Eurozone Breakup Probabilities

Quick, look at the prediction markets!

The Intrade prediction markets currently predict a 30% chance that one country will leave the Euro by the end of 2012, a 59% chance that one country will leave by the end of 2013, and 60% chance that breakup will happen by the end of 2014. Looking at the graphs for the period since June 10, one can see that the June 17th election results brought down the two nearer term probabilities by a substantial amount, while the longer term 2014 probability barely moved.

It's also helpful to look at the spreads between the 2013 and 2012 prices and between the 2014 and 2012 prices.

From the graph of the spreads, it's very obvious that the markets perceived the recent election as just "kicking the can down the road". Longer term probabilities diverged from the near term ones, but the longer term probabilities converged to each other. From this data, it seems that the markets perceive the probability of a breakup by 2014 is almost equal to the probability of a breakup by 2013. Either way, things look bleak for the Eurozone.

Friday Roundup

Some more bond vigilante-unsustainable debt commentary for the UK. The analysis is peculiar because the question is why so many people are willing to invest in UK bonds now. If expectations for the future are dour, why would investors have faith now? This may be linked to the story on a possible bubble in US government bonds. Current demand for safe assets is because of collateral needs; once the economy recovers borrowing costs are going to skyrocket.

Koo takes a close look at Eurozone fiscal and monetary union dynamics, and concludes that neither system deals with balance sheet recessions effectively, especially as they are often asymmetric shocks. An interesting point is that monetary policy, when it tries to ease the impact of these shocks for certain states (ie Germany), the cheap credit causes new problems in other countries. For as much as the ECB pursues "Deutschland über alles", there may be nothing left to be over if the monetary union doesn't develop a system of interstate transfers.

Demand for safe assets doesn't necessarily lead to a shortfall in aggregate demand...only if monetary policy can function as an offset. Is the German current account surplus sucking up your country's growth? Not if your central bank holds tight to a nominal aggregate and keeps growth on track. Just as Scott Sumner says, if your central bank is doing a good job, there are no "depression economics"; fiscal policy doesn't boost output, and current account deficits don't hurt growth. The article does outline a pretty scary chain of events for why demand shocks matter

If demand still fails to materialise, economies go on to restructure via the supply-side.
A vicious circle ensues as capacity is reduced at the expense of the least efficient businesses. Unemployment rises. The economy contracts.
All the while those who still have wealth are encouraged to hoard even more, a fact which only exentuates the contraction in broad money supply, preventing liquidity from reaching those who would most likely be prepared to spend.

Is there really that much regulation holding back the natural gas energy boom? It doesn't look like it. If anything, regulation looks to be too lax, with large scale environmental concerns just shoved under the rug. The NYT piece does bring up an interesting point. Companies, at this point, have an incentive to just get the gas out as fast as possible, before the regulations start coming into effect. Sounds like a dangerous starting point with massive first mover advantages.

Greater transparency in European repo markets would be helpful, but to what extent would it actually solve anything? No doubt more aggregate statistics would help with systemic regulation, but there's still concern that unknown unknowns could crop up. Especially since there's no legal way to force every piece of data from firms, there could always be off-sheet risks building up. And when individual transactions can lose billions of dollars, these unknown risks could break the bank.

Also on the transparency front, European governments are resisting shifts to more transparent accounting standards. It looks like many European states, especially Germany, are concerned about hidden pension debts that may rise to the surface. This does not bode well for the Eurozone in the medium-term, even if national leaders can't wade through the politics to an agreeable solution.

On the topic of the Eurozone, there's an interesting new VoxEU article on the tragedy of the commons problem with regard to the ECB and the peripheral central banks. In a nutshell, the authors argue that since national banks could determine what collateral was considered "safe", they would have an incentive to be too lenient on their own banks in order to gain an advantage in lending costs in the Eurozone. In effect, each national bank's action had a negative risk externality that would be born by the entire Eurozone. This means that fiscal solutions to the crisis are not sufficient. The problem goes deeper, starting with the conflicting incentives of sovereign central banks and the European central bank.

Friday Roundup

Niall Ferguson takes a break from his usual Newsweek hackery and takes a look at the political constraints surrounding the Eurozone. The narrative is rather similar to previous ones regarding the decentralization of economic and political power, and all the attendant problems that arise with coordination. Killer paragraph from the article:

Imagine that the United States had never ratified the Constitution and was still working with the 1781 Articles of Confederation. Imagine a tiny federal government with almost no revenue. Only the states get to tax and borrow. Now imagine that Nevada has a debt in excess of 150 percent of the state’s gross domestic product. Imagine, too, the beginning of a massive bank run in California. And imagine that unemployment in these states is above 20 percent, with youth unemployment twice as high. Picture riots in Las Vegas and a general strike in Los Angeles.

Now imagine that the only way to deal with these problems is for Nevada and California to go cap in hand to Virginia or Texas—where unemployment today really is half what it is in Nevada. Imagine negotiations between the governors of all 50 states about the terms and conditions of the bailout. Imagine the International Monetary Fund arriving in Sacramento to negotiate an austerity program.

Capital control regimes look to be an interesting field of analysis for the future. The authors do make an important note: control over the capital account, to a certain extent, implies a control over the balance of trade. this is an important point for future negotiations, as it is a reason why capital controls should be used sparingly.

Apparently Bernanke doesn't shy away from strong language when the financial system is on the line. Although he's been relatively lukewarm about further easing to lower unemployment, he seems totally on board to do "whatever necessary" to stop the Eurozone contagion from spreading to the United States. One wonders what's the consideration preventing him from doing something similar to solve the US employment crisis.

The political argument about Glass-Steagall is quite interesting. The thesis goes that, after the merging of commercial and investing institutions, bank lobbies became much more unified, thereby warping the government towards helping the banks. This seems like an issue that would be interesting to study in a political business cycle or political DSGE model. It would make banking regulation endogenous, and the results could be quite unpredictable.

While I do think the broad enets of the efficient market hypothesis are true, I think the new concern with systemic risk is well deserved. I think viewing the EMH as a limitation on information, and not a limitation on the presence of crises is very important. Otherwise it leads to a dangerous bias, as described in the article:

There may be a deeper bias at work. In business and investing, choices under conditions of uncertainty are made all the time, and mistakes are routine. By contrast, developed country policymakers’ default stance seems to be that proactive or preemptive measures require a high degree of certainty, owing to a deep-seated belief that financial markets are stable and self-regulating. 

If one believes that market instability is rare, then it is reasonable to refuse to act unless there is a compelling case to do so. In light of experience, the view that the financial system is only exceptionally unstable or on an unsustainable path seems at least questionable.  

Unsurprisingly, the article is short on specifics on how to regulate systemic risk, but it is certainly one of the biggest issues for financial stability.

Finance is incredibly complicated, making it hard for anyone to regulate it. This is one of the issues that makes me skeptical of the argument that markets can regulate themselves when it comes to complex financial products. The payoffs are too volatile and uncertain for the market to truly know. Of course, it's unlikely that regulators know any better. However, this is no excuse for government to throw up its hands; rather, it's an opportunity to craft simpler rules that are robust to errors.

What are the systemic risks associated with money market funds? They played a large role in the liquidity crisis and financial turmoil in 2008, and thus their systemic role will be important for future analysis.

An insightful look into the failure of the Gaussian model and the real reasons why it was so destructive. Modelers never truly believed in it, and rating agencies never got around to implementing them. However, due to the demand for AAA rated assets, financial engineers gamed the system to satisfy the demand and earn hefty bonuses. It seems that the story is much more about individual incentives and corporate governance, and much less about an "equation that destroyed finance" or the financial conspiracy.

Friday Roundup

China is not much of a global economic leader. China doesn't see financially protecting Europe as critical for its own economy; it feels that is is segmented enough to protect itself. This also shows how China is not willing to provide global public goods (ie stable finance). It is no economic hegemon, and therefore doesn't act in a way conducive to global economic coordination.

There's been a series of good posts from FT alphaville on the issues facing European finance. Given the meteoric rise and fall of finance in Europe, one has to wonder why the markets didn't price in the risk. The most plausible answer? There was too much that they could never have known; markets were too opaque. This should be a lesson for people who think they can "calculate" the optimal level of risk. You know too little about probabilities to make a surefire judgment; you should resort to looking at fragilities instead.

Banking union? Not likely. International economic coordination is hard, and Europe isn't quite up to it. There's just too many different interests at play for a banking union to work; who would we hold responsible to pay? Banking is a market that extends beyond governance, which makes it almost impossible to solve the problems with capital flight and get the Euro on solid footing.

China is slowing down further: steel edition It's really quite staggering how many different factors are converging at the same time: China bleeding into Australia, India slowing down, and then the Eurozone is falling apart. We have no idea how bad it's going to get, which makes the fragility of all financial systems particularly worrisome.

Global equities fall on the announcements of one Federal reserve chair. Asia was counting on further easing, and the fact that Bernanke didn't come out clearly in support of it is not good news. The announcement really marks how the United States truly is a monetary superpower; a tentative decision on QEIII is enough to send markets roiling. These are the kinds of problems that make me really wish that monetary policy was done in a more rule-based fashion that took into account the gigantic output gap. Perhaps something like NGDP targeting...

More on the safe assets story and the fiscal cliff. This shadow banking dimension is something I want to investigate going forward because it seems to be a new channel for traditional fiscal and monetary policies. Shadow banking seems to make fiscal policy more powerful as it improves the stock of collateral, whereas it makes monetary policy more problematic as stocks of collateral are bought up.

An interesting look at the linkages between Europe and the United States. I think the finance data coupling indicates that the relationship really goes beyond simple export statistics. This is an interesting problem from the concepts of "opacity", because we really don't know the extent of the connection. All that we know is that there are hints of financial coupling, which might make the Eurozone contagion problematic for the United States.

Friday Links and Thoughts

An interesting analysis of global supply chains and the recent crisis.  In the Great Recession, European firms that were exporters suffered higher losses of sales than those who were importers or were not very open to international markets.  In terms of a "debundling" of globalization, this means the firms that were the core supply chain coordinators did better in the recession than the export parts periphery.  This suggests that the debundling of globalization makes these supply chain members similar to the commodity exporting countries under previous regimes, as the parts manufacturers are now the commodified, low skill level exporters.

Germany is just stuck in the worst of worlds.  If Greece leaves the Euro early, the chaos of capital flows are likely to overwhelm Europe and cause a more severe economic contraction.  However, if Greece's exit is inevitable, then it may be better to do so now because the costs of an exit are only going to increase in the future.

A new paper on the history of global reserve currencies.  Eichengreen and Mehl find that the US dollar overtook the UK's pound sterling much earlier than previously believed.  The change in dominance took place in the 1920's and the US dollar continued its strength through the end of World War II.  One of the key findings of the paper is that the US dollar was so successful because of the depth of the U.S. financial markets. In effect, because of the large home market in the United States, it was seen as more stable reserve currency.  This has three important implications:

1. First is that finance, in many ways, functions as an increasing returns to scale industry in the short run.  As a result of a larger financial industry, a certain country may gain a comparative advantage in finance.  
2. The second is that larger currency unions, if stable, are more likely to be the base of a global reserve currency.  This is interesting in the context of Europe, because those countries, although they are bound together, failed to foster a shift to a European reserve currency because of fundamental internal imbalances.  Reserve currency status then becomes another key determinant in whether a currency union benefits or hurts a region.
3. Third is that macroprudential policy will be increasingly important for the preservation of a reserve currency. Without that level of moderation to promote medium-term sustainability, financial markets aren't stable enough for reserve currencies to remain.

China's financial system is incredibly fragile.  Although, on aggregate, capital is flowing into China, the flows could easily reverse based on the decisions made by a small population of affluent Chinese.  To me, it represents another reason why fears about China should take place in the tail, and not the medium results.  Growth is likely to be in for a bumpy landing, but if not it is likely to collapse.  Hard.

Perhaps manufacturing is special.  Its recovery has been quite strong in the recent recovery, and it may bode well for the furthering of science and engineering in the United States.  The fact that manufacturing firms played such a large role in increasing spending in research and development creates possibilities that manufacturing really is special in an age of otherwise stagnation.

A credible argument against the Sumner critique of monetary policy.  Is there a possibility that central bank independence could be jeopardized by higher levels of unconventional policy action?  In a world of high levels of debt and overly expansionary fiscal policy, Fed tightening would become a lightning rod for criticism.  At that point, the Fed could easily lose its independence as fiscal authorities came under attack.  Thus, the Fed can't be an omnipotent actor because it would create massive possibilities for moral hazard on part of the fiscal authorities.  This seems to be another interesting avenue for fragility in NGDP targeting.  Central bank robustness leads to governmental fragility.

A Look Back Through the Lens of Complexity: "Bigger is Better"

When fears about the Euro were not always so well developed

Recent developments in Europe have created fears that Greece will soon exit the Euro. The spectacular way that the Euro has failed has led some to wonder why the Euro came together in the first place. Interestingly, the concern about a systemic Eurozone crisis did not really register when the Greek crisis started. Perhaps there were some musing that the crisis could spread, but it seemed that people believed that there would be a rescue package and that the crisis would pass. Size would come to the rescue, and an economy larger than that of the United States, the EU would end the threat of financial contagion.

If only they were right.

We now see massive capital outflows from the periphery and a frighteningly fast flight to quality within the Eurozone. But wasn't size supposed to blunt these impacts? While this narrative of "strength through fragility" seems hopelessly naive now, it's interesting to note that even in May/June of 2010 Foreign Affairs published an article by Richard Rosecrance extolling the benefits of size and larger currency arrangements in an era of turbulent capital flows. Rereading the essay, many of the key passages remind us how hindsight is 20-20, and that the narrative of the day can often push policy in the wrong direction.

The essay starts with a description of the Asian financial crises that roiled markets in the late 1990's as a justification for larger economic zones and currency areas;

But eventually the trading-state model ran into unexpected problems. Japanese growth stalled during the 1990s as U.S. growth and productivity surged. Many trading states were rocked by the Asian financial crisis of 1997-98, during which international investors took their money and went home. Because Indonesia, Malaysia, Thailand, and other relatively small countries did not have enough foreign capital to withstand the shock, they had to go into receivership. As Alan Greenspan, then the U.S. Federal Reserve chair, put it in 1999, "East Asia had no spare tires." Governments there devalued their currencies and adopted high interest rates to survive, and they did not regain their former glory afterward.

Russia, meanwhile, fell afoul of its creditors. And when Moscow could not pay back its loans, Russian government bonds went down the drain. Russia's problem was that although its territory was vast, its economy was small. China, India, and even Japan, on the other hand, had plenty of access to cash and so their economies remained steady. The U.S. market scarcely rippled. 

Small trading states failed because the assumptions on which they operated did not hold. To succeed, they needed an open international economy into which they could sell easily and from which they could borrow easily. But when trouble hit, the large markets of the developed world were not sufficiently open to absorb the trading states' goods. The beleaguered victims in 1998 could not redeem their positions by quick sales abroad, nor could they borrow on easy terms. Rather, they had to kneel at the altar of international finance and accept dictation from the International Monetary Fund, which imposed onerous conditions on its help. In the aftermath of the crisis, the small trading states vowed never to put themselves in a similar position again, and so they increased their access to foreign exchange through exports. Lately, they have proposed forming regional trade groups to get larger economically, by negotiating a preferential tariff zone in which to sell their goods and perhaps a currency zone in which to borrow cash.

The story of the Eurozone has shown us that increasing lending through large currency zones is a fool's errand. Private capital flows to the periphery destroyed the PIGS' competitiveness even though they were being quite fiscally conservative. The ability to borrow easily in good times has actually worsened situations, as at the first sign of debt troubles capital can quickly move out of the periphery states, again forcing them to "kneel at the altar of international finance and accept dictation from the International Monetary Fund."  Comically, Greece has been forced to accept "onerous conditions" from Germany for their help in the bailouts. While larger currency areas may secure cheaper funding in the short run, long run capital prospects don't improve.  In a sense, the larger currency area is a form of manufactured stability. It allows volatility to be restrained in good times, only to become fearsome in times of crisis. It's a blowup strategy, with all of the risk in the far left tail.

Moreover, a common currency area actually prevents a country from pursuing the other solution to sudden financial shocks: higher trade in goods. While the Asian economies faced the problem that "the large markets of the developed world were not sufficiently open to absorb the trading states' goods", Greece is facing the exact opposite problem. Past capital flows have left the economy severely overvalued and other markets may be willing to buy Greek goods, if only Greece could devalue its currency!  To worsen the problem, fears about Greece's debt situation lowers global equity values, further reducing global demand for Greek goods! A common currency area takes away from the external devaluation adjustment mechanism and therefore only aggravates the problems that small countries face in financial crises.

The fact that there is no adjustment mechanism makes the larger market available to each state less useful.  According to Rosencrance:

The 27 states that now compose the European Union will soon be accompanied by almost ten others, making Europe stretch from the Atlantic to the Caucasus. Member states have benefited from participating in an enlarged market extending beyond their national borders. The absence of tariffs in the EU allows greater cross- border commercial cooperation, which promotes specialization and efficiency and provides consumers in the member states with cheaper goods for purchase. Over time, as economists such as Andrew Rose and Jeffrey Frankel have shown, such trade zones increase their members' trade volume and GDP growth. There are also administrative advantages: southern and eastern European states with less advanced economies have found help and tutelage from veteran EU members and have not been allowed to fail (even if their fiscal policies have been reined in). 

But when Germany is running a massive current account surplus vis-a-vis virtually every other member of the Eurozone, the cross-border commercial cooperation is a joke. The cheaper German goods for purpose are only that way because of past capital flows that rendered periphery states uncompetitive. Given the horrendous costs of internal devaluation and the low likelihood that it would restore problems with capital structure, any possible microeconomic efficiency from trade is being swamped by disastrous levels of youth unemployment and civil unrest. When there's no transfer union, these asymmetric effects of trade flows on the different countries become incredibly important. We can no longer say "Europe is benefiting", we instead see the periphery on the verge of a full-fledged financial contagion.

It is also interesting to note that Rosencrance also makes an institutional argument here. Through the interaction of the "responsible" core states with the "irresponsible" periphery states, the periphery states will be brought up to the core states' level of institutional maturity. However, large capital flows promoted by a common currency rendered these kinds of supply side reforms unnecessary, and this institutional shift never happened. And as the Eurozone drama is unfolding, it is quite possible that some periphery states will be allowed to fail as the "help and tutelage from veteran EU members" abandons them.

In addition to these new harsh economic realities, the political realities of the situation don't seem to match up with Rosencrance's arguments either. According to the essay:

The peaceful expansion of trade blocs today, moreover, is likely to bring outsiders in rather than keep them out. It has done so in Europe and to some degree in North America and Asia as well. Self-sufficient trade blocs are impossible and will not be sought after. The key to a successful trade group, in fact, is that as it grows, it attracts sellers from the outside. 

What would China, India, and Japan do if the United States and the EU formed a trade partnership? They would not find an Asian pact a satisfactory rejoinder to the transatlantic combination. Since the major markets of the world are located in Europe and North America, Asian exporting nations would have to continue to sell to them. And if Japan eventually joined the partnership, the stakes for China and India would rise. China and India might not be significantly challenged if they could substitute domestic sales for exports. But even they, as big as they are, could not do so entirely. However important Chinese consumption becomes, it will not be able to sop up all the goods that China currently exports to technologically advanced and luxury markets in Europe, the United States, and Japan. To avoid falling behind, Beijing and New Delhi would need a continuing association with markets elsewhere.

What all this means is that the patterns of global politics and economics that have prevailed for the last half millennium are increasingly outmoded. During that period, eight out of the 11 instances of a new great power's rise led to a "hegemonic war." With a potential Chinese challenge looming in the 2020s, the odds would seem stacked in favor of conflict once again, and in other eras it would have made sense to bet on it. 

Yet military conflict is not likely to occur this time around, because even if political power sometimes repels, today economic power attracts. The United States does not need to fight rising challengers such as China or India or even to balance one off against another. It can use its own market capacity, combined with that of Europe, to draw surging protocapitalist states into its web. 

During the Cold War, the economic force of the West eventually surpassed and subverted even the heavy industrial growth of the Soviet economy. In the 1980s, the attractions of North Atlantic, Japanese, and even South Korean capitalism were a critical factor in Soviet leader Mikhail Gorbachev's decision to renew his country's economic and political system -- and end the Cold War. They also helped stimulate Deng Xiaoping's reforms in China after 1978.
Now that the formula for capitalist economic success has become widely understood and been replicated, Western economic magnetism will stem not just from the triumphs of individual economies but from their development as an increasingly integrated group. The expansion and agglomeration of economies in Europe -- and perhaps also across the Atlantic -- will serve as a beacon for isolated successes such as those in Asia.

The argument here seems to be that larger scale economic integration would be a virtuous cycle and therefore serve to moderate international conflict. As a result of integration in certain regions, other states will be forced to integrate with them, creating a unified global trade and financial regime. However, if large economic regime are important to this process, doesn't this just heighten the fragility embedded in the international system? This is especially vivid for the Euro now as, if anything, the collapse of the Eurozone would severely discredit the argument that open, integrated, western economies are the correct way forward. The failure of agglomeration would serve as a deterrent to the "isolated successes such as those in Asia."

A look back on such essays about the Euro serves as a reminder on how limited our capacity for prediction really is, and how the common narrative at any given time can hide the fragilities that persist in complex systems. The reasons behind large scale political developments such as the EMU are often opaque and create economic regimes whose faults are only revealed to us later. It is for this reason that our awareness of fundamental fragilities within economies is incredibly important. We do not know what we are truly doing, so we must strive towards a system that is robust to our errors.

Grexit Opacity: Why Are We Predicting Again?

Do we know how much we don't know?

(Photo credit from Reuters)

With the recent Greek elections, there's been a lot of talk about a possible Greek exit (or the cutely named "Grexit") from the Euro.  What has struck me about the situation is how much of it is still "up in the air".  You know, with  €436M dollar bonds lying around to be paid and high levels of uncertainty on what the EUR/USD exchange rate will end up as.  Much of it will be dependent on the political resolution in Greece, but also on political resolve in core countries such as Germany and France.

But time is running out.  If the breakup is going to work, it needs to be a surprise, but with European integration as is it's hard to imagine how Greece would be able to prevent capital flight.  Moreover, if they decide to break from the Euro, the other periphery countries would have a great incentive to leave the Euro as well, leaving only Germany to deal with the loss of so much Euro denominated debt.  Immediate losses could easily reach 400 billion in initial bank losses.

To me, this all illustrates how little we truly know about the way highly interconnected and leveraged economies work.  How do you build a model in which economic conditions in Greece endogenously create the political conditions over many rounds, endogenously weakening the political situation in Germany to create a contagious financial crisis over Europe?  There is no analytically tractable way to solve that system!  Moreover, we know about these factors now that there's been so much turmoil, but how was one supposed to be able to forecast all these issues beforehand?  I also see this as a worrying issue about NGDP targeting.  While, in the long run, NGDPLT makes sense, the real question is how the credibility is established in the short run.  If unanchored expectations can have so much impact on the interpretation of debt, it seems terrifying that so much of the global economy would become pinned on the monetary decisions of a few.  It just creates a whole new host of unknown possibilities.  We can barely work with the unknowns that we know about; I dread to think of the unknown unknowns that still remain.

The presence of those unknowns is also asymmetric.  There is likely nothing left that will manage to make Greece substantially better.  Had there been a quick fix, it would have already been tried.  Even if Germany decides to massively shift to increase Eurozone NGDP (which would also make Germany overheat by a large amount), it wouldn't be a cure-all; serious debt and supply-side issues would still remain.  We're reasonably certain of how good it can get; we have no idea how bad the left tail can go.

We can't continue down the path of development like this.  Antifragile solutions need to be found.

Escaping from the Golden Fetters

An intermediate to currency disunion

The prospects for the Eurozone look bleak.  CDS spreads are going up, large countries have downgraded debt, politics is turning against fiscal consolidation, and the central bank still feels trying to save the Euro would jeopardize (what's left of) its credibility.  This has led to widespread pessimism about the long-run sustainability of the Euro, including from my fellow soon-to-be-undergraduate blogger Evan.  But, we must remember that "The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again."  Our goal for the endgame of the European economy is irrelevant if sovereign debt crises interrupt our theorizing.  Especially given the precipitous state of several other key economic powerhouses, such as India and China, adding a large scale currency adjustment hardly seems like a credible option.  The sheer physical demands of such a transition would make it nigh impossible to create an orderly transition.

Thus, even if all the nations are bound by the "golden fetters" of the Euro, simply abandoning the fetters is not a sufficient answer.To begin this walk away from the abyss, there needs to be more room for national policy in a continent that is otherwise deeply integrated.  The apparent struggles of the Eurozone are a particularly interesting case of what Dani Rodrik calls for in a path to a saner globalization.  We cannot let the perfect become the enemy of the good, and therefore let a potentially destabilizing deep integration get int the way of the many beneficial forms of shallower integration. Nations are different; why shouldn't their laws be the same?  In the words of Rodrik:

We have to think of these differences not as aberrations from the norm of international harmonization, but as the natural consequences of varying national circumstances.  In a world where national interests, perceived or real, differ, the desire to coordinate regulations can do more harm than good.  Even when successful, it produces either weak agreements based on the lowest common denominator or tougher standards that may not be appropriate to all.  It is far better to recognize these differences than to presume that they can be papered over given sufficient time, negotiation, and political pressure (The Globalization Paradox, 262).

Too often, attempts at harmonization result in policies that are "one size fits none."  Interest rates or macroprudential requirements may be too high in one polity, too lower in another, thereby aggravating the procyclical tendencies for both.  Stricter fiscal pacts and banking unification won't help; if anything, they would likely worsen the situation.

So if the Euro isn't going away in the short run, then there needs to be a way to introduce frictions to give national governments "policy space" to adjust.  This is where national macroprudential policies and potentially capital controls come into play.  Even if Eurobonds and enhanced lender of last resort capabilities are necessary, they need to be paired with policies that can ensure that the question of liquidity does not evolve into a question of later solvency.  Without national policy space, differing unit costs of capital and labor can evolve into serious financial issues, replicating the current European debt crisis.

This kind of financial segmentation would be even more appropriate given the dangerous roles of private capital flows in promoting the current crisis.  Private capital, freed from exchange rate risk and in search for higher yields, would flow from core banks to the periphery.  However, due to the poor institutional underpinnings of the periphery, there was no proper way to organize that capital (interfluidity).  In the time of adjustment, the common currency then prevents any kind of external devaluation that otherwise might have blunted the highly procyclical capital flows.  Since the currency cannot self adjust the capital flows, the governments may have to take a stronger role in ensuring that destructive capital flows don't distort national economies.

Eventually, when things have stabilized, the Euro can be steadily phased out  But with the current uncertainty and chaos, that option hardly seems viable.

Update 4/29/12:


New article from the economist that discusses the prospects for financial integration:

Breaking that interrelationship requires a number of things, Lord Turner argues. He would like to see Eurobonds that can, among other things, act as a risk-free asset that liberates banks from the “wrong-way risk” of holding their own sovereign’s debt; and he argues, too, for a pan-euro-zone approach to bank resolution, deposit insurance and supervision. National authorities should, he thinks, have responsibility for pulling “macroprudential” levers designed to prick booms before they get out of hand.

A much more integrated euro-zone banking system is a logical response to the euro crisis, but boy will it be difficult. Just imagine the implications. A big European supervisory authority that excludes Britain, the continent’s biggest financial centre; a system that would see taxpayers in creditor countries backing the banks of debtor countries; a process that could end up with supervisors in Frankfurt telling the Spanish, say, they cannot have more credit. Thorny stuff, but still better than the direction in which the euro zone is now travelling.

 But why are we trying for force all European countries into the same financial straitjacket if they're, quite obviously, Not The Same?

Debt and Growth: The Chicken or the Egg?

..., and what to put in the European omelet?


How does debt affect growth?  The well-known correlation found by Rheinhart and Rogoff in their analyses of financial crises found that growth tends to substantially slow down as the debt to GDP ratio approaches 90%.  Based on this correlation, policy makers began to advocate austerity as a way to reduce debt, and thereby restore growth.

Of course, correlation does not prove causation, and Paul Krugman jumped at that, pointing out that it was quite likely that causation ran the other way.  As a result of anemic growth, countries would pursue countercyclical fiscal policy.  This would create the appearance that only low growth countries pursue higher levels of debt.  However, the association between the two variables actually arises from textbook countercyclical fiscal policy.  Had the government decided to retrench, the economy would have suffered even more, compounding the growth problem.

So how to resolve these issues?  A recent VoxEU article on the relationship between debt and growth caught my eye, as it proposed a novel mechanism to estimate the effect of debt on growth.  While I don't understand the full mechanics, the working paper seems to use the stock of foreign debt as a variable to instrument the stock of debt.  At the end of the analysis, the authors conclude that, while R+R find a strong correlation, the new data instrumented for endogenity cannot reject the null hypothesis that debt has no effect on growth.  This then has a critical role in determining policy because it suggests that countries, when in dire output straits, should not ignore the role of fiscal policy.  The debt effects are unlikely to be strong enough to overwhelm any first order effects from fiscal stimulus.  Especially given the recent interest in hysteresis and reductions in potential output, it seems almost certain that fiscal retrenchment is not the answer.  Along these lines, I also found some older articles, one an old study looking at old U.S. time series data, and another on Latin American growth, that both suggest we should be worry about the output gap.  Long run growth can be seriously affected by temporary deviations, and therefore we need to fill the gap, whether by fiscal or monetary policy.

Another note in the paper that was particularly interesting was that the authors traced much of the negative correlation between debt and growth to the destructive policies governments would pursue when at high levels of debt.  In the words of the authors:

We believe that there is a subtle channel through which high levels of public debt can have a negative effect on growth. In the presence of multiple equilibria, a fully solvent government with a high level of debt may decide to put in place restrictive fiscal policies aimed at reducing the probability that a change in investors’ sentiments would push the country towards the bad equilibrium. These policies, in turn, may reduce growth (Perotti 2012), especially if implemented during a recession (such policies may even be self-defeating and increase the debt-to-GDP ratio, DeLong and Summers 2012, UNCTAD 2011).3 In this case, it would be true that debt reduces growth, but only because high debt leads to panic and contractionary policies.

This argument piqued my interest for two key reasons.  The first is that it echoes a paper by Bernanke on the effect of supply shocks on the economy.  In the paper, Bernanke argued that a lot of the damage from a supply shock wasn't actually from the shock itself, but rather from the monetary policy response.  In the case of debt, much of the harm from high levels of debt isn't from the debt, but rather from the fiscal policy response.

The second is that this advice on debt and growth seems particularly pertinent for the Eurozone.  This paper provides strong evidence that the austerity cure is anything but.  Even if growth is needed, but fiscal retrenchment is not the answer.  Netherland's recent rejection of harsh cuts, and France's electoral shift both show that democracy is having its say and is refusing this cup of self-defeating suffering.  They recognize that cutting budgets cannot be the only way forward, and that policy needs to be fundamentally changed to recognize the elaborate chicken and egg relationship between debt and fiscal policy.  I only hope that they figure out that omelet before the bond markets take away the chance.