, redenominate all bank accounts and private contracts in their borders, and devalue. Plus big wealth taxes. Now they can tell their pensioners, "see, we didn't cut your benefits after all." Would the pensioners be fooled? Would this set of steps make them more competitive? And if Illinois or California politicians started talking about this sort of thing, how fast would the bank run start?

A Greek departure would also be disastrous for the rest of Euroland. Yes, Greece is small. But  people with bank accounts in Spain or Italy would see clearly that their leaders do not understand sovereign default can coexist with a currency union. The run starts. Sorry, intensifies.  Greece is a huge precedent.  

Austerity, Stimulus, or Growth Now?

(This is also a Bloomberg "Business class" column, with minor improvements.)

Austerity isn't working in Europe. Greece is collapsing, Italy and Spain’s output is declining, and even Germany and the U.K. are slowing down. In addition to its direct economic costs, these “austerity” programs aren't even swiftly closing budget gaps. As incomes decline, tax revenue drops, and it is harder to cut spending. A downward spiral looms.

These events have important lessons for the U.S. Our government cannot forever borrow and spend 10 percent of gross domestic product each year, with an impending entitlements fiasco to boot. Sooner or later, we will have to fix our finances, too.  Europe's experience is a warning that austerity -- a program of sharp budget cuts and (even) higher tax rates, but largely putting off “structural reforms” for a sunnier day -- is a dangerous path.

Why is austerity causing such economic difficulty? What else should we do?


Lack of “stimulus” is the problem, say the Keynesians, epitomized by the New York Times and its columnist Paul Krugman, who has been crusading on this point. They claim that falling output in Europe is a direct consequence of declining government spending. Yes, 50 percent of GDP spent by the government is simply not enough to keep their economies going. They -- and we -- just need to spend more. A lot more.

Where will the money come from? Greece, Spain and Italy simply cannot borrow any more. So, say the Keynesians, Germany should pay. But even Germany has limits. The U.S. can still borrow at remarkably low rates, they point out. But remember that Greece was able to borrow at low rates right up to the moment that it couldn’t borrow at all. There is nobody to bail out the U.S. when our time comes. What should we do then?

The traditional Keynesian answer was: move on to monetary stimulus. Deliberately inflate and devalue. Break up the euro so the southern European countries can inflate and devalue even more.

Lately, Keynesians have been pushing an even more audacious idea: deficits pay for themselves. In a March 17 column, Krugman wrote: “there’s a plausible case that spending more now actually improves the long-run fiscal picture.”

U.S. Federal revenue is less than 20 percent of GDP. For deficit spending to pay for itself, then, $1 of spending must create more than $5 of output. Economists have been arguing about whether this “multiplier” is more or less than one; five is beyond any reported estimate. Keynesians made fun of “supply siders” in the 1980s, who made similar claims for tax cuts. At least those cuts had incentives on their side, which stimulus doesn't.

Is there another explanation, and a more plausible way forward?

The stimulus explanation is curious for what it omits. Think of Greece. Is it irrelevant that Greece is 100th on the World Bank’s “ease of doing business” list, behind Yemen, 135th on “starting a business” and 155th on “protecting investors?” Is it irrelevant that professions from truck driving to pharmacies are still rigorously protected, that businesses can’t fire people, that (according to a Greek colleague) you can’t even get a driver’s license without paying a bribe? Does it not matter at all that, as the International Monetary Fund delicately put it in its latest report on Greece, the “structural reform program” aimed at “deeply ingrained structural rigidities in labor, product, and service markets” got nowhere?

Does it not matter that Greece has a high combination of individual, corporate, wealth and social taxes, higher still under "austerity?" True, Greeks famously don’t pay taxes, but businesses that must operate illegally to avoid taxes are much less efficient.

Money is fleeing Greece, Italy and Spain. Does talk of exiting the euro, followed quickly by devaluation, inflation (the IMF predicts 35 percent in Greece, should it leave), and capital controls, have nothing to do with lack of investment?

Keynesians urge devaluation to gain competitiveness. Greek wages have in fact declined about 10 to 12 percent, according to the IMF -- so much for the impossibility of nominal wage declines. Yet investment and production aren’t turning around. Greek “demand” needn’t matter -- the whole point of the euro area is that Greece can sell to Germany, so long as Greece stays in the Eurozone. But it isn't happening. Is that a mystery? Would lower wages compel you to invest money in Greece, surmount a thicket of regulation, expose yourself to the threats of wealth, property and business taxation, currency expropriation and capital controls, or even nationalization?

In sum, isn't it plausible that a good part of Europe’s austerity doldrums are linked to “supply,” not “demand,” “microeconomics” not “macroeconomics,” weeds in the economic garden, not a want of fertilizer? Isn't it plausible that factors beyond simple declines in government spending matter in the economy’s response to a debt crisis?

That insight suggests a different strategy: Let’s call it “Growth Now.” Forget about “stimulating.” Spend only on what is really needed. We could easily stop subsidies for agriculture, electric cars or building roads and bridges to nowhere right now, without fearing a recession. Most "spending" is in fact transfer payments, which even Keynesian economics recognizes are not very stimulative, not the mythical (and curiously carbon-intensive)  roads and bridges, and most of that goes to people who are relatively well off

Rather than raise tax rates further on “wealth” and the “rich,” driving them underground, abroad, or away from business formation, fix the tax code, as every commission has recommended. Lower marginal rates but eliminate the maze of deductions. In Europe, eliminate the fears of wealth confiscation, euro breakup and currency devaluation that are driving saving and investment out of the south.

Most of all, remove the profusion of regulation and (increasingly) direct government management of the economy.

Growth is the key to paying off debts. The only way to escape large debt/GDP ratios is to embark on a decade or more of solid  growth. Growth like this comes from long-run productivity, not short-run stimulus. 

Europe is beginning to figure this out. Italy’s prime minister, Mario Monti, is addressing his country’s debt crisis by proposing far-reaching deregulation, now. While his proposals aren't complete or close to radical enough, and they are combined with some unfortunate business-stifling tax increases, it’s remarkable that anyone in Europe is beginning to talk about this approach.

“Structural reform” is vital to restore growth now, not a vague idea for many years in the future when the stimulus has worked its magic. Europe learned that it’s also a lot harder politically than the breezy language suggests. “Reform” isn’t just “policy” handed down by technocrats like rules on the provenance of prosciutto; it involves taking away subsidies and interventions that entrenched interests have grown to love, and support politicians to protect. They will fight it tooth and nail.

That is even more reason to address growth now, while there is a crisis. The will to do so will evaporate if better times return, and the ability to do so will disappear if the economies plunge.

To London

I'll be at the Booth campus in London next Monday March 12 as part of a panel discussion with Francesco Garzzarelli and Charles Goodhart on "Financial Stability and the Macroeconomy," sponsored by the Becker-Friedman Institute. More information on the event here. Presuming, of course, that the fact that Greece has finally defaulted doesn't mean the end of the world, as so many predicted. Ex-students, colleagues, and blog readers, if you come to the event, stop and say hi.