Archive for April, 2010

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lessons of the euro crisis

Friday, April 30th, 2010

I normally avoid quoting from Krugman’s NY Times column, assuming that everyone reads it. But his column today is too important to ignore.

The deficit hawks are already trying to appropriate the European crisis, presenting it as an object lesson in the evils of government red ink. What the crisis really demonstrates, however, is the dangers of putting yourself in a policy straitjacket. When they joined the euro, the governments of Greece, Portugal and Spain denied themselves the ability to do some bad things, like printing too much money; but they also denied themselves the ability to respond flexibly to events.

Paul Krugman, “The Euro Trap”, New York Times, 30 April 2010.

Krugman points out that none of these countries were in serious fiscal difficulties prior to the 2008 financial crisis – Spain’s budget was actually in surplus! Yet all three are in deep trouble today. By joining the euro, countries give up all possibility of using currency devaluation to reduce wages and costs relative to their trading partners. The United Kingdom retained its national currency, so has been able to adjust wages (increase competitiveness) by devaluation rather than deflation. Countries in the euro zone can increase their competitiveness only by deflation, which is difficult and painful, with more unemployment, compared to adjustment with flexible exchange rates.

The future is not bright for Greece, Portugal and Spain.

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Martin Wolf on financial reform

Thursday, April 29th, 2010

As promised, Martin Wolf this week looks at fundamental changes that might make the financial system more stable by reducing “the risk taken on by the gamblers working legally inside the machine”. He begins by looking at Canada.

An obvious solution is to revert to a tightly regulated, oligopolistic banking system. This is the sort of system Canada has enjoyed. But it is stodgy. It is also inconsistent with globalisation. Access by residents to foreign finance and by domestic institutions to foreign risks makes such cartels inherently unstable.

Martin Wolf, “Why cautious reform is the risky option”, Financial Times, 28 April 2010.

Martin then lists numerous ways to improve the system. The proposals are sensible, but far from radical – for example “impose much higher capital and collateral requirements against trading in derivatives”. Martin himself admits “None of this deals fully with the huge issue of securing greater macroeconomic stability: but a less unstable financial system would surely help.” Perhaps this is the most we can expect from financial reform. But the ‘stodgy’ Canadian system is beginning to look more and more attractive to me. Less excitement is not necessarily bad.

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Obama the conservative?

Thursday, April 29th, 2010

Berkeley economist Brad DeLong argues that Barack Obama, despite Republican cries that he is governing as a European-style socialist, is actually governing from the centre.

[For example,] in dealing with the financial sector’s distress, Obama has acquiesced in the Bush-era policy of bailouts for banks without demanding anything of them in return – no nationalizations and no imposition of the second half of Walter Bagehot’s rule that aid be given to banks in a crisis only on the harsh terms of a “penalty rate.” Obama has thus positioned himself to the right not only of Joseph Stiglitz, Simon Johnson, and Paul Krugman, but also of his advisers Paul Volcker and Larry Summers. ….

On healthcare reform, Obama’s proudest moment, his achievement is…drum roll…a scheme that almost precisely mimics the reform that Mitt Romney, a Republican who sought the presidency in 2008, brought to the state of Massachusetts. The reform’s centerpiece is a requirement imposed by the government that people choose responsibly and provide themselves with insurance – albeit with the government willing to subsidize the poor and strengthen the bargaining power of the weak. ….

[Y]ou could close your eyes and convince yourself that, at least as far as the substance is concerned, Obama is in fact a moderate Republican named George H.W. Bush, Mitt Romney, John McCain, or Colin Powell.

J. Bradford DeLong, “Obama the Centrist”, Project Syndicate, 28 April 2010.

I disagree. Obama’s policies are to the right of most policies supported by these centrist Republicans.

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Chinese savings and world recession

Monday, April 26th, 2010

Paul Krugman and others have argued that China, by undervaluing its currency to run a current account surplus, is draining aggregate demand from the rest of the world. But is the Chinese economy large enough for its savings to have much of an impact on the rest of the world? Hans Genberg of the Bank for International Settlements and Wenlang Zhang of the Hong Kong Monetary Authority run the numbers, and find that the answer is a resounding “No!”

To get a sense of the quantitative importance of policy changes in China on the rest of the world let us contemplate the consequences of China reducing its external saving/investment gap, i.e. its current account balance, by, say, 5% of Chinese GDP. As China’s GDP represents about 10% of the rest of the world’s GDP, the improvement in the current account balance for all other countries taken together would be 0.5% of GDP. Let us assume that each economy in the rest of the world will get an equal improvement in its current account balance (as a percentage of its GDP) as a result of the increased imports of China.

This improvement can be thought of as an autonomous increase in demand. How large will be the impact on GDP? Assuming a multiplier of 1.5 we would get an increase in US GDP by 0.75%. Although it obviously is helpful, it is hardly a change that will qualify as a major source of a recovery, especially since the improvement in the US current account would be phased in over several years. If we use Okun’s Law to calculate the effect on employment we would conclude that the unemployment rate in the US would decline by about 0.25% (0.75/3), not much bigger than a rounding error.

Hans Genberg and Wenlang Zhang, “Can China save the world by consuming more?”, VoxEU, 25 April 2010.

Genberg and Zhang add that there are good reasons for China to decrease savings – increase the consumption and living standards of its citizens – even if this “will not solve the income and employment problems in the Eurozone and the US”.

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This Time is Different

Sunday, April 25th, 2010

Robin Wells and Paul Krugman have written an interesting review of This Time Is Different: Eight Centuries of Financial Folly by Carmen M. Reinhart and Kenneth S. Rogoff (Princeton University Press, 2009). It is a generally positive review, with complaints reserved for the absence of theory, “the limits of a history-based, theory-shy approach”. The reviewers fill this perceived gap with theorizing of their own. They also praise Reinhart and Rogoff for providing early warning of economic disaster in the United States:

The Reinhart-Rogoff approach has already paid off handsomely in making sense of current events. In 2007, at a time when the wise men of both Wall Street and Washington were still proclaiming the problems of subprime “contained,” Reinhart and Rogoff circulated a working paper—now largely subsumed into Chapter 13 of This Time Is Different—that compared the US housing bubble with previous episodes in other countries, and concluded that America’s profile resembled those of countries that had suffered severe financial crises. And sure enough, we had one too. Later, when many business forecasters were arguing that the deep recession would be followed by a rapid, “V-shaped” recovery, they circulated another working paper, largely subsumed into Chapter 14, describing the historical aftermath of financial crises, which suggested that we would face a prolonged period of high unemployment—and so we have.

Robin Wells and Paul Krugman, “Our Giant Banking Crisis—What to Expect”, The New York Review of Books 57:8 (13 May 2010).

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the continuing Greek tragedy

Sunday, April 25th, 2010

Barcelona-based economist Edward Hugh thinks that  Greek debt restructuring (“a polite word for default”) now seems inevitable. But, he argues, it is existing bondholders – not EU taxpayers – who are expected to pay for the bailout.

[S]ome sort of Greek default is now no longer simply a theoretical possibility among many others, indeed talk of the inevitability of some form of debt restructuring (albeit voluntary) grows with every passing day. ….

One indication that the ground may be being prepared for some kind of restructuring can be found in the decision reported by German Deputy Finance Minister Joerg that any aid to Greece would come in the form of pooled loans from the euro-zone countries and not through the purchase of Greek bonds. Plans to purchase bonds are “off the table,” he said. This procedure implies that government loans would be strongly guaranteed, while private bond holders would really pay the price for the Greek “rescue”. ….

When all is said and done, one thing is obvious, the forthcoming [EU/IMF] loan will clearly have some kind of super-senior status (which means it would be payable before ALL other creditors – German voters would settle for nothing less), and this implies that it is likely to be existing bondholders, and not EU national governments, who are going to be invited invited to pay for the Greek bailout. How they will react to this realisation is what remains to be seen in the days and weeks to come.

Edward Hugh, “The Greek Tragedy Continues”, A Fistful of Euros, 23 April 2010.

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13 Bankers

Saturday, April 24th, 2010

Journalist Louis Uchitelle, in Sunday’s New York Times, reviews 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown by Simon Johnson and James Kwak (Pantheon, 2010). Uchitelle explains the meaning of the book’s title, and points out that its authors – now vocal critics of crony capitalism in the United States – failed to speak out before the current crisis erupted in 2008.

[T]he authors skewer Lawrence H. Summers, … Obama’s chief economist. In 1998, while he was deputy secretary in the Clinton Treasury, he opposed the efforts of Brooksley Born, then running the Commodity Futures Trading Commission, to regulate derivatives. Her efforts “provoked furious opposition, not only from Wall Street but also from the economic heavyweights of the federal government,” Johnson and Kwak write.

… Johnson and Kwak describe a phone call from Summers to Born that gives the book its title. “I have 13 bankers in my office,” he declared, “and they say if you go forward with this you will cause the worst financial crisis since World War II.”

No wonder derivatives remained unregulated. And in the end, they played a huge role in producing what was in fact “the worst financial crisis since World War II.” Summers was dead wrong.

But if the case against him and others is so obvious, why did Johnson and Kwak … fail to speak up before the crisis erupted? Johnson, in particular, has emerged as a critic only in the past two years. If only he had separated himself sooner from the legions of mainstream economists who insisted that bankers and markets would self-correct.

Louis Uchitelle, “Your Money, Their Pockets”, New York Times Sunday Book Review, 25 April 2010.

Johnson and Kwak blog at baselinescenario.com.

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Greece and the future of the euro

Friday, April 23rd, 2010

Carleton University economist Nick Rowe is worried about the Greek fiscal crisis, and so am I. On Friday, 10-year Greek bonds were selling at prices that yield 8.1%. This is higher than yields on equivalent bonds issued by the Philippines and India, but low for a country that is on the verge of default.

We can expect bond yields to rise sharply in Greece, and also in the weaker eurozone countries, such as Portugal and Spain. This will have repercussions for the entire eurozone – and the rest of the world.

I’m scared again. I haven’t felt this scared for over a year. Things were starting to look better, in Canada in particular, but around the world more generally. Now Greek bond yields are shooting up. ….

It’s difficult to know what will happen in the Eurozone. My own guess, for a worst-case scenario, is that we will see multiple Argentinas. No country will want to leave the Euro, but some might have no choice. The only way for a government to pay wages will be in scrip. That scrip will become a new national currency. They will rewrite the laws to make debts payable in the same national currencies.

Nick Rowe, “Eurozone: is this the big one?”, Worthwhile Canadian Initiative, 22 April 2010.

Actually, one country might abandon the euro very soon. That country – surprise – is Germany. The euro has never been popular in Germany. Four professors have threatened to sue their government in constitutional court to bring back the Deutsche Mark “should eurozone governments provide assistance to Greece in a manner that contravenes the no bail-out rule”. There is a real possibility  that such a suit will succeed.

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schooling and growth

Thursday, April 22nd, 2010

Harvard economist Lant Pritchett is famous for holding the view that there is no evidence whatsoever for a connection between schooling and economic growth. In a recent paper, he updates – and summarizes – much of the material from his much longer “Does Learning to Add Up Add Up?”, drafted in 2003 for the Handbook of the Economics of Education, edited by Erik Hanushek and F. Welch (North-Holland, 2006). Here are three excerpts to encourage you to read the full 45-page essay. Pritchett is a joy to read, and this is classic Pritchett.

If what I have said is interpreted as saying “education does not have any impact on growth” then this is automatically rejected by every audience of academics and policy makers, for several reasons. First, claiming “education has no impact” is completely at odds with their own lived experience: people who have PhDs are relatively rich and/or powerful and know that this is because they have high schooling. So to deny that schooling has an economic impact is not scientifically wrong, it is just silly, it contradicts their own internal narrative of not just economic causation but their own life. And of course they have huge amounts of evidence that their own experience—education leads to more earnings/utility—is generalized. There are, by now, thousands and thousands of Mincer regressions from countries all over the world which show that people with more education have higher earnings . An upward sloping earnings/education profile rivals Engel’s law as the most consistently and robustly demonstrated fact in economics. In fact , there are many who would wonder why, if we are interested in the returns to education, we are even bothering with all of this messy aggregate data like GDP, why not stick to the micro evidence, which is solid and secure and be done with it? The reason is that there is no way to infer the macro-economic impact of increases in schooling from the micro-economic earnings profile. (pp. 27-28)

Bad, corrupt , autocratic governments that had terrible economic policies and crappy institutions—e.g. Haiti— expanded schooling. Good pro-growth, strong institution countries also expanded schooling a ton. The OECD countries already leading the pack also, in absolute terms expanded schooling a ton. (p. 38)

The way forward is to figure out what there is inside of education policy that does make a difference for growth (and for other benefits of education as well) and get out of a simple minded expand the number of little bottoms in seats and the economy will grow mentality. Part of the answer is … an emphasis on actual learning achievement (ideas in heads rather than butts in seats), part of the answer is … the composition of education across levels at various stages of economic growth, part of the answer is the labor market conditions in which schooled people are able to work. But we are only to get to these more sophisticated, complex, and interactive theoretical and empirical research once we are able to leave the conventional platitudes behind. (p. 42)

Lant Pritchett, “Does Schooling Help Explain Any of the Big Facts about Growth?”, 24 January 2009. Draft paper based on a presentation given to the Growth Commission session on education and growth.

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the financial doomsday machine

Wednesday, April 21st, 2010

Martin Wolf, drawing on the ideas of Andrew Haldane (Bank of England) and Adair Turner (chairman of the UK’s Financial Services Authority), provides his readers with yet another brilliant Wednesday column.

The combination of state [deposit] insurance (which protects creditors) with limited liability (which protects shareholders) creates a financial doomsday machine. …. Its most dangerous effect comes via the extremes of the credit cycle. Most perilous of all is the compulsion upon the authorities to blow another set of credit bubbles, to forestall the devastating impact of the implosion of the last ones. In the end, what happens to finance is not what matters most but what finance does to the wider economy. ….

Financial systems are important servants of the economy, but poor masters. A large part of the activity of the financial sector seems to be a machine to transfer income and wealth from outsiders to insiders, while increasing the fragility of the economy as a whole. Given the extent of the government-induced distortions in the system, even the fiercest free marketeer should accept this. ….

So what is to be done? ….

One idea, popular in US Republican circles, is: “just say no” to bail-outs. This is a delusion. Since financial institutions are powerfully interconnected, the government cannot credibly commit itself to not rescuing the system when in peril.

Another idea, popular among US liberals, is that the chief issue is “too big to fail”. …. Size matters. But it is certainly not all that matters.

A third notion is that … if only oversight had been effectively imposed, the pattern of overleveraging and default could have been halted. This, too, is unlikely. ….

In the end, halting the financial doomsday machine is going to involve fundamental changes in policy towards – and the structure of – the financial system. …. I plan to address that issue next week.

Martin Wolf, “The challenge of halting the financial doomsday machine”, Financial Times, 21 April 2010.

There is much more in the full column. If you are not an FT subscriber, take advantage of free registration, and reserve four of the limited monthly downloads for Martin’s Wednesday column. Martin Wolf is “must reading” for anyone interested in world economic affairs.

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