Europe again

C. Fred Bergsten and Jacob Kierkegaard think Europe will pull things together and the Euro will not collapse. The frequent crises there in the last year derive from a game of "chicken" by actors trying to stick each other with as much as possible of the cost of averting a collapse; all actors recognize that whatever fraction they end up bearing, the cost to them of doing what it takes to prevent collapse, is much less than the cost of collapse, they say.

At The Monkey Cage, it's pointed out that games of chicken sometimes end badly. I think Bergsten and Kierkegaard are quite aware of this, but it's interesting that they think it's unlikely to happen in this instance. Their advice regarding Euro zone leaders, to "watch what they do, not what they say" is clearly worth remembering, as the events and words leading up to the ECB action on credit via European banks indicate.

For me, the threat of an actual collapse of the Euro, or of the European banking system, diminished greatly when the ECB proffered its three-year loans of 450 billion or so Euros to European banks last December. The banks used some of it to buy Euro area sovereign bonds (Bergsten and Kierkegaard claim that they were under pressure from the ECB to do that; I've read elsewhere that these bonds were actually required as collateral, but I don't have the source handy so can't vouch for it). What bothers me most about their analysis is that while mentioning optimal currency area theory, they don't go into it in any depth. A key point, to which they give some but perhaps not enough attention, is the imbalance in terms of trade caused by areas with very different cost structures, such as Portugal, Spain, and even Italy, sharing a currency with Germany. They seem to think that "structural reforms", especially of the labor market, will fix that. In fact, in their reading (and also in that of many opponents of Euro area austerity and ECB's relatively tight monetary policies) a main goal of the ECB is to get such structural---and political, if necessary---change in some of the Euro area countries. I think they underestimate the difficult of getting this done---especially if it goes hand in hand with "austerity". They do recognize the need for growth:

Even the most successful financial engineering in the euro
area will ultimately fail, however, if the debtor countries,
and indeed the region as a whole, are unable to restore at
least modest economic growth in the fairly near future. This
requires at least three major steps:
* The borrowing countries must adopt convincing progrowth
structural reforms, especially in their labor
markets, as well as budgetary austerity.
* The strong economies in the northern core of Europe,
especially Germany, must terminate their own fiscal
consolidations for a while and adopt new expansionary
measures, i.e., they should buy more Italian and Greek
goods and services rather than debt instruments.
* The ECB must promptly reduce its policy interest rate
by at least another 50 basis points and buy sufficient
amounts of periphery bonds through the SMP to help
push their interest rates down to sustainable levels.

Do they really have confidence that to save the Euro Germany will loosen its fiscal policy enough to create a significant boost to the European "periphery" from trade, and that the ECB will loosen monetary policy enough to offset their prescribed austerity in the periphery, and boost Euro periphery growth (from trade and from credit availability)? I guess they are saying that they do. There's a lot of room for political turmoil here if it doesn't happen this way, and what current heads of state and Euro institution leaders think may in that case not end up being the determining factor. Also, EU leaders will is one thing, but many actors' notions of "expansionary austerity" seem to be rooted in a misunderstanding of economic dynamics. ECB president Draghi's background is somewhat reassuring here, but he's not the only actor, and even he seems to be playing off a willingness to do macro stabilization against other goals of political and economic reform.

Regarding the budget rules that are part of the new fiscal institution building Bergsten and Kierkegaard are so partial to, conservative (but reality-based) economist Martin Feldstein on European austerity is worried: How to Create a Depression contains as good a description as any of the Keynesian (or neo-Keynesian, if you like, in the sense of post-WWII US macroeconomics) notion of automatic fiscal stabilization.

Feldstein does not succumb to the temptation that attracts many right-wing hacks (he, of course, is not a hack), and even many proudly centrist folk (including hacks) who are not terribly well informed on economics, to take all Eurozone deficits as evidence of fiscal irresponsiblility:

Italy, Spain, and France all have deficits that exceed 3% of GDP. But these are not structural deficits, and financial markets would be better informed and reassured if the ECB indicated the size of the real structural deficits and showed that they are now declining. For investors, that is the essential feature of fiscal solvency.

An important part of the deficit agreement in December is that member states may run cyclical deficits that exceed 0.5% of GDP – an important tool for offsetting declines in demand. And it is unclear whether the penalties for total deficits that exceed 3% of GDP would be painful enough for countries to sacrifice greater countercyclical fiscal stimulus.

The most frightening recent development is a formal complaint by the European Central Bank that the proposed rules are not tough enough. Jorg Asmussen, a key member of the ECB’s executive board, wrote to the negotiators that countries should be allowed to exceed the 0.5%-of-GDP limit for deficits only in times of “natural catastrophes and serious emergency situations” outside the control of governments.

Perhaps this is just part of the game of chicken. Certainly it's heartening that the December ECB agreeement does explicitly distinguish between structural and cyclical sources of deficits, and foresee a role for automatic fiscal stabilization through cyclical deficits. But one worries: to what extent does Asmussen represent a broader consensus at the ECB, and what will they do---how long will they drag things out, how tight will they keep money---to try to get their way. And what would be the consequences if they do? Is the economic story of the Eurozone for the next decade or two going to be a continuing game of chicken, accompanied by stagnation? Will this be politically tenable?

US banks insuring European debt

Food for thought if you have any interest in the potential impact of the European situation on US banks.  I have no opinion yet on the quantitative significance of this.  $518 billion, though, is not prima facie chump change.

At Bloomberg, a report by Yalman Onaran: Selling More CDS on Europe Debt Raises Risk for U.S. Banks. 

The best bit: "The banks say their net positions are smaller because they purchase swaps to offset ones they’re selling to other companies."

Christina Romer reviews the empirical evidence: fiscal stimulus works

Next time someone tells you that we know fiscal stimulus doesn't work because we tried it and we still have 9% unemployment, hand them a copy of this talk by Christina Romer.  It reviews the evidence that fiscal policy works, and in particular that the ARRA fiscal stimulus helped prevent even higher unemployment than actually occurred.


Latest European finance agreement

The "voluntary" agreement by holders of Greek bonds to accept a 50% loss is better news than I expected for Europe. See this story from BloombergTim Duy's worries (found via Mark Thoma's excellent blog yesterday, before the current agreement was announced) still have some force for me, though.   However, "a signal from leaders that the European Central Bank will maintain bond purchases in the secondary market" (Bloomberg) sounds interesting.   In more detail:

Leaders tiptoed around the politically independent ECB’s broader role in keeping the euro sound, making no mention of its bond-purchase program in a 15-page statement. The Frankfurt- based central bank has bought 169.5 billion euros in bonds so far, starting with Greece, Ireland and Portugal last year, then extending the coverage to Italy and Spain in August.

While Trichet didn’t mention the controversial purchases either, his successor, Mario Draghi of Italy, indicated that the policy will continue. Speaking in Rome yesterday, Draghi said the ECB remains “determined to avoid a poor functioning of monetary and financial markets.”

This, from Duy yesterday, may explain the tiptoeing:

The German contingent has effectively shut down the ECB. From the Wall Street Journal:

Lawmakers also pressed Ms. Merkel to push banks considered systemically relevant to raise core capital to 9% by a deadline of June 30, 2012 and urged her to insist on an end to the European Central Bank's program of purchasing euro-zone bonds on the open market to prop up weakened euro-zone members as soon as the EFSF is launched. German lawmakers also called for a clear European commitment to the ECB's independence.

The Germans fear the inflationary consequences if the ECB essentially monetizes the debt of the periphery. But the lack of a credible lender of last resort is crippling rescues efforts, and will continue to do so.

I agree with Duy (and Paul Krugman) that it's ultimately crucial for the ECB to provide this credibility, backing Spanish and Italian bonds, for instance, against a speculative run. Just possibly, Draghi's statement is an attempt to indicate that, pace the German parliament, they will.

Duy: "The whole issue of leverage looks to be little more than a smoke and mirrors effort to make the real firepower of the fund appear to be much greater than reality." In Wolfgang Munchau's even more pointed words": "to disguise a lack of money".

Or possibly, it is smoke and mirrors to disguise a role for the ECB . Perhaps this is wishful thinking. One would really like to know what is in Mario Draghi's mind right now. But at least EU leaders have been decisive about one of the needed actions (the 50% haircut). ECB backing of European bonds is another, about which there is clearly more uncertainty than one would like, but some hope.  It would be far better to remove that uncertainty---doing so sooner rather than later lowers the ultimate cost to EU economies and finances.  It is expectations---confidence that the bank will if necessary back those EU governments whose money is leveraged in the EFSF rescue fund---that are crucial.  Ideally, too, the ECB would concomitantly pursue a looser overall monetary policy, stimulating the EU's economies and thus reducing the cyclical component of their deficits (increasing the tax base, and reducing the need for unemployment-insurance payouts and other äutomatic" cyclical social safety-net spending).   Optimally, the bank would not counteract the tendency of looser money to depreciate the Euro ("sterilize" it, in the jargon), as the high Euro is hurting exports from the European countries whose economies are in the worst shape.  Here Duy is probably right that talks with China to provide funds point in the wrong direction.  Chinese purchases of Euro-denominated assets strengthen (increase the value of) the Euro.

Another reason I shoulda voted for Hillary? Read Brad DeLong's review of Ron Suskind's "Confidence Men"

From Ron Suskind's "Confidence Men", via Brad DeLong's Grasping Reality:

[Elizabeth] Warren was caught off guard by Romer's intensity, and her thoughtfulness.... Question after question, the two engaged in an intellectual thrust-and-parry, until finally... Romer broke her stride. "Why is it always the women?" Romer said. "Why are we the only ones with balls around here?"

Hmm, maybe I shoulda voted for Hillary in the 2008 Democratic primaries... Except back then, I feared she had a lot of the centrist, believe-what-all-the-Serious People are saying, don't-fight-the-consensus tendencies that have turned out so badly for Obama, as witness e.g. her position before the Iraq war.

Maybe Elizabeth Warren should be running for something bigger than Senate...

Do read Brad's critical review of the book... very enlightening about the book and about administration policy.  (Also available at Brad's blog.)

Soros on the Euro

George Soros on Europe's troubles and how to avert a crisis.

I don't think his solution of a new treaty creating a unified European Treasury, is going to happen before the European situation gets much worse.  I'm not sure a unified Treasury is required to deal with the current crisis, but I'm not confident Europe will be decisive enough in recognizing the fact that Greece will default, protecting and strengthening (taking over when necessary) affected banks, helping out Spain and Italy, avoiding counterproductive austerity and tight monetary policy, and so on.   Things look pretty bleak for the world and US economies over the next year.

From AP (11:30 AM Sept. 16)

U.S. Treasury chief Timothy Geithner is meeting with European finance ministers in Poland, which may suggest that the U.S. is growing more concerned about Europe's direction.

The U.S. is now pushing for a more decisive solution. On Friday, European leaders pushed back, saying they want to postpone a decision on more Greek payouts until October.

Perhaps the fact that the US is pushing Europe on this should be considered positive, but it also underlines the seriousness of the situation.

Latvian Austerity

Interesting post by Ed Hugh at Fistful of Euros on austerity in Latvia... goes somewhat beyond the usual point that the "success" of austerity in the Baltic republics (in the sense that they are not considered to be in imminent danger of defaulting on their debt, and in the sense that GDP is again growing) has come at the cost of enormous drops in GDP (which the current growth in GDP has still not made up).  Krugman is also good on this, but Hugh's post goes into a lot of detail and argues that even in terms being able to pay their debt, things may not look so good in a few years.

What's basically been going on is "internal devaluation", i.e. massive wage and price deflation, in order to reverse the decline in competitiveness that followed Latvia's pegging its currency to the Euro.  This has been accomplished in part by austerity that has been extremely contractionary, and has resulted in a massive shift toward exporting by the Latvian economy, earning it foreign exchange with which to pay euro-denominated debt.   But the huge cost in macroeconomic contraction might have been partially avoided by devaluing instead of maintaining the peg (although massive devaluation, while macroeconomically stimulative through the export demand channel, may in some circumstances cause macro problems as well...).

Irish taxpayers now working for Goldman Sachs, BNP Paraibas et. al...

I had held off on posting about Ireland because I read some pieces that suggested the final deal was going to involve Irish banks' bondholders taking some losses.  From RTE news, I read that:

The Minister [for finance, Brian Lenihan] also said that subordinated bondholders would be dealt with aggressively but said the European partners had ruled out making senior bondholders pay as it would have a spill over effect on the euro.

See also the Financial Times.  The IMF favored senior bondholders taking some losses, but the Europeans wouldn't accept it, and the Irish government caved.

What I was going to say was that the Irish problem is essentially about the fact that the Irish government decided, at the beginning of the crisis, to guarantee all of Irish banks' debts.  What they should now do is repudiate that guarantee...if not explicitly, than by refusing any bailout that doesn't, effectively, involve a partial writedown.  If they don't, it's likely the next Irish government will repudiate, if they can find a legal mechanism for doing so (and my guess is that they'll find *something*).  The current plan is basically asking all Irish citizens to tithe themselves for years to ensure that those who unwisely lent to Irish banks fueling the Irish real estate bubble, suffer no loss.  A real political winner if I ever heard of one.  Sinn Fein --- that's the party that was formerly the political wing of the Irish Republican Army---has already won a byelection, in Donegal, presumably over voter anger at the economic and debt situation.  Moreover, the plan will likely be contractionary in a Keynsian sense, making it still more onerous for Irish firms and workers to produce the surplus to render to the bondholders.

About two thirds of the Irish deficit is payments to uphold this guarantee of bank debt; the Irish deficit is not primarily a matter of excessive government spending otherwise.

More on Ireland and Europe from Ken Rogoff

...and on Ireland from Barry Eichengreen.  No accident, I suspect, that this blast was originally published in German at Handelsblatt.

Taylor on what the Taylor rule implies for the present situation

Interesting... from John B. Taylor's blog:

"The Taylor rule says that the federal funds rate should equal 1.5 times the inflation rate plus .5 times the GDP gap plus 1. Currently the inflation rate is about 1.5 percent and the GDP gap is about -5 percent (using the average of the seven estimates of the gap provided in the recent update by Justin Weidner and John Williams).

So a little algebra gives a funds rate of 1.5X1.5 + .5X(-5) + 1 = .75 percent.

This number is nowhere near -6 percent, which is what you sometimes hear people say the Taylor rule implies."

I think I've hear the numbers near -6 percent from Krugman, and possibly Delong... the issue, I guess, is that they are not adopting the specific slope and intercept from Taylor's 1993 paper, but are employing some procedure based on economic data for estimating an appropriate slope and intercept---based on "a period during which the Fed has set interest rates too low for too long".

Update: Actually, the Krugman post I was probably thinking of doesn't use Taylor's 1993 rule (which is indeed the one cited in Taylor's post,  which is also (modulo trivial algebra) equation (1) of his 1993 paper:

f = 1 + 1.5 p + 0.5 y,

where p is the inflation rate over the past four quarters, and y is the deviation of GDP from target ("output gap").  It uses Mankiw's "Taylor rule" (this having become a generic term for prescriptions for setting the federal funds rate as an affine (i.e. straight-line, with slope and intercept) function of inflation and the output gap), i.e.:

f =  c p  + c y  + d

where c and d are coefficients to be chosen on some basis, p and y as before.

Mankiw's uses equal coefficients on inflation and the output gap, whereas Taylor's inflation coefficient is thrice its output coefficient.  Krugman fits c and d  to data for 1998--2008.  Thus he does do what Taylor gives as the explanation for the people who get -6%: "they change the Taylor rule, replacing variables or estimating coefficients with data during which the Fed has set interest rates too low for too long."  Presumably Taylor thinks interests rates were set too low during part of the 2000's at least....I wonder, though, what result one would get by letting output and price coefficients be fitted independently...probably something not too different from Mankiw's rule.

At issue seems to be how the Taylor rule should be determined.  Taylor's 1993 paper shows that his rule fits the behavior of the fed funds rate from 1987--1992 fairly well.  One might reasonably ask that included as part of such a rule be a publicly disclosed formula for updating it, perhaps based on a window of economic data, or some time-profile of weighting of data, so that recent experience influences the rule more than that of decades ago.  Krugman, at least, is quite clear about what he's doing along these lines; Taylor does not derive his rule from an explicit fit, merely showing graphically that it fits the preceding fivish years of data reasonably well.