Tag: europe

Pain Is the Agenda: The Method in the ECB’s Madness

Krugman is puzzled by the European Central Bank:

I’ve been hearing various attempts to explain the ECB’s utterly bizarre refusal to cut interest rates… The most popular story seems to be that the ECB wants to “hold politicians’ feet to the fire”, letting them know that they won’t get relief unless they do what’s necessary (whatever that is). This really doesn’t make any sense. If we’re talking about enforcing austerity and wage cuts in the periphery, how much more incentive do these economies need?

He is certainly right that if the goal is resolving the crisis, or even price stability, then refusing further rate cuts is mighty strange. But who says those are the goals? His final question is meant to be rhetorical, but it really isn’t. Because the more austerity you want, the more enforcement you need.

I met someone the other day with a fairly senior position at the Greek tax authority; her salary had just been cut by 40 percent. When, outside of an apocalyptic crisis, do you see pay cuts like that? Which, for you or me or Paul Krugman, is an argument to End This Depression Now. But if you are someone who sees pay cuts as the goal, then it could be an argument for not quite yet.

It’s a tenet of liberalism — and a premise of the conversation Krugman is part of — that there are conflicting opinions, but not conflicting interests. But sometimes, when people seem to keep doing things with the wrong outcome, it’s because that’s the outcome they actually want. Paranoid? Conspiracy theory? Maybe. On the other hand, here’s Deutsches Bundsbank president Jens Weidmann:

Relieving stress in the sovereign bond markets eases imminent funding pain but blurs the signal to sovereigns about the precarious state of public finances and the urgent need to act. Macroeconomic imbalances and unsustainable public and private debt in some member states lie at the heart of the sovereign debt crisis. It may appeal to politicians to abstain from unpopular decisions and try to solve problems through monetary accommodation. However, it is up to monetary policymakers to fend off these pressures.

That seems pretty clear. From the perspective of the central banker, resolving the crisis too painlessly would be bad, because that would allow governments to “avoid unpopular decisions.” And it’s true: If there’s something you really want governments to do, but you don’t think they will make the necessary decisions except in a crisis, then it is perfectly rational to prolong the crisis until you see the right decisions being made.

So, what kind of decision are we talking about, exactly? Krugman professes bafflement — “whatever that is” — but it’s not really such a mystery. Here’s an editorial in the FT on the occasion of last summer’s ECB intervention to support the market for Italy’s public debt:

Structural reform is the quid pro quo for the European Central Bank’s purchases last week of Italian government bonds, an action that bought Italy breathing space by driving down yields. … As the government belatedly recognises, boosting Italy’s growth prospects requires a liberalisation of rigid labour markets and a bracing dose of competition in the economy’s sheltered service sectors. This is where the unions and professional bodies must play their part. Susanna Camusso, leader of the CGIL, Italy’s biggest trade union, is threatening to call a general strike to block the proposed labour law reforms. She would be better advised to co-operate with the government and employers… The government’s austerity measures are sure to curtail economic growth in the short run. Only if long overdue structural reforms take root will the pain be worthwhile.

A couple of things worth noting here. First the explicit language of the quid pro quo — the ECB was not just doing what was needed to stabilize the Italian bond market, but offering stabilization as a bargaining chip in order to achieve its other goals. If ECB was selling expansionary policy last year, why be surprised they’re not giving it away for free today? Note also the suggestion that a sacrifice of short-term output is potentially worthwhile — this isn’t some flimflam about expansionary austerity, but an acknowledgement that expansion is being give up to achieve some other goal. And third, that other goal: Everything mentioned is labor market reform, it’s all about concessions by labor (including professionals). No mention of more efficient public services, better regulation of the financial system, or anything like that.

The FT editorialist is accurately presenting the ECB’s view. My old teacher Jerry Epstein has a good summary at TripleCrisis of the conditions for intervention; among other things, the ECB demanded “full liberalisation of local public services…. particularly… the provision of local services through large scale privatizations”; “reform [of] the collective wage bargaining system … to tailor wages and working conditions to firms’ specific needs…”;  “thorough review of the rules regulating the hiring and dismissal of employees”; and cuts to private as well as public pensions, “making more stringent the eligibility criteria for seniority pensions” and raising the retirement age of women in the private sector. Privatization, weaker unions, more employer control over hiring and firing, skimpier pensions. This is well beyond what we normally think of as the remit of a central bank.

So what Krugman presents as a vague, speculative story about the ECB’s motives — that they want to hold politicians’ feet to the fire — is, on the contrary, exactly what they say they are doing.

It’s true that the conditions imposed by the ECB on Italy and Greece were in the context of programs relating specifically to those countries’ public debt, while here we are talking about a rate cut. But there’s no fundamental difference — cutting rates and buying bonds are two ways of describing the same basic policy. If there’s conditions for one, we should expect conditions for the other, and in fact we find the same “quid pro quo” language is being used now as then.

Here’s a banker in the FT:

The future of Europe will therefore be determined by the interests of the ECB. Self-preservation suggests that it will prevent complete collapse. If necessary, it will overrule Germany to do this, as the longer-term refinancing operations and government bond purchase programme suggest. But self-preservation and preventing collapse do not amount to genuine cyclical relief and policy stimulus. Indeed, the ECB appears to believe that in addition to price stability it has a mandate to impose structural reform. To this extent, cyclical pain is part of its agenda.

Again, there’s nothing irrational about this. If you really believe that structural reform is vital, and that democratic governments won’t carry it out except under the pressure of a crisis, then what would be irrational would be to relieve the crisis before the reforms are carried out. In this context, an “irrational” moralism can be an advantage. While one can take a hard line in negotiations and still be ready to blink if the costs of non-agreement get too high, it’s best if the other side believes that you’ll blow it all up if you don’t get what you want.  Fiat justitia et pereat mundus, says Martin Wolf, is a dangerous motto. Yes; but it’s a strong negotiating position.

But this invites a question: Why does the ECB regard labor market liberalization (aka structural reform) as part of its mandate? Or perhaps more precisely, when the ECB negotiates with national governments, on whose behalf is it negotiating?

The answer the ECB itself might give is, society as a whole. After all, this is the consensus view of central banks’ role. Elected governments are subject to time inconsistency, or are captured by rent seekers, or just don’t work, so an “independent” body is needed to take the long view. It’s never been clear why this should apply only to monetary policy, and in fact there’s a well-established liberal view that the independent central bank model should be extended to other areas of policy. Alan Blinder:

We have drawn the line in the wrong place, leaving too many policy decisions in the realm of politics and too few in the realm of technocracy. … the argument for the Fed’s independence applies just as forcefully to many other areas of government policy. Many policy decisions require complex technical judgments and have consequences that stretch into the distant future. Think of decisions on health policy (should we spend more on cancer or aids research?), tax policy (should we reduce taxes on capital gains?), or environmental policy (how should we cope with damage to the ozone layer?). Yet in such cases, elected politicians make the key decisions. Why should monetary policy be different? … The justification for central bank independence is valid. Perhaps the model should be extended to other arenas. … The tax system would surely be simpler, fairer, and more efficient if … left to an independent technical body like the Federal Reserve rather than to congressional committees.

I’m sure there are plenty of people at the ECB who think along the same lines as the former Fed Vice-Chair. Indeed, that central banks want what’s best for everyone is practically an axiom of modern economics. Still, it’s funny, isn’t it, that “structural reform” so consistently turns out to mean lower wages?

Martin Wolf’s stuff on the European crisis has been essential. But it has one blind spot: The only conflicts he sees are between nations. What perplexes him is “the riddle of German self-interest.” But maybe the answer to the riddle is that national interests are not the only ones in play.

It’s hard not to think here of Perry Anderson’s thesis, developed (alongside other themes) in The New Old World, that the EU project is fundamentally a response by European elites to their inability to roll back social democracy at the national level. The new supra-national institutions of the EU have allowed them to bypass political cultures that remain stubbornly (if incompletely) egalitarian and solidaristic. In Alain Supiot’s summary:

In Anderson’s view, the European project has engendered neither a federation nor an intergovernmental organization; rather it is the most fully realized form of Hayek’s ultraliberal ‘catallaxy’. … Like a secular version of faith in divine providence, belief in the spontaneous order of the markets entails a desire to protect it from the untimely interventions of people seeking ‘a just distribution’ which, according to Hayek, is nothing more than ‘an atavism, based on primordial emotions’. Hence the need to ‘dethrone the political’ by means of constitutional steps which create ‘a functioning market in which nobody can conclusively determine how well-off particular groups or individuals will be’. In other words, it is necessary to put the division of labour and the distribution of its fruits beyond the reach of the electorate. This is the dream that the European institutions have turned into a reality. Beneath the chaste veil of what is conventionally known as the EU’s ‘democratic deficit’ lies a denial of democracy.

Jerry Epstein puts it more bluntly. The ECB’s insistence on structural reform “represents a cynical raw power calculus to destroy worker and citizen protections  without any real belief in the underlying neo-liberal economics they use to justify it.” (If you prefer your political economy in audiovisual form, he has a video talking about this stuff.)

This kind of language makes people uncomfortable. Rather than acknowledge that the behavior of people in power could represent a particular interest — let alone that of the top against the bottom, or capital against labor — much better to throw your hands up and profess bafflement: their choices are “bizarre,” a “riddle.” This isn’t, let’s be clear, a personal failing. If you or I occupied the same kind of positions as Krugman or Wolf, we’d be subject to the same constraints. And I anyway don’t want to find myself talking to no one but a handful of grumpy old Marxists.

But on the other hand, as Doug Henwood likes to quote our late friend Bob Fitch, “vulgar Marxism explains 90 percent of what happens in the world.” And then, I keep looking back through FT articles on the crisis, and finding stuff like this:

The central bank has long called for eurozone economies to press ahead with structural reforms. That the ‘E’ in EMU, or Economic and Monetary Union, has not occurred is a complaint often voiced by ECB officials. On this score, the central bank has managed to win an important concession in forcing Italy to sign up to liberalising its economy. Some may see this as a pyrrhic victory for the damage that the bond purchases have done to the central bank’s independence. But there was a significant threat to stability if the central bank did not act. …That Mr Trichet, always among the more politically savvy of central bankers, managed to get some concessions on structural reform was all that could be hoped for.

One has to wonder: What does it mean for the ECB to “win an important concession” from an elected government? Who is it winning the concession for? And if the problem with the ECB is just an ideological fixation on its inflation-fighting credibility, why would it be willing to sacrifice some of that credibility to advance this other goal?

It’s hard to suppress a lingering suppression that central bankers are, after all, bankers. And then you think, isn’t there an important sense in which finance embodies the interests of the capitalist class as a whole? (In an anodyne way, this is even sort of what its conventional capital-allocation function means) You wonder if the only reason Karl Marx called “the modern executive is a committee for managing the common affairs of the whole bourgeoisie,” is that central banks didn’t yet exist.

Imagine you’re a European capitalist, or business owner if you prefer the sound of that. You look at the United States and see the promised land. Employment at will — imagine, no laws limiting your ability to fire whoever you want. Private pensions, gone. Unions almost gone, strikes a thing of the past. Meanwhile, in 2002, 95 out of every 1,000 workers in the Euro area — nearly ten percent — was on strike at some point during the year. (In Spain, it was 270 out of every 1,000. In Italy, over 300.) And of course there’s the vastly greater share of income going to your American peers. Look at it from their point of view: Why wouldn’t they want what their American cousins have?

It seems to me that what would really be bizarre, would be if European capitalists did not see the crisis as a once-in-a-lifetime opportunity. They’d be crazy — they’d be betraying their own interests — if, given the ECB’s suddenly increased power vis-a-vis national governments, they didn’t insist that it extract all the concessions it can.

Isn’t that what they’re doing? Moreover, isn’t it what they say they’re doing? When the “Global Head of Market Economics” at the world’s biggest bank says that the ECB should only cut rates “as part of a quid pro quo with governments agreeing to more far-reaching structural reform,” what do you think he means?

Prices and the European Crisis, Continued

In comments to yesterday’s post on exchange rates and European trade imbalances, paine (the e. e. cummings of the econosphere) says,

pk prolly buys your conclusion. notice his post basically disparaging forex adjustment solutions on grounds of short run impact. but long run adjustment requires forex changes.

I don’t know. I suppose we all agree that exchange rate changes won’t help in the short run (in fact, I’m not sure Krugman does agree), but I’m not convinced exchange rate changes will make much of a difference even in the long run; and anyway, it matters how long the long run is. When the storm is long past the ocean is flat again, and all that.

Anyway, what Krugman actually wrote was

We know that huge current account imbalances opened up when capital rushed to the European periphery after the euro was created, and reversing those imbalances must involve a large real devaluation.

We “know,” it “must”: not much wiggle room there.

So this is the question, and I think it’s an important one. Are trade imbalances in Europe the result of overvalued exchange rates in the periphery, and undervalued exchange rates in the core, which in turn result from the financial flows from north to south after 1999? And are devaluations in Greece and the other crisis countries a necessary and sufficient condition to restore a sustainable balance of trade?

It’s worth remembering that Keynes thought the answer to these kinds of questions was, in general, No. As Skidelsky puts it in the (wonderful) third volume of his Keynes biography, Keynes rejected the idea of floating exchange rates because

he did not believe that the Marshall-Lerner condition would, in general, be satisfied. This states that, for a change in the value of a country’s currency to restore equilibrium in its balance of payments, the sum of the price elasticities for its exports and imports must be more than one. [1] As Keynes explained to Henry Clay: “A small country in particular may have to accept substantially worse terms for its exports in terms of its imports if it tries to force the former by means of exchange depreciation. If, therefore, we take account of the terms of trade effect there is an optimum level of exchange such that any movement either way would cause a deterioration of the country’s merchandise balance.” Keynes was convinced that for Britain exchange depreciation would be disastrous…

Keynes’ “elasticity pessimism” is distinctly unfashionable today. It’s an article of faith in open-economy macroeconomics that depreciations improve the trade balance, despite rather weak evidence. A recent mainstream survey of the empirical literature on trade elasticities concludes,

A typical finding in the empirical literature is that import and export demand elasticities are rather low, and that the Marshall-Lerner (ML) condition does not hold. However, despite the evidence against the ML condition, the consensus is that real devaluations do improve the balance of trade. 

Theory ahead of measurement in international trade!

(Paul Davidson has a good discussion of this on pages 138-144 of his book on Keynes.)

The alternative view is that the main relationship is between trade flows and growth rates. In models of balance-of-payments-constrained growth, countries’ long-term growth rates depend on the ratio of export income-elasticity of demand and import income-elasticity of demand. More generally, while a strong short-run relationship between exchange rates and trade flows is clearly absent, and a long-run relationship is mostly speculative, the relationship between faster growth and higher imports (and vice versa) is unambiguous and immediate. [2]

So let’s look at some Greek data, keeping in mind that Greece is not necessarily representative of the rest of the European periphery. The picture below shows Greece’s merchandise and overall trade balance as percent of GDP (from the WTO; data on service trade is only available from 1980), the real exchange rate (from the BIS) and real growth rate (from the OECD; three-year moving averages). Is this a story of prices, or income?

The first thing we can say is that it is not true that Greek deficits are a product of the single currency.  Greece has been running substantial trade deficits for as far back as the numbers go. Second, it’s hard to see a relationship between the exchange rate and trade flows. It’s especially striking that the 20 percent real depreciation of the drachma from the late 1960s to the early 1970s — quite a large movement as these things go — had no discernible effect on Greek trade flows at all. The fall in income since the crisis, on the other hand, has produced a very dramatic improvement in the Greek current account, despite the fact that the real exchange rate has appreciated slightly over the period. It’s very hard to look at the right side of the figure and feel any doubt about what drives Greek trade flows, at least in the short run.

Now, it is true that, prior to the crisis, the Euro era was associated with somewhat larger Greek trade deficits than in earlier years. (As I mentioned yesterday, this is entirely due to increased imports from outside the EU.) But was this due to the real appreciation Greece experienced under the Euro, or to the faster growth? It’s hard to judge this just by looking at a figure. (That’s why God gave us econometrics — though to be honest I’m a bit skeptical about the possibility of getting a definite answer here.) But here’s a suggestive point. Greece’s real exchange rate appreciated by 25 percent between 1986 and 1996. This is even more than the appreciation after the Euro. Yet that earlier decade saw no growth of the Greek trade deficit at all. It was only when Greek growth accelerated in the early 2000s that the trade deficit swelled.

I think Yanis Varoufakis is right: It’s hard to see exit and devaluation as solutions for Greece, in either the short term or the long term. There are good reasons why, historically, European countries have almost never let their exchange rates float against each other. And it’s hard to see fixed exchange rates, in themselves, as an important cause of the crisis.

[1] Skidelsky gives the Marshall-Lerner condition in its standard form, but the reality is a bit more complicated. The simple condition applies only in cases where prices are set in the producing country and fully passed through to the destination country, and where trade is initially balanced. Also, it should really be the Marshall-Lerner-Robinson condition. Joan Robinson was robbed!

[2] Krugman wrote a very doctrinaire paper years ago rejecting the idea of balance of payments constraints on growth. I’ve quoted this here before, but it’s worth repeating:

I am simply going to dismiss a priori the argument that income elasticities determine economic growth, rather than the other way around. It just seems fundamentally implausible that over stretches of decades balance of payments problems could be preventing long term growth… Furthermore, we all know that differences in growth rates among countries are primarily determined by differences in the rate of growth of total factor productivity, not by differences in the rate of growth of employment. … Thus we are driven to supply-side explanations…
The Krugmans and DeLongs really have no one to blame but themselves for accepting that all the purest, most dogmatic orthodoxy was true in the long run, and then letting long-run growth take over the graduate macro curriculum.

UPDATE: I should add that as far as the trade balance is concerned, what matters is not just a country’s growth, but its growth relative to its trade partners. This may be why rapid Greek growth in the 1970s was not associated with a worsening trade balance — this was the trente glorieuse, when all the major European countries were experiencing similar income growth. Also, in comments, Random Lurker points to a paper suggesting that another factor in rising Greek imports was the removal of tariffs and other trade restrictions after accession to the EU. I haven’t had time to read the paper properly yet, but I wouldn’t be surprised if that is an important part of the story.

Also, I was discussing this at the bar the other night, and at the end of the conversation my very smart Brazilian friend said, “But devaluation has to work. It just has to.” And she knows this stuff far better than I do, so, maybe.

Do Prices Matter? EU Edition

The Euro crisis. One thing sensible people agree on is that the crisis has little or nothing to do with fiscal deficits  (government borrowing), and everything to do with current account deficits (international borrowing, whether public or private.) And one thing sensible people do not agree on, is how much those current account deficits are due to relative costs, or competitiveness.

A thorough dissection of competitiveness in the European context is here; Merijn Knibbe has some good posts critiquing it at the Real World Economics Review. Krugman, on the other hand, defends the competitiveness story, suggesting that the alternative to believing that relative prices drive trade flows, is believing in the “doctrine of immaculate transfer.” What he means is, the accounting identity that net capital flows equal net trade flows doesn’t in itself provide the mechanism by which trade adjusts to financial flows. A country with an increasing net financial inflow must, in an accounting sense, experience an increasing current account deficit; but you still need a story about why people choose to buy more from, or are able to sell less to, abroad.
So far, one can’t disagree; but the problem is, Krugman assumes the story has to be about relative prices. It’s not the case, though, that relative prices are the only thing that drive trade flows. At the least, incomes do too. If German wages fall, German goods may become more cost-competitive; but in any case, German workers will buy less of everything, including vacations in Greece. Similarly, if Greek wages rise, Greek goods may be priced out of international markets; but in any case Greek workers will buy more of everything, including manufactured goods from Germany. Estimating the respective impacts of relative prices and incomes on trade flows, or the elasticities approach, is one of the lost treasures of the economics of 1978. Both income and price elasticities solve the immaculate transfer problem, since capital flows from northern to southern Europe were associated with faster growth of both income and prices in the south. But their implications for policy going forward are quite different. If the problem is relative prices, a devaluation will fix it; this is what Krugman believes. If the problem is income elasticities, on the other hand, then balanced trade within Europe will require some mix of structural reforms (easier said than done), permanently faster growth in the north than the south, or — blasphemy! — restrictions on trade.
Let’s pose two alternatives, understanding that the truth, presumably, is somewhere in between. In the one case, EU current account imbalances are due entirely to countries’ over- or undervalued currencies. In the other case, current account imbalances are due entirely to differences in growth rates. One thing we do know: In the short run — a year or two — the latter is approximately true. In the short run, the Marshall-Lerner-Robinson condition is almost certainly not satisfied, so a change in prices will have the “wrong” effect on foreign exchange earnings, or at best — if the country’s imports and exports are both priced in foreign currency — have no effect. In the long run, it’s less clear. Do prices or incomes matter more? Hard to say.
So what is the evidence one way or the other? One simple suggestive strand of evidence is the intra- and extra-European trade balances of various countries in the EU. To the extent that trade flows have been driven by price, the deficit countries should have seen larger deficits with other EU countries than with other countries, and the surplus countries similarly should have seen larger surpluses within the union than outside it. Those countries whose currencies would otherwise, presumably, have appreciated relative to other EU members should have shifted their net exports towards Europe; those countries whose currencies would otherwise have depreciated should have shifted their net exports away. Is that what we see?
As is often the case with empirical work, the answer is: Yes and no. From Eurostat, here are trade balances as percent of GDP, within and outside the currency union, for selected countries and selected years.
Intra-EU Trade Balance
1999 2007-2008 2011
Germany  2.0% 4.8% 2.1%
Ireland 19.0% 7.4% 12.6%
Greece -10.0% -9.6% -5.3%
Spain -2.9% -4.0% -0.6%
France -0.3% -3.1% -4.3%
Italy 0.5% 0.5% -0.2%
Netherlands 14.8% 24.5% 27.9%
Austria -3.9% -3.0% -5.0%
Extra-EU Trade Balance
1999 2007-2008 2011
Germany  1.2% 2.8% 4.0%
Ireland 6.1% 7.8% 15.1%
Greece -3.9% -9.1% -4.4%
Spain -2.1% -5.1% -3.8%
France 1.0% -0.1% 0.0%
Italy 0.8% -1.2% -1.4%
Netherlands -11.8% -17.5% -20.5%
Austria 1.4% 2.7% 1.9%
What we see here is sort of consistent with the competitiveness story, and sort of not. Germany did increase its intra-EU net exports about twice as much as its extra-EU net exports over the pre-crisis decade, just as a story centered on relative prices would predict. And on the flipside, the fall in Irish net exports over the pre-crisis decade was entirely with other EU countries, again consistent with the Krugman story. 
But for the other countries, it’s not so simple. The increase of the Euro-era Greek deficit, for instance, was entirely the result of increased imports from non-Euro countries. Euro-area trade, and non-Euro exports, were approximately constant in the ten years from 1999. This is more consistent with a story of rapid Greek income growth, than uncompetitively high Greek prices. Similarly, the movement toward current account deficit of Spain was mostly, and of Italy entirely, a matter of trade with non-EU countries. This is not consistent with the relative-price story, which predicts that intra-EU trade imbalances should have grown relative to extra-EU imbalances. Note also that today, Germany’s net exports to the rest of the EU area are no higher than when the Euro was created, while Greece and Spain have substantially improved their intra-EU balances; but all three countries have moved further toward imbalance with extra-EU countries. This, again, is not consistent with a story in which trade imbalances are driven primarily by the relative price distortions created by the single currency.
Conclusion: Krugman is right that how much relative prices have contributed to intra-European current account imbalances, is a question on which reasonable people can disagree. But as a doctrinaire Keynesian, I remain an elasticity pessimist. It seems to me that we should at least seriously consider a story in which European current account imbalances are due to relatively rapid income growth in the periphery, and slow income growth in Germany, as opposed to changes in competitiveness. A story, in other words, in which a Greek exit from the Euro and devaluation will not do much good.
UPDATE: While I was writing this, Merijn Knibbe had more or less the same thought.

Davies on the Disorder in Europe

My friend Jen writes about informal labor markets in South Africa. She was telling me the other day about street vendors who make their living buying packs of a dozen pairs of socks and selling them pair by pair. In that same spirit of finding a niche in the very last step of the distribution network, I thought I would pass on some material from a talk I attended last week by Sir Howard Davies. It’s below the fold, with occasional comments from me in brackets. A lot may seem familiar, but enough was new to me — and Davies is high enough up in this world; he’d had dinner the night before with Charles Dallara — that I think it’s worthwhile to put down my notes in full.

There are six and half questions to ask about the Euro system. Is the crisis over? Why did anyone think it would work? Why did it take so long to fall apart? Are the responses to date sufficient? What more is needed? Why even bother? And the half question, what’s it all mean for the UK?

To question 1, no surprise, the answer is No.  “The ECB has been making really good policy for a country that doesn’t exist.” The fundamental problem of pan-European banks with no pan-European regulator or lender of last resort is no closer to being resolved; “some sticking-plaster has been applied,” that’s all.

On question 2, there were three reasons:

Some people said, “Yes, you will need a fiscal authority, but it will happen.” Europe policy in general has developed through a process of leap forward, then retrofit. And after all, it says right in the treaty “Ever closer union.”

Other people thought the stability and growth pact would ensure appropriate policy.

A third group of people, including Davies, believed something like, “Yes, these economies are very different, with different labor market institutions and so on, but without the option of devaluation they will be forced to converge.” Periodic devaluations had allowed southern European countries to avoid structural reform, but now everyone would have to behave like the Germans.

Well, all these views were wrong. Why? Three reasons:

– Maastricht turned out to be the high point of enthusiasm for federalism. Every single vote on additional federalism has said, No.

– The SGP turned out to be both too tight, in that it didn’t leave enough space for countercyclical fiscal policy, and too loose, in that it had no enforcement mechanism. [So it sounds like Davies would be on board with John Quiggin’s “hard Keynesianism.”]

– Lower interest rates were not used for fiscal consolidation. [This seems wrong to me, at least for Italy and Spain.] And there was no convergence to German levels of productivity.

On question 3, the first answer was that the first decade of the euro was, in Mervyn King’s unfelicitous coinage, NICE — Non-Inflationary with Consistent Expansion. And the ECB, while prohibited from buying government bonds directly, bought them in secondary markets at equal rates, meaning there was no pressure for fiscal discipline on member states. [Again, I’m resistant to this story, except for Greece and maybe Portugal.] Davies recalls talking to a Morgan Stanley bond dude, explaining how he marketed Greek debt: “A Greek bond is just like a German bund, except with an extra three points of interest.” There was a real market failure here, says Davies, and the banks that ended up holding this stuff (all European, by the way, American institutions have successfully elimianted almost all their exposure) deserve their haircuts.

[It would be interesting to explore the idea that an unsustainable current account deficit is precisely one that can only be financed with an interest rate premium.]

Question 4, the adequacy of the response. “The problem is that they are focused on the last crisis and the next crisis, but not on the current crisis.” By which he means that they are putting in place rules that would have helped if they’d already been in place years ago, while ignoring the ways in which “responsible” fiscal policy will exacerbate the current downturn. The problem right now is that austerity just makes the growth picture worse, and that the European “rescue capacity” is too small.

Question 5, what more is needed. In the short run, a better firewall is needed to prevent contagion from the worst-hit countries and institutions. In the longer run, Europe needs (a) some system for Europe-wide public borrowing (one idea would be for debt up to, but not above, the SGP levels to be backed by the community as a whole); and (b) a pan-European bank regulator and lender of last resort. But the Germans won’t go for it.

Which brings us to Question 6. Wouldn’t some countries be better off leaving? Greece’s departure is probably inevitable, he said. But it poses major challenges — even if you had an agreed-on procedure for converting Greek euros to the new Greek currency, which euros are the Greek ones? “If the coin says Greece, no problem. Greek government bonds, ok, those are Greek. And if you are living in Greece and have an account in a Greek bank, then that is probably a Greek euro. But, I have a boat in Greece and an account at Barclay’s in Athens. Are those Greek euros? I hope not. How about someone living in Athens but with a bank account in London, is that a Greek euro?” And beyond those technical problems, there are even worse political problems, that should make exit the last possible resort. Because, who will benefit from the failure of the euro, politically? In France, the fascists — Marie le Pen based her whole campaign around it. “In Greece, it would be the anarchists and the communists, they’re the only ones who have been against the euro.” [OH NOES the anarchists.] The communists in Hungary, Sinn Fein in Ireland, etc. “Only in the UK can you say that the Euro-skeptics are not mad people.”

Nonetheless, Greek exit is probably unavoidable. “My hunch is that Greece will not make it,” because they lack social capital. The Irish are stoic, they will accept lower pay and higher taxes. They say, ah well, we had a good few years but it had to end. Not the Greeks, they won’t pay taxes. [There was a shaggy-dog story in here about local officials in Spain and Greece competing to see who can waste more EU money.] Gas costs $6 a gallon in Greece because it’s almost the only thing the government can reliably tax. “Latvia could make austerity work because they’d been in the USSR for 50 years, they were used to unpleasant and dramatic things happening. The population would accept incredible privation.” The Greek population, sadly, will not.

And on the last half question: If the solution is “more Europe,” that will be a big problem for the UK. Cameron is a Euro-skeptic; it’s not just because he’s responding to popular opinion, but nonetheless popular opinion is heading that way. The UK is going to face increasing pressure to detach itself from the EU.

And a few other observations, from the Q&A:

“You can’t imagine Italy having an unelected government for long, but they are urgently engaged in some necessary reforms that would otherwise be impossible.”

There has never been a referendum in favor of the euro.

German wages have not gone up, German property values have not gone up, why should ordinary Germans feel like they are the beneficiaries of the euro and want to do more to save it? [Sounds like an argument for Thomas Jørgensen’s “Drink finer wines, drive nicer cars, and party harder!” platform.]

Most likely, Greece will have a disorderly exit, and that will concentrate the minds of European policymakers to take the necessary steps to prevent a repeat. Avoiding future defaults will require some kind of collective guarantee of Euro-area bonds, but Germans won’t accept that until it’s clear that the altenrative is catastrophe. So, “Greece may have to perform this service.”

The alternative is for Greece to do what Latvia did, structural reforms, get rid of anti-competitive policies. The problem is, you don’t have a full technocratic government in Greece, you still have elected officials with real power. [And that, I think, is what it all comes down to.]

I Was Born on the Wrong Continent

… because I want to vote for this guy:

François Hollande, the leading challenger for the French presidency, has described the banking industry as a faceless ruler and his “true adversary”. As he launched in earnest his campaign to become France’s first socialist head of state since the mid-1990s, Mr Hollande said he would seek a Franco-German treaty to overturn the “dominance of finance” and re-orient Europe towards growth and big industrial projects.

At a rally on the outskirts of Paris in front of thousands of supporters on Sunday afternoon, he said: “My true adversary does not have a name, a face, or a party. He never puts forward his candidacy, but nevertheless he governs. My true adversary is the world of finance.” … Mr Hollande promised, if elected, to separate the investment activities of French banks from their other operations, ban them from tax havens and establish a “public” credit ­rating agency for Europe. He also promised higher taxes for people earning more than €150,000 a year and attacked the “new aristocracy” of today’s super-rich. A financial transaction tax would be introduced, with France acting with other European countries willing to participate….

In a powerful speech that advisers said he had written himself over the weekend, the socialist candidate came out fighting, looking to make an impression on the broader French public by taking aim at some carefully chosen national bêtes noires. These included globalisation, unemployment and shrinking domestic industry. But uppermost were bankers….

“I have always followed the line on which I was fixed,” he said. “I am a socialist. The left did not come to me through heritage. It was necessary for me to move towards it.”

Certain leftists I know will say this is just populist bluster, that nothing is finance’s fault, and that this kind of language is just a distraction from genuine radical politics. But it’s not all bluster: As Arin D. points out, French bankers seem to have been born on the wrong continent, too.

 Maybe we can arrange a swap?

Is There Really a European Sovereign Debt Crisis?

The past few months have seen a flurry of articles warning that the next stage of the financial crisis will be a flight from sovereign debt, specifically in the European periphery. Even people who don’t believe in confidence fairies when it comes to the US or the UK accept the conventional wisdom that financing the deficit of the PIIGS countries (Portugal, Ireland, Italy, Greece and Spain) is a problem — that there is simply no way to convince the public to hold the amount of debt these countries will have to issue in the absence of austerity. For these countries, it’s sadly conceded, in the absence of the option of devaluation the hard exigencies of the bond market leaves them no choice but slash spending and force down wages. But is it true? Here are the relevant debts and deficits, in billions of euros (not percent of GDP, for reasons that will be clear in a moment.)
General Government Debt and Net Borrowing

2010 2009 2008
Greece Net debt 259 230 199
Net borrowing 19 32 18
Ireland Net debt 86 58 41
Net borrowing 28 23 13
Italy Net debt 1542 1473 1395
Net borrowing 80 80 42
Portugal Net debt 135 121 105
Net borrowing 12 16 5
Spain Net debt 1051 1054 1088
Net borrowing 97 118 44
PIIGS Net debt 3073 2936 2828
Net borrowing 236 269 122

Source: IMF, World Economic Outlook (General government here includes all levels of government; “net” means that intra-government borrowing is excluded.) As we can see, deficits approximately doubled in the PIIGS countries between 2008 and 2009, and stabilized in 2010. But how big are these deficits? Are they, for example, big compared with the balance sheet of the European Central Bank?
ECB Assets (billions of euros)

4th week of October of…
2010 2009 2008 2007 2006 2005
Euro-area bank loans 547 701 831 451 444 389
Euro-area securities 471 361 153 133 121 133
Total assets 1878 1786 1958 1249 1119 999

Source: ECB, Weekly Financial Statements In passing, it’s interesting how different the balance sheet of the ECB looks from the Fed’s especially before the crisis. While the asset side of the Fed’s balance sheet, at least until three years ago, consists almost entirely of treasury bills, the ECB has more lending to banks, much more foreign exchange reserves, much more gold (about 10 percent of its pre-crisis assets!) and relatively little in the way of securities. For present purposes, though, two points stand out. First, the ECB increased its security holdings by E320 billion over the past two years, or E160 billion a year. This is equal to two-thirds of the total annual borrowing of the PIIGS countries. So in principle the ECB would only have to increase its current rate of securities purchases by 50 percent to meet the entire borrowing needs of the five threatened countries. Second, looking now at stocks rather than flows, the ECB increased its balance sheet about about 1 trillion euros between 2005 and 2008. Another similar increase would allow the ECB to purchase one-third of the entire outstanding debt of the PIIGS countries. Interestingly, this is very similar to the increase in the Fed’s balance sheet over the same period. More to the point, it’s well within the range that has been suggested as an appropriate size for a second round of quantitative easing (QE2). Now, I’m not suggesting that the ECB should actually finance all new borrowing by ECB countries facing crises, or try to monetize a substantial portion of their existing debt. For one thing, there’s no need to; presumably even modest additional purchases would be enough to convince private actors to hold the debt at a reasonable price, if the ECB made it clear it stood ready to do more. I’m just saying that the frequently-heard argument that the governments of Southern Europe are “too big to save” isn’t obviously true. It seems more likely that any European QE2 — quantitative easing in its current use, remember, just means big central bank purchases of long-dated government debt — that had appreciable macroeconomic effects would be more than enough to solve the sovereign debt problem as well. Of course people (or their equivalents in the world of respectable business opinion) get very upset when you suggest that a government debt problem can be solved by just monetizing it. Oh, they say, but that’s inflationary. Maybe; but in the current context that’s an argument for it, rather than against it. And given that the 2005-2008 expansion of the ECB balance sheet didn’t produce any noticeable upward pressure on prices, it;s hard to see why another comparable one would. OK, they say, but what about the incentives? Why should governments ever show fiscal discipline if they know the ECB will just bail them out when they get in trouble? And there’s the heart of the matter, I think. It’s not that Greece, Spain, and the rest need tough austerity because they can’t be bailed out; rather, they won’t be bailed out in order to force them to implement austerity. The metaphor you sometimes see for the European sovereign debt situation is of mountain climbers roped together above a cliff. If one falls, it goes, the others can hold him up. But if they don’t act quickly and more fall, then the ones still holding on may be pulled down themselves if they don’t cut their companions loose. Maybe a more apt analogy would be that the climbers up top have a powerful winch, securely bolted to the rock; they could pull up the danglers just by turning a crank. But they wonder, wouldn’t it be better to leave them hanging, to teach them a lesson?

EDIT: The counterargument is that, while there is no technical problem with the ECB guaranteeing the financing of budget gaps in peripheral Europe, this would exacerbate the anti-democratic character of Euorpean institutions by giving the ECB a quasi-fiscal role. This is a trickier question.