The Slack Wire

ΣΥ.ΡΙΖ.Α.

So the ECB’s agenda is pain. What about our agenda?

One positive thing about the crisis in Europe is that, unlike many earlier occasions on which neoliberalism has been imposed by financial coercion, this one is calling forth a serious response from the left. Hopefully, we’ll see a victory for Syriza in tomorrow’s elections in Greece. In the meantime, check out their economic program. Good stuff.

THE ECONOMIC PROGRAMΜΕ OF SYRIZA-EKM

UPDATE: Well, that was disappointing. The Guardian says it was moral victory; perhaps we’ll get a Greek perspective here in the next week.

In the meantime, the question has been raised, what do I specifically like about this program? Well, let’s be honest, beside the tone of it — which is wonderful — it’s not everything one might hope for. But it’s a small party in a small country, putting together its program in a short time under extreme conditions. That said, I think the focus on tax reform, and on taxing the rich — including the Church — is important. Unlike Spain or Italy or Ireland, Greece does have a genuine fiscal problem. Resolving that in a progressive way is important. And if it does turn out that GReece leaves the Euro — I won’t guess how likely that is — capital flight is going to be a huge problem. Putting in place the institutions now to capture the wealth of that fraction of the Greek elite that abandons ship strikes me as very worthwhile.

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?

Posts in Three Lines

I don’t know what other peoples’ experience is, blogging, but me, I find myself thinking about far more posts than I ever manage to put on electronic paper. Seems like if one can’t write them, at least one should write down the idea of them. So here is some of what I wish I’d wrote.

The paranoid hypothesis on European austerity. Maybe the ruling class in Europe isn’t so confused, maybe the crisis, like the Euro project in general, is an effort to do an end run around European national-democratic institutions, where social democracy is still stubbornly implanted. This is the thesis, mostly implicit, of Perry Anderson’s The New Old World, and more explicitly of the NLR discussion of the same. Jerry Epstein offers some supporting evidence at Triple Crisis.
What’s So Effective About Effective Demand? There’s a conventional understanding that “effective demand” means demand backed by money; no, that’s just demand. Keynes introduced the term specifically to call attention to the way actual expenditure depends on expected income, and the possibility of multiple self-consistent expectation equilibria. Think effect as in “in effect,” not “having effect.”
Margaret. It’s a good movie, you should see it. It’s dialectical. Best thing I’ve been to in a while.
Honest Signals: Thoughts Around Mary Gaitskill. Her stories are the best fiction I’ve read in the past couple years; she’s attuned, like almost no one else, to the way we are both free reasoning selves and embodied social animals. Her collection Don’t Cry is particularly attuned to the “honest signals” we use to communicate unconsciously, a kind of natural telepathy, and ways in which our moral and physical selves don’t quite coincide. I’ve been writing this post in my head for the past year and change.
Larry Summers and the Anti-QE. He wants the government to take advantage of transitory low rates to adopt a more favorable financing position. Fine, except this is precisely the opposite of what quantitative easing is supposed to be doing. In general, sound finance for government is the opposite of Keynesianism; the Keynesian view is that government financing decisions should be taken with an eye to their effect on private, not public, balance sheets.
The Future Is Stasis. Everyone knows the Fermi paradox, almost everyone knows its updated version as the Great Filter. My opinion, this is almost certain proof that the future is socialism, or rather socialism or extinction. Humans will never live anywhere but Earth.
Low interest rates, really? My next project with Arjun Jayadev is a short paper arguing that, contrary to conventional wisdom, interest rates in the past decade were not historically low. The central bank does not set “the” interest rate. For business borrowers, in particular, changes in the Fed Funds rate have very little effect on credit conditions. 
The logic of business cycles. I’m still struggling with the monetarist/New Keynesian thesis that a less than full employment state of aggregate demand is just equivalent to an excess demand for money, or for some set of financial assets. Leijonhufvud argues that this is the case in the downturn, but that there is then an unemployment quasi-equilibrium in which all markets clear except for a notional excess supply of labor. Seems right.
Tobin’s article, “Commercial Banks as Creators of Money.” 1963. An old one, but a bad one. Sometimes it’s worth reviving old arguments.

Crotty on Keynes on politics. One of the best things about studying economics at the University of Massachusetts was learning Keynes from Jim Crotty. What’s tragic is that his book on Keynes’ political vision has never been published, so no one who hasn’t sat in his classroom knows Crotty’s Keynes. I should disseminate some of it here.
Relitigating the ACA. Well, we are. Which means we need to revisit the individual mandate, a right-wing approach to health care that inexplicably migrated almost overnight to the liberal side. The economic arguments for it, IMO, remain bullshit; the ethical and political arguments are worse.
Adventures in Central Bank Independence. It’s increasingly at least somewhat recognized that Bernanke’s policies as a central banker in the face of an incipient depression fall more than a bit short of what he advocated as an academic. Best piece on this evolution I’ve seen is by Laurence Ball. Krugman’s cited it, but he left out some sordid details.

Graeber’s Debt. Don’t care what anyone says, it’s the best book I read last year. The final section — on the last half century — is weaker than the rest of it, but it’s still got a higher rate of brilliancies per page than any other piece of social science I’ve read since I don’t know when. Plus, the dude practically started OWS.

“Mortal Beings Cannot Hold Land to Maturity.” The special place of very long-lived assets in our economy doesn’t get the attention it deserves. (Hello Henry George!) It’s arguable that most investment is technologically longer-lived than it optimally should be, and the rents from the “excess” assets (and of course land) constitute some of the most politically important classes under modern capitalism.

Classics: A Pattern Language. I’d like to write a bunch of posts on books you ought to read. This would be the first one. Utopian architecture theory from the 1970s: how the world should be, from the scale of cities down to the chairs in your kitchen.

One could write lots more hypothetical posts, I certainly won’t write all of them. Maybe, with some luck, two or three. So I admit this exercise is a little pointless: Map is not territory. But if you’re short on territory, it can be fun to draw maps.

UPDATE: It looks like this is now a thing.

Welcome Wonkupy

When I first started reading blogs a decade ago (I’m pretty sure the first blogpost I ever read was one of these Eschaton posts on Trent Lott) there was a distinctly truncated Left in the blog world, especially on economics. Just mainstream liberals, conservatives, and libertarians as far as the eye could see. Which, what else is new, right? Except that it really wasn’t true of mailing lists, the predecessor medium, where you had super active lists like PEN-L and LBO Talk. I used to wonder if there was something specific about the formats that made mailing lists more hospitable to radical politics. Like, flatteringly, maybe we prefer collective discussions rather than one-man shows? Anyway, the question is moot now, because there’s certainly no shortage of left/radical blogs now, economics-oriented and otherwise.

All of which is a long-winded introduction to introducing a new progressive economics blog, Wonkupy. It’s by “Rotwang,” a very sharp comrade who needs to remain pseudonymous for professional reasons. It bills itself as “Occupy for wonks,” but my sense is it’s going to be more the other way round; well worth reading either way.

That said, I have some disagreements with his current post, arguing that criticism of private equity is a distraction. I put them in comments there, but since it touches on some regular themes at the Slack Wire, I thought I’d post an abridged version here.

Rotwang’s argument is that it’s wrong to suggest that buyouts and takeovers of firms by private equity funds and the like have any systematic effect on the way those firms are managed: profit maximization at the expense of workers and the pubic is the order of the day whether the bosses are vulture capitalists or just the regular kind. (It’s sort of a political-economic version of the Modigliani-Miller theorem.) Rotwang:

In [private equity] discussions, it is easy to focus on outright theft, abuse of borrowing, and inefficient government subsidies. We suggest this is not unique to PE, but is generic to Capitalism. One could imagine regulatory responses to such problems, but we insist the problems are part of the system, not tumorous growths on something otherwise fundamentally healthy. A narrow focus on PE glosses over the features it shares in common with Capitalism in general, now and throughout history. The narrow view plays to limited and ineffective remedies that fail to engage the long-standing, systematic problems of capital markets.

I disagree — tentatively on the substance, but emphatically on this way of framing it.

Suppose for the moment it’s true that the problems with private equity are no different from the problems with capitalism in general. I still don’t think that’s a valid reason to not talk about private equity in particular. After all, “X in general” is just all the specific instances of X. To the extent that the way productive enterprises are treated by PE firms like Bain is a representative example of why an economy oriented around the private pursuit of profit is incompatible with a humane and decent society, I don’t see what’s wrong with starting with it as a particularly vivid and timely example. Of course you have to then move on to a more general critique — there’s nothing that stops management at companies that aren’t subject to buyouts from acting like Bain, and many do — but a ban on discussion of particular cases doesn’t smooth the way to that general critique.

The other question is, is it really true that there is no difference between what a firm like Bain does and what a “normal” capitalist firm does? Rotwang writes, “From the worker’s standpoint, it makes little difference if her life is ruined by PE or by old management,” which is inarguable. But are we sure ruination is equally likely in either case?

It seems to me that while capitalist firms always pursue profit, and this pursuit is always ultimately inimical to the interests of workers, it’s not always equally single-minded. Managers want their firms (and themselves personally) to make money, but they also want them to survive, to grow, to gain market share, to be perceived as prestigious, cutting-edge, etc., and, in a non-trivial number of cases, to make genuinely good products by whatever objective standard of the business that they’re in. To the extent that finance exercises more active control of the firm, those other motives get subordinated to pure pursuit of profits. And I think that does tend to make life worse for their workers, and communities and customers, and everyone else who depends on the business as an ongoing enterprise.

No question, there is (or was; is Occupy still a thing?) a strong anti-finance vibe around OWS. There’s nothing wrong with criticizing that — especially in its weirder Ron Paulish forms — but it seems to me this is a case where “Yes, and” is distinctly preferable to “no, but”. For some people, a criticism of private equity may be an alternative to a broader critique of capitalism, but for many more, I suspect, it’s a starting point towards it.

Adventures in Cognitive Dissonance

Brad DeLong, May 25:

WHAT ARE THE CORE COMPETENCES OF HIGH FINANCE? 

The core competences of high finance are supposed to be (a) assessing risk, and (b) matching people with risks to be carried with people with the risk-bearing capacity to carry them. Robert Waldmann has a different view:

I think their core competencies are (a) finding fools for counterparties and (b) evading regulations/disguising gambling as hedging.

Regulatory arbitrage, and persuading those who do not understand risks that they should bear them–those are not socially-valuable activities.

Brad DeLong, yesterday:

NEXT YEAR’S EXPECTED EQUITY RETURN PREMIUM IS 9% 

If you have any risk-bearing capacity at all, now is the time to use it.

So I guess last week’s doubts have been assuaged. Or did he really mean to write “If you have any capacity for being fooled into being a swindler’s counterparty, now is the time to use it”?

EDIT: Oh and then, the post just after that one argued — well, really, assumed — that the current value of Facebook shares gives an unbiased estimate of future Facebook earnings, and therefore of the net wealth that Facebook has created. (I guess not a single dollar of FB revenue comes at the expense of other firms, which must be a first in the history of capitalism.) Is there some way of consistently believing both that current stock values give an unbiased estimate of the present value of future earnings, and that stock values a year from now will be much higher than they are today? I can’t see one. But then I’ve never had the brain for theodicy.

UPDATE: Anyone reading this should immediately go and read rsj’s much better take on the same DeLong post over at Windyanabasis. He explains exactly why DeLong is confused here.

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.

Their Way Won’t Do

(Today was the last day of classes here. The final slide for my macro course was an abridged version of this Brecht poem, which captures the discomfort any reasonable person ought to feel when they first study economics. The students could relate.)

Years Ago When I

Years ago when I was studying the ways of the Chicago Wheat Exchange
I suddenly grasped how they managed the whole world’s wheat there
And yet I did not grasp it either and lowered the book
I knew at once: you’ve run
Into bad trouble.

There was no feeling of enmity in me and it was not the injustice
Frightened me, only the thought that
Their way of going about it won’t do
Filled me completely.

These people, I saw, lived by the harm
Which they did, not by the good.
This was a situation, I saw, that could only be maintained
By crime because too bad for most people.
In this way every
Achievement of reason, invention or discovery
Must lead only to still greater wretchedness.

Such and suchlike I thought at the moment
Far from anger or lamenting, as I lowered the book
With its description of the Chicago wheat market and exchange.

Much trouble and tribulation
Awaited me.

Only Ever Equilibrium?

Roger Farmer has a somewhat puzzling guest post up at Noah Smith’s place, arguing that economics is right to limit discussion to equilibrium:

An economic equilibrium, in the sense of Nash, is a situation where a group of decision makers takes a sequence of actions that is best, (in a well defined sense), on the assumption that every other decision maker in the group is acting in a similar fashion. In the context of a competitive economy with a large number of players, Nash equilibrium collapses to the notion of perfect competition.  The genius of the rational expectations revolution, largely engineered by Bob Lucas, was to apply that concept to macroeconomics by successfully persuading the profession to base our economic models on Chapter 7 of Debreu’s Theory of Value… In Debreu’s vision, a commodity is indexed by geographical location, by date and by the state of nature.  Once one applies Debreu’s vision of general equilibrium theory to macroeconomics, disequilibrium becomes a misleading and irrelevant distraction. 

The use of equilibrium theory in economics has received a bad name for two reasons. 

First, many equilibrium environments are ones where the two welfare theorems of competitive equilibrium theory are true, or at least approximately true. That makes it difficult to think of them as realistic models of a depression, or of a financial collapse… Second, those macroeconomic models that have been studied most intensively, classical and new-Keynesian models, are ones where there is a unique equilibrium. Equilibrium, in this sense, is a mapping from a narrowly defined set of fundamentals to an outcome, where  an outcome is an observed temporal sequence of unemployment rates, prices, interest rates etc. Models with a unique equilibrium do not leave room for non-fundamental variables to influence outcomes… 

Multiple equilibrium models do not share these shortcomings… [But] a model with multiple equilibria is an incomplete model. It must be closed by adding an equation that explains the behavior of an agent when placed in an indeterminate environment. In my own work I have argued that this equation is a new fundamental that I call a belief function.

(Personally, I might just call it a convention.)

Some recent authors have argued that rational expectations must be rejected and replaced by a rule that describes how agents use the past to forecast the future. That approach has similarities to the use of a belief function to determine outcomes, and when added to a multiple equilibrium model of the kind I favor, it will play the same role as the belief function. The important difference of multiple equilibrium models, from the conventional approach to equilibrium theory, is that the belief function can coexist with the assumption of rational expectations. Agents using a rule of this kind, will not find that their predictions are refuted by observation. …

So his point here is that in a model with multiple equilibria, there is no fundamental reason why the economy should occupy one rather than another. You need to specify agents’ expectations independently, and once you do, whatever outcome they expect, they’ll be correct. This allows for an economy to experience involuntary unemployment, for example, as expectations of high or low income lead to increased or curtailed expenditure, which results in expected income, whatever it was, being realized. This is the logic of the Samuelson Cross we teach in introductory macro. But it’s not, says Farmer, a disequilibrium in any meaningful way:

If by disequilibrium, I am permitted to mean that the economy may deviate for a long time, perhaps permanently, from a social optimum; then I have no trouble with championing the cause. But that would be an abuse of the the term ‘disequilibrium’. If one takes the more normal use of disequilibrium to mean agents trading at non-Walrasian prices, … I do not think we should revisit that agenda. Just as in classical and new-Keynesian models where there is a unique equilibrium, the concept of disequilibrium in multiple equilibrium models is an irrelevant distraction.

I quote this at such length because it’s interesting. But also because, to me at least, it’s rather strange. There’s nothing wrong with the multiple equilibrium approach he’s describing here, which seems like a useful way of thinking about a number of important questions. But to rule out a priori any story in which people’s expectations are not fulfilled rules out a lot of other useful ways about thinking about important questions.

At INET in Berlin, the great Axel Leijonhufvud gave a talk where he described the defining feature of a crisis as the existence of inconsistent contractual commitments, so that some of them would have to be voided or violated.

What is the nature of our predicament? The web of contracts has developed serious inconsistencies. All the promises cannot possibly be fulfilled. Insisting that they should be fulfilled will cause a collapse of very large portions of the web.

But Farmer is telling us that economists not only don’t need to, but positively should not, attempt to understand crises in this sense. It’s an “irrelevant distraction” to consider the case where people entered into contracts with inconsistent expectations, which will not all be capable of being fulfilled. Farmer can hardly be unfamiliar with these ideas; after all he edited Leijonhufvud’s festschrift volume. So why is he being so dogmatic here?

I had an interesting conversation with Rajiv Sethi after Leijonhufvud’s talk; he said he thought that the inability to consider cases where plans were not realized was a fundamental theoretical shortcoming of mainstream macro models. I don’t disagree.

The thing about the equilibrium approach, as Farmer presents it, isn’t just that it rules out the possibility of people being systematically wrong; it rules out the possibility that they disagree. This strikes me as a strong and importantly empirically false proposition. (Keynes suggested that the effectiveness of monetary policy depends on the existence of both optimists and pessimists in financial markets.) In Farmer’s multiple equilibrium models, whatever outcome is set by convention, that’s the outcome expected by everyone. This is certainly reasonable in some cases, like the multiple equilibria of driving on the left or the right side of the road. Indeed, I suspect that the fact that people are irrationally confident in these kinds of conventions, and expect them to hold even more consistently than they do, is one of the main things that stabilizes these kind of equilibria. But not everything in economics looks like that.

Here’s Figure 1 from my Fisher dynamics paper with Arjun Jayadev:

See those upward slopes way over on the left? Between 1929 and 1933, household debt relative to GDP rose by abut 40 percent, and nonfinancial business debt relative to GDP nearly doubled. This is not, of course, because families and businesses were borrowing more in the Depression; on the contrary, they were paying down debt as fast as they could. But in the classic debt-deflation story, falling prices and output meant that incomes were falling even fast than debt, so leverage actually increased.

Roger Farmer, if I’m understanding him correctly, is saying that we must see this increase in debt-income ratios as an equilibrium phenomenon. He is saying that households and businesses taking out loans in 1928 must have known that their incomes were going to fall by half over the next five years, while their debt payments would stay unchanged, and chose to borrow anyway. He is saying not just that he believes that, but that as economists we should not consider any other view; we can rule out on methodological grounds the  possibility that the economic collapse of the early 1930s caught people by surprise. To Irving Fisher, to Keynes, to almost anyone, to me, the rise in debt ratios in the early 1930s looks like a pure disequilibrium phenomenon; people were trading at false prices, signing nominal contracts whose real terms would end up being quite different from what they expected. It’s one of the most important stories in macroeconomics, but Farmer is saying that we should forbid ourselves from telling it. I don’t get it.

What am I missing here?