Brexit or Fixit

Many commenters compare Brexit to the American revolution. I think the constitutional convention is a better analogy for the moment and challenge ahead. A first attempt at union resulted in an unworkable Federal structure. Europe needs a constitutional convention to fix its union.

The EU's first attempt was basically aristocratic/technocratic. Brussels tells the peasants what to do. The EU  needs a hardy dose of accountability, representation, checks and balances -- all the beautiful structures of the US Constitution. What little thought the EU put in to these matters is clearly wanting.

America did not wait for a state to leave. But, though even the Pope admits the EU structure wasn't working, the EU needed this wake up call. Bring the UK to the convention, and bring them back. Fixit. (#Fixit?)


Out of control economic regulation, labor laws, mandated social programs and "60% of British laws are made in Brussels" (I don't know the source of the widely quoted number, but the sentiment is as important as the fact)  are the most sensible arguments I heard for Brexit.

Fraser Nelson's WSJ essay expressed this well

The Brexit campaign started as a cry for liberty, perhaps articulated most clearly by Michael Gove, the British justice secretary... Mr. Gove offered practical examples of the problems of EU membership. As a minister, he said, he deals constantly with edicts and regulations framed at the European level—rules that he doesn’t want and can’t change. These were rules that no one in Britain asked for, rules promulgated by officials whose names Brits don’t know, people whom they never elected and cannot remove from office. Yet they become the law of the land. Much of what we think of as British democracy, Mr. Gove argued, is now no such thing.

The important point, I think, is not the outcome -- too much silly regulation, labor laws, and so on. The process is the important point.

America is, in my opinion, also a victim of stifling economic regulation, job-killing labor laws, incentive-destroying social programs. But, we still have a process in place -- in trouble, creaky, under attack by results-at-any-cost progressivisim.  But we have a process. Regulations are supposed to be authorized by Congress; should follow the Administrative Procedures act, with public comment, cost benefit analysis, and so forth; can be challenged administratively and then in court; and Congress itself can pass laws over-ruling regulators (which the President can veto, as he has).  Europe is missing this process; and european law is even worse than economic regulation here.

Last week's immigration ruling is an example of the same forces under strain in the US. I happen to agree with the Administration on policy grounds: People who have been here their whole lives, parents of US citizen children, should not face the constant risk of deportation, and should be allowed to work legally. (I had no idea there was such a thing as a "work permit" in the US, until President Obama mentioned it.) But, Congress passed silly laws mandating the opposite, and the Administration moved beyond its authority. When States are suing the Administration in the Supreme Court over its actions, we are in danger of Texit. But at least Texas can sue. Britain had no similar way to object to EU edicts.

Process matters, because democracy needs to form consensus and acceptance. When you force things down people's throats, they eventually gag.

Again quoting WSJ

Instead of grumbling about the things we can’t change, Mr. Gove said, it was time to follow “the Americans who declared their independence and never looked back” and “become an exemplar of what an inclusive, open and innovative democracy can achieve.” Many of the Brexiteers think that Britain voted this week to follow a template set in 1776 on the other side of the Atlantic. 

The answer for Europe is that it must allow people the option to change things they don't like. And 1787, not 1776 is the inspiration.

On economics, I think it's overblown.

Will this be a disaster for the British economy? Probably not. Norway, Switzerland, and Japan seem to get along.  If the UK decided to be a free economy free trade and open banking center, it could do wonders.

It is nice to see a consensus (though sometimes implicit) on the advantages of free trade. Leave did not argue for the importance of preserving British jobs with trade restrictions.  Alas, "free trade" now means "access to markets" or managed mercantilism.

The benefits of a continent-wide open labor market are easy to see in my business. As I visit universities around Europe, the typical smart young professor might come from Slovakia, have done an undergraduate degree in Spain, Masters' in the UK, PhD in Italy, is working in Sweden, with spouse working in London. The result is a resurgence of European universities, now dramatically better than they were two decades ago. The irony of Brexit is that English is the common language of Europe, making this integration possible.

So why are markets going so wild? I think political follow-on is very unstable. If Brexit leads to Britain becoming Norway it's not a big deal. If the UK breaks up, and the EU breaks up, we have big trouble ahead. Fixit instead.

Greece and Taxes

An interview for the Greek Reporter, in English, perhaps cheering the like-minded and sure to infuriate some conventional wisdom.

I agree with the "anti-austerians" on one point: Raising taxes was a bad idea. In my emphasis what counts are marginal tax rates on growth-producing activities, rather than Keynesian pump-priming, however, which is an important distinction.

The article says "A recently released study by the Economics Department at the National Kapodistrian University of Athens revealed that Greece has the third highest taxation rate among 21 European countries." If anyone has a link, especially if it's in English, send it in the comments.

Taylor Truman Medal Speech

John Taylor's speech  on receiving the Truman medal for economic policy is noteworthy. John thinks about the institutions that govern monetary and financial policy. We spend too much time on the will-she-raise-rates-or-won't-she sort of decisions that we forget how important this institutional structure is to good, predictable and (as John might put it) rule-based policy.

John reflects on the institutions of postwar policy:

Seventy years ago Harry Truman signed the Bretton Woods Agreements Act of 1945. It officially created two new economic institutions: the International Monetary Fund and the World Bank. A year later he signed the Employment Act of 1946. It created two more new institutions: the President’s Council of Economic Advisers (CEA) and the Congress’s Joint Economic Committee (JEC). And in 1947 came the General Agreement on Tariffs and Trade (GATT) and the Truman Doctrine, and in 1948 the Marshall Plan.

Prewar problems:

... One serious economic evil leading up to World War II arose from competitive devaluations and currency wars...

A second economic evil stemmed from extensive “exchange controls,” in which importers of goods were forced to make payments to a government monopoly in foreign exchange. The government would determine what types of goods could be imported and how much to pay exporters. Exchange controls also involved multiple exchange rates, government licenses to export and import, and even officially conducted barter trade. They deviated from the principles of economic freedom, and caused all sorts of distortions and injustices...

Bretton Woods:

Each country—each party to the agreement—would commit to two basic monetary rules... First, they would swear off competitive devaluations by agreeing that any exchange rate change over 10% from certain values, or pegs, would have to be approved by a newly-created IMF. ... It was called an adjustable peg system.

Second, countries agreed to remove their exchange controls, with a transition period because many had extensive controls in place. The countries, however, did not agree to remove capital controls, which include restrictions on making loans, buying or selling bonds, and equity investments.

John's judgement:

In important respects the blueprint succeeded. Exchange controls were removed, though it took more than a decade, and the currency wars ended, though the adjustable peg system itself fell apart in the 1970s and gave way to a flexible exchange rate system. The 1970s were difficult because monetary policy lost its rules-based footing and both inflation and unemployment rose. 

But in the 1980s and 1990s policy became more focused and rules-based and economic performance improved greatly. Though not part of the blueprint, virtually all the developed countries that signed the original agreement—and others like Germany and Japan—also abandoned capital controls. By the late 1990s, many emerging market countries were adopting rules-based monetary policies, usually in the form of inflation targeting, and entered into a period of stability. Some emerging market countries, such as Brazil, began to remove capital controls, and the IMF recommended adding their removal to the articles of agreement.

I'm a bit skeptical of this judgement. (And I think I've persuaded John, so we'll see what happens in later writings.) Bretton Woods featured pegged exchange rates, something of a gold standard to the dollar, and capital controls to lessen exchange rate pressures. All three blew up by 1970. The basic structure of Bretton Woods failed.

The restoration of order in the 1980s featured important reforms to monetary and fiscal policies internationally, and the Bretton Woods institutions (IMF, CEA, etc.) may have had something to do with it. But Bretton Woods was gone.

Bretton Woods did, however, help to keep the chaos of the 1930s from returning. John's point may be that bad rules are better than no rules.

On to the present:

Unfortunately this benign situation has not held, and today the challenges facing the international monetary system eerily resemble those at the time of the creation...

Consider currency movements. Quantitative easing (QE) started in earnest in 2009 in the United States. It was followed by a period where the dollar was low relative yen. It was followed by QE in Japan in 2013 which depreciated the yen, as was the expressed intent of Japan governor Haruhiko Kuroda. That was followed by QE in the Eurozone in 2014 which depreciated the euro, as was the expressed intent of ECB president Mario Draghi. The dollar- yen-euro story from 2009 to 2014 looks a lot like the pound-dollar-lira story from 1931 to 1936, even though U.S policy makers today consider the exchange rate effect to be by-products of their actions, not the direct intent. So QE begets QE, which begets QE, and so on.

There is a big challenge understanding just how QE affects currencies. Notice John says "followed by." But if you regard QE as signals of future interest rates, it is easier to understand. Exchange rates are a sort of present value of future interest differentials.  Continuing

Interest rate decisions at central banks around the world also resemble currency wars. Whether you ask them or watch them, you can tell that central bankers are following each other. Extra low U.S. interest rates were followed by extra low interest rates in many other countries, in an effort to prevent sharp currency appreciations. Those low interest rates appear to have resulted in a boom-bust pattern in emerging market countries evident in the recent commodity cycle...

Capital also flows in response to interest rate differentials—even if attenuated by policy reactions. .. A host of government interventions and restrictions on housing markets have been used to prevent the low interest rates from causing bubbles. Macro-prudential regulations, which have legitimate purposes, are also being used to counter the effects of the low interest rates.

Worse,

There’s also been a revival of capital controls. Even the IMF has endorsed capital controls, calling them “capital flow management” or CFM for short.

John's conclusion

In my view we need a new strategy to deal with these problems.

So as in the 1940s we should forge an agreement where each country commits to certain rules... 

. A second reform would set up rules for eventually removing capital controls. Currently, 36 countries now have open capital accounts, but 48 are classified as “gate” countries and 16 as “wall” countries with varying degrees of capital controls.

John rethinks the role of the 40s institutions.

.. recreating the ‘40s founded institutions for today’s global economy must go beyond the IMF. The World Bank was originally created to supplement private capital flows for reconstruction and development. But today capital flows and savings to finance investment are abundant—some even see a glut.

He goes on to rethink the roles of CEA, JEC, GATT, WTO, and so forth.

Last but not least, international economic policy and foreign policy are intertwined. The Bretton Woods generation understood that.

...we see the same international cross-border encroachment on freedom, including economic freedom. In my view the United States should commit to promoting economic freedom as part of its foreign policy strategy. It should also strongly support economic leaders who are committed to economic freedom in their own countries. This is the lesson learned from the transitions from government control to market economies two decades ago, especially in Poland. The U.S. government strongly supported Polish economic reforms—the removal of price controls, of barriers to new businesses, and of subsidies of old state enterprises, along with a restoration of the rule of law and property rights. Today international support packages tend to do just the opposite: encourage more government subsidies and controls.

It is amazing just how much of the international financial and monetary architecture resides in institutions set up in the 1940s. Good rules need good institutions. But institutions need rethinking on occasion.

Greece and Banking, the oped

Source: Wall Street Journal; Getty Images

A Wall Street Journal Oped with Andy Atkeson, summarizing many points already made on this blog. This was published August 5, so today I'm allowed to post it in its entirety. You've probably seen it already, but this blog is in part an archive. If not, here is the whole thing, with my preferred first paragraph.
Local pdf here.

Greece's Ills [and, more importantly, the Euro's] Require a Banking Fix 

Greece suffered a run on its banks, closing them on June 29. Payments froze and the economy was paralyzed. Greek banks reopened on July 20 with the help of the European Central Bank. But many restrictions, including those on cash withdrawals and international money transfers, remain. The crash in the Greek stock market when it reopened Aug. 3 reminds us that Greece’s economy and financial system are still in awful shape. 


Greece’s banking crisis revealed the main structural problem of the eurozone: A currency union must isolate banks from sovereign debt. To fix this central structural problem, Europe must open its nation-based banking system, recognize that sovereign debt is risky and stop letting countries use national banks to fund national deficits.

If Detroit, Puerto Rico or even Illinois defaults on its debts, there is no run on the banks. Why? Because nobody dreams that defaulting U.S. states or cities must secede from the dollar zone and invent a new currency. Also, U.S. state and city governments cannot force state or local banks to lend them money, and cannot grab or redenominate deposits. Americans can easily put money in federally chartered, nationally diversified banks that are immune from state and local government defaults.

Depositors in the eurozone don’t share this privilege. A Greek cannot, without a foreign address, put money in a bank insulated from the Greek government and its politics. When Greece’s banks fail, international banks can’t step in to offer safe banking services independently of the Greek government.

European bank regulations encourage banks to invest heavily in their own country’s bonds, even when they have lousy ratings. The flawed banking architecture of Europe’s currency union pretends that sovereign default will never happen. Wise Europeans have known about these flaws for years, but the system was never fixed because it allows indebted countries to finance large debts.

This is the euro’s central fault. A currency union must treat sovereign default just like corporate or household default: Defaulters do not leave the currency union, and banks must treat sovereign debt cautiously. When Europeans can put their money into well-diversified pan-European banks, protected from interference from national governments, inevitable sovereign defaults will not spark runs, or destroy local banks and economies. And government bailouts will be far less tempting.

That is the long-term fix, but how does the eurozone get out of its current mess? The ECB’s latest Greek bailout deal is focused on long-run structural reforms, asset sales, budget targets and illusory tax increases. It might at best revive growth in a year or so.

But without well-functioning banks, Greece’s economy will collapse long before such growth arrives. To revive the banks and the economy, Greeks must know their money is safe, now and in the future. So safe that Greeks put money back in the banks, pay debts and seamlessly make payments—with no chance of a euro exit, tightened capital controls that impede international payments or depositor “bail-ins,” a polite word for the government grabbing deposits.

The United States offers a precedent. The U.S. economy ground to a standstill in the banking panic of 1933. The administration of Franklin D. Roosevelt closed America’s banks with a national banking holiday to stem the bank run. It then took immediate steps to restore confidence with the clear promises of the Emergency Banking Act of 1933 to resolve insolvent banks, promises backed up by the remarkable rhetoric of FDR’s first fireside chat and the intact borrowing power of the federal government. When banks reopened, Americans lined up to redeposit their money. In the 1980s, the U.S. deregulated banks to allow extensive branch and interstate banking, further isolating local banks from local troubles.

Europe is headed toward bailing out both the Greek government and Greece’s struggling banks. Instead, Europe should resolve and recapitalize the banks alone, put them under private European ownership and control, and insulate them from further Greek government interference. Then Europe can let Greece default, if need be, without another bank run.

Then move on to Italian and Spanish banks, which are similarly larded up with government debts and are threatening the euro. These banks can still be defused slowly, selling their government debts, without huge bailouts.

Europe needs well-diversified, pan-European banks, which must treat low-grade government debt just as gingerly as they treat low-grade corporate debt. Call it a banking union, or, better, open banking. The Greek tragedy can serve to revive the long-dormant but necessary completion of Europe’s admirable common-currency project.

Europa hat die Banken missbraucht

An editorial in Süddeutche Zeitung, on Greece, banks and the Euro, summarizing some recent blog posts.

I don't speak German, so I don't know how the translation went, but it sounds great to me:

Die jüngste Griechenland-Krise rückt das größte Strukturproblem des Euro in den Vordergrund: Unter dem Dach einer gemeinsamen Währung müssen Staaten genauso wie Firmen pleitegehen können. Banken müssen international offen sein, sie dürfen nicht vollgepackt sein mit den Schuldtiteln lokaler Regierungen. So war der Euro ursprünglich konzipiert. Leider haben Europas Politiker die erste Prämisse vergessen und sind zur zweiten gar nicht erst vorgedrungen. Jetzt ist es Zeit, beides in Angriff zu nehmen.... 

The English version:

Greek Lessons for a Healthy Euro

The most recent Greek crisis brings to the foreground the main structural problem of the euro: Under a common currency sovereigns must default just like corporations default. And banks must be open internationally, not stuffed with local governments’ debts.

This is how the euro was initially conceived. Alas, europe’s leaders forgot about the first and never got around to the second. It’s time to fix both.



If Volkswagen defaults on its debts and goes bankrupt, nobody dreams that it therefore has to leave the euro zone and start paying its workers in Volkswagen marks. In a currency union, governments cannot print their way out of trouble, so they are just like companies.

When Greece got in to trouble, the first bailout went to the German and French banks who had bought lots of Greek debt. Those debts were all transferred to official holders, meaning, indirectly the German taxpayer.

Why, with the 2008 financial crisis already in the rear view mirror, were European banks — too big to fail, apparently — allowed to load up on Greek debt, to the point that they had to be bailed out? Why did europe’s bank regulators let banks hold sovereign debt as a risk free asset?

The problem has only gotten worse. Greek banks are stuffed with Greek government debt. That’s why there was a run. Greeks, knowing their banks will fail if the government defaults, rush to get money out. They have stopped paying their mortgages, as they have stopped paying taxes, and stopped paying each other. The economy is plummeting. Even with the banks now supposedly open, capital controls remain in place so Greeks cannot pay for imports. And savvy Greeks know there is still a chance of Grexit, deal failure, depositor “bail-ins,” and tightened capital controls. They would be fools to put money back in banks.

A modern economy cannot function without banks. Greece will not restart its economy, restart its tax collections, and restart any hope of paying its debts without completely open and trustworthy banks.

Banking across Europe should be open, and divorced from local government debt. A Greek should be able to put his or her euros in a pan-european bank, whose assets are diversified across Europe and will not even hiccup if Greece’s government defaults. A Greek business should be able to borrow from the same bank, whose deposits come from all over Europe. If a Greek bank fails, any European bank should be able to come in and operate it the next morning. And the Greek government should have no right to grab deposits, force banks to buy its debts, or change the currency of those deposits.

If this had been the case, there would have been no run. The Greek economy would not have collapsed. And then Europe could have been a lot tougher with the Greek government about repayment.

This is how the United States works. When states and cities in the U.S. default — such as Detroit, Puerto Rico, or, possibly Illinois — there is no run on the banks, and banks do not fail or close. Why? Because nobody dreams that defaulting states or cities must secede from the dollar zone and invent a new currency.  State and city governments cannot force state banks to lend them money, and cannot grab or redenominate deposits. Americans can easily put money in Federally chartered, nationally diversified banks that are immune from state  and local government defaults.

As a result, when one of our state governments gets in fiscal trouble, nobody thinks they need to rush to their bank to get their money out, there is no “contagion,” and much less pressure for bailouts.

This was how the euro was supposed to be set up. Many economists have been warning about it for years. But governments like to use their banks as piggy banks, and it never happened.

Greece is not the end. Italian and Spanish banks are just as loaded up with their governments’ debts, and just as prone to a run. There is time to de-fuse this bomb slowly, but that time will run out.

Sovereign default without exit and open banking are the key requirements for the european currency union. A currency union does not need “fiscal union.” The US did not bail out the city of Detroit, or states when they failed. A currency union does not require similar economies. Panama uses the US dollar. A currency union does not need countries to have similar cultures, values, economic development, or productivity. A currency union does not need political union.  Europe used gold as the common currency for centuries, centuries when Kings defaulted frequently.

Many people say that small countries need their own currencies, so they can artfully devalue. But a century’s worth of devaluations and inflations did not produce a Greek growth miracle. There is no exchange rate at which Greece’s government workers will start exporting Porsches to Stuttgart.  Rather, it was binding themselves to the euro that produced a boom, only sadly wasted.

Greece off the euro will be a disaster. Drachmas will surely not be convertible, so Greece will end up like Cuba or Venezuela, with government workers and pensioners paid in worthless local currency, and everyone who can get paper euros operating on a cash basis.  No efficient large businesses can work in such an economy.  Greece’s only hope is to liberalize its economy, open to Europe, grow strongly, and pay back its debts.

The euro is a great and worthy project, and a necessary precursor to healthy open economies in small countries of a globalized world. It’s time to finish building it as originally conceived, not turn it into a bailout union.

Mr. Cochrane is a Senior Fellow of the Hoover Institution at Stanford University.

Greece and Banking

Source: Wall Street Journal; Getty Images

A Wall Street Journal Oped with Andy Atkeson, summarizing many points already made on this blog.

Greece suffered a run on its banks, closing them on June 29. Payments froze and the economy was paralyzed. Greek banks reopened on July 20 with the help of the European Central Bank. But many restrictions, including those on cash withdrawals and international money transfers, remain. The crash in the Greek stock market when it reopened Aug. 3 reminds us that Greece’s economy and financial system are still in awful shape. 

Greece’s banking crisis revealed the main structural problem of the eurozone: A currency union must isolate banks from sovereign debt. To fix this central structural problem, Europe must open its nation-based banking system, recognize that sovereign debt is risky and stop letting countries use national banks to fund national deficits.

If Detroit, Puerto Rico or even Illinois defaults on its debts, there is no run on the banks. Why? Because nobody dreams that defaulting U.S. states or cities must secede from the dollar zone and invent a new currency. Also, U.S. state and city governments cannot force state or local banks to lend them money, and cannot grab or redenominate deposits. Americans can easily put money in federally chartered, nationally diversified banks that are immune from state and local government defaults.

Depositors in the eurozone don’t share this privilege....

For the rest, you have to go to WSJ, Hoover (ungated) or wait 30 days until I'm allowed to post it here.

Lucrezia Reichlin and Luis Garicano have an excellent Project Syndicate piece on the same topic.

Writing contest: This is our first paragraph. The Journal's editors thought it was better with latest news first. Which works better?

Mankiw and Conventional Wisdom on Europe

Greg Mankiw wrote a week ago in the Sunday New York Times, ably explaining the  conventional view that the Euro is a bad idea, and that even countries as small as Greece (11 million people) need national currencies. Excerpt:

Monetary union works well in the United States. No economist suggests that New York, New Jersey and Connecticut should each have its own currency, and indeed it would be highly inconvenient if they did. Why can’t Europeans enjoy the conveniences of a common currency?

Two reasons. First, unlike Europe, the United States has a fiscal union in which prosperous regions of the country subsidize less prosperous ones. Second, the United States has fewer barriers to labor mobility than Europe. In the United States, when an economic downturn affects one region, residents can pack up and find jobs elsewhere. In Europe, differences in language and culture make that response less likely.

As a result, Mr. Friedman and Mr. Feldstein contended that the nations of Europe needed a policy tool to deal with national recessions. That tool was a national monetary policy coupled with flexible exchange rates. Rather than heed their counsel, however, Europe adopted a common currency for much of the Continent and threw national monetary policy into the trash bin of history.

Making matters worse, however, was the common currency. In an earlier era, Greece could have devalued the drachma, making its exports more competitive on world markets. Easy monetary policy would have offset some of the pain from tight fiscal policy. Mr. Friedman and Mr. Feldstein were right: The euro has turned into an economic liability that has exacerbated political tensions. For this, the European elites who pushed for the currency union bear some responsibility.

I am a big euro fan. This seems a good moment to explain why I don't accept this conventional view, despite its authority from Milton Friedman to Marty Feldstein and Greg Mankiw and even to Paul Krugman.

Short: I am also a big meter fan. I don't think each country needs its own measure of length, or to shorten it when local clothiers are having trouble and would like to raise cloth prices.

Longer: This conventional view is deeply old-Keynesian. In this view, each region, including ones as small as Greece (11 million) or Ireland (4.6 million), less than the Los Angeles metro area (13 million), suffers "demand" shocks, which governments must actively offset with fiscal stimulus or monetary policy.

This strikes me as one of those many stories that people repeat all the time until they believe it, but whose foundations are seldom examined.  (There is a "thesis topic" label here for such examination. Comparisons of US states to European countries on these dimensions seems fruitful.)

What are these local demand shocks for small open economies in the eurozone? "Aggregate demand" is, well, aggregate, not regional.  Changing fortunes of local industries is more what we call "supply," not "demand." For small open economies (LA) much "demand" comes from other cities and states, not local.

What is this "fiscal union," apparently providing countercyclical Keynesian stimulus at the right moment?  In the US, we have Federal contributions to social programs such as unemployment insurance. Europe has the common agricultural policy and many other subsidies. We do not have systematic, reliably countercyclical, timely, targeted, and temporary local fiscal stimulus programs. Just how big is the local cyclical variation in state or local level government spending or transfers? (And why does fiscal union matter so much anyway? If you're a Keynesian, then local borrow and spend fiscal stimulus should be plenty. The union matters only when countries near sovereign default and can't borrow.)

The local and cyclical qualifiers matter. Yes, both US and Europe have some pretty large cross-subsidies. But most of these are permanent. The rest of the nation subsidizes corn ethanol to Iowa year in and year out. Social security payments come year in and year out, and transfer money from states with workers to those with retirees. Monetary policy has at best short-run effects, so the argument for currency union has to be about local cyclical, recession-related variation in economic fortunes, not permanent transfers.

And Federal fiscal transfers only started in the 1930s. We had a currency union in 1790, and no substantial Federal fiscal transfers at all until the 1930s. How did we get along all this time?

A sense in which this is a centrally old-Keynesian argument is that Greg is not making a second, common, and also wrong (in my view) case for national currencies: the view that currency union demands central bailouts of sovereign debt.  No, Greg (and the conventional wisdom he echoes) has in mind only the necessity of Keynesian countercyclical policy. Aphorisms such as "currency union demands fiscal union" are dangerous, as they have many meanings.

So, this conventional view presumes that there really are big regional "demand" shocks; that there is a big, important Keynesian fiscal multiplier, even away from the zero bound, and that our government really does a lot of recession-related fiscal transfers, larger than Europe's (agricultural subsidies, etc.) and that the US pre WWII was a disastrous too-large currency area. I'm not convinced on any of these points.

(To be sure, I will admit a multiplier of about one for state to state transfers. If the federal government takes money from the citizens of New York, and sends the money to people in Florida,  businesses will move from New York to Florida to follow the money and GDP will rise in Florida. And decline in New York.)

Consider Greece, "In an earlier era, Greece could have devalued the drachma, making its exports more competitive on world markets. Easy monetary policy would have offset some of the pain from tight fiscal policy." So, Greece's GDP is falling because of "tight fiscal policy?" Calamitous regulation, corruption, closed markets, and now closed banks, frozen payments are not relevant? Tight fiscal policy? Greece is still running primary deficits. After blowing through one and a half GDP's worth of what are now transfers from the rest of the EU, they've run through another half a GDPs' worth, and GDP collapses more. Really, Greece's economic problems are.... a lack of adequate borrowing and spending? And all Greece needs is one more devaluation, and suddenly will be shipping Porsches to Stuttgart in return for worthless pieces of paper rather than the other way around?

Greg passes on the labor mobility story. Here too I'm dubious and curious to see numbers. The story is also told that there is less and less labor mobility in the US, especially of people leaving dying regions. And there are lots of Polish-plumber stories from Europe, that open borders leads to lots of migration.  Here again, cyclical migration, on the scale for which  monetary policy can substitute, seems unlikely. How big are business-cycle frequency migration flows across states in the US vs. Europe?

Again, the US  until 1933 poses an interesting challenge. Your school stories of westward migration were not a business cycle frequency response to demand shocks. And when people traveled by horse or foot, the vast majority of Americans never moved more than 20 miles from where they were born. The costs of labor mobility in Europe today are vastly smaller than the costs of labor mobility in the US 19th century.

Conversely, and perhaps more centrally, I  less trusting of the stabilizing influence of central banks. Dispassionate omniscient central banks can, in theory, wisely spot demand shocks and cleverly devalue currencies to offset them, while not responding to supply shocks, political demands, and so forth. The same technocrats could quietly redefine the meter as needed to let tailors respond to shocks without changing prices.

But the history of small-country central banks is not so reassuring. Grece and Italy's repeated devaluations and inflations did not bring great prosperity.

Joining a common currency is a pre-commitment against bad monetary policy as well as foreswearing of hypothetical good monetary policy. Political forces seldom think there's enough stimulus.  When Greece and Italy they joined the euro, they basically said, defaulting and inflating now will be extremely costly. They were rewarded for the precommitment with very low interest rates. They blew the money, and are now facing the high costs they signed up for. But that just shows how real the precommitment was.

Micro, macro and politics interconnect. The case for separate currencies is to protect the economy from sticky wages, sticky prices, and sticky people. But none of these stickinesses are written in stone. A plausible answer to my question about pre-new deal US is that prices and wages were not sticky (whatever that means) before the era of regulation. Well, that is a loss, and only very imperfectly addressed by artful devaluation of the currency.  Not every block can have its own currency, so local and industry variation within a country remains hobbled by sticky prices, wages, and people. If sticky wages,  prices and people are the central economic problem, we ought to have a lot of policies to unstick them. We do the opposite, and Europe even more so. The very social programs that Greg implicitly praises for fiscal stimulus tie people to location and undermine labor market flexibility.

The strongest case for a separate currency might come from a small economy like Chile, which sells one product (copper), subject to big price fluctuations, and otherwise is pretty closed, and has institutions with sticky nominal wages that it doesn't want to fix. When the price of copper declines, price times marginal product of labor declines, so real wages should decline, and the value of haircuts provided to copper miners should decline as well. Chile may prefer to keep nominal wages steady and let the exchange rate rather than wage rate discourage imports.

But even Chile exports a lot more than copper these days. Texas is still booming despite a large decline in oil prices. The same argument does not hold for company towns within the US, which do not use their own currency. Stanford  has extremely sticky wages (tenure), and suffers "demand" shocks, (positive lately), without offsetting fiscal stimulus and tremendous labor immobility. It takes a year to hire faculty. But nobody thinks Stanford should have its own currency, and periodically devalue that currency. Why not? Because we are open.

So I think a lot of the conventional view seems to think implicitly of fairly closed economies, operating in parallel. But Europe's economies are open. Moreover, the whole point of the eurozone is to open them further. Small open economies are much worse candidates for their own currency.

Surely each block should not have its own currency, nor each city. We'd probably all agree that very small countries should not -- Luxemburg, say. So the question is really whether the Greece that Greece wants to be -- more open than today -- is effectively of the same size.

So, to sum up, Greg's article very nicely summarizes the conventional view. Recognize that this conventional view is deeply old-school Keynesian, both in its view of fluctuations, the need for constant "demand" management, and the success of "demand" managers to do their job. There is room for disagreement on that theory, and more productively on the underlying facts Greg passes on.

Ben-Gad and the Minotaur

Michael Ben-Gad has a smashing review, "Into the Labyrinth", of Yanis Varoufakis' The Global Minotaur (Disclaimer: I have not read it and don't intend to.) It's a great piece of writing as well as a cogent analysis. Some excerpts:

"The idée fixe that dominates The Global Minotaur, and apparently dominated Mr Varoufakis’s squabbles with the other Eurogroup ministers of finance, is that some countries are inherently more productive than others and therefore always generate current account surpluses, while others always generate deficits, and fixed exchange rates or monetary unions only exacerbate this imbalance. Hence, for the world economy to function, the surpluses need to be recycled though a system of regular transfer payments from the core to the periphery.

Why do these imbalances emerge? According to the theory of comparative advantage as formulated by David Ricardo in the early 19th century, different countries specialise in the production of particular goods and then exchange them for others, and trade is mutually beneficial even if some countries are more efficient at producing all goods. Mr Varoufakis’s theory rejects all this. Instead, he argues, some countries are destined to specialise in the production of goods and services, while others on the periphery will forever specialise in consuming them. Put into layman’s terms, what this means is that the people of Germany, the Netherlands, and Finland produce cars, wooden clogs, or mobile phones and sell them to the people of Greece, who pay for it all with money – and to make this trade sustainable the cash needs to be regularly replenished in an endless loop by the people of Germany, the Netherlands, and Finland.

This is a story we hear quite often beyond Mr. Varoufakis -- that a currency union requires countries to be similar, with similar productivity. I'm glad to see it so effectively skewered. In Ricardo's famous example, Portugal sells wine to Britain, which sells wool to Portugal, even if one is better at both than the other. They were on a common currency, gold.

On predictable US-bashing:

In Mr Varoufakis’s world the biggest villains are companies such as Walmart that exploit their efficiency to immiserate communities by making them pay less And of course the worst thing about Walmart is that it is American.

....Apparently, between the end of the war and the collapse of the Bretton Woods agreement in 1973, the Americans had a global plan, helpfully labelled ‘the global plan’, to dominate the world by permanently running current account surpluses and paying down its debt. Then this ended and was replaced by a new global plan to dominate the world by running permanent current account deficits and letting its debt soar. Devious Yanks. 

This last paragraph gets the golden skewer award for prose.

First,  he would have all remaining government debts still owed to banks written off. Why? Well, everyone hates banks, and it is apparently a neoliberal myth that their shares are owned by pension funds, university endowments or just ordinary people saving for retirement. Banks are really owned by Bond villains who live underneath hollowed-out volcanos.

Second, a substantial part of the remaining debt – about 60 per cent of GDP – would be mutualised across the eurozone so that, whenever the spirit moved them, governments could costlessly default on their bond payments, each one safe in the knowledge that any repudiated debt would immediately become an obligation for the taxpayers in the 18 remaining countries – unless, of course, they defaulted first. This is a variation on the prisoner’s dilemma game, but on steroids. 

Oh, I give up, just go read the whole thing.

Then read his equally good review of Thomas Pikettty, from a year ago, which starts

Reading Thomas Piketty’s Capital in the Twenty-First Century from front to back was a mistake.

Better to read the last hundred pages first, with their recommendations for the confiscation of wealth and marginal income tax rates nearing 100 per cent, and then read the preceding 470 pages to decide whether the flimsy evidence, conjecture and questionable theories the author offers justify such draconian measures....

Greece again

I read this morning's news of a deal -- we'll see how long it lasts -- with interest. Here's a video exchange with Rick Santelli on the subject on CNBC (I can't seem to get the embed to work, so you have to click the link.)

My main thought: what about the banks? The minute Greece reopens its banks, it's a fair bet that every person in Greece will immediately head to the bank and get every cent out. The banks' assets are largely Greek loans, which many aren't paying -- why pay a mortgage to a bank that's already closed and will probably be out of business soon anyway -- and Greek government debt; mostly Treasury bills that only roll over because banks hold them. They can't sell either, so the banks will instantly be out of cash.

The deal reported in today's papers really barely mentions that problem. But that is the problem of the hour.


Greece is basically off the euro now. Being in the euro does not mean that restaurants take euros. Being in the eurozone means that banks use euros, that you can take euros out and arrange international transfers using euros.

The economy is paralyzed. The main thing a deal needs is a way to reopen banks in a matter of days. Privatization and labor laws are fine, but that generates growth a year from now at best. And raising taxes? They must be kidding.

I've read with interest some proposals that the EU take over the banks. The EU takes on the bad assets, gives or sells the rest to large international banks, and these operate under EU rules -- not Greek regulators; they can't buy any Greek debt, and Greece can't tax them.  It's expensive, yes, but it's basically as shoot-the-hostage approach. A functioning economy would help Greek finances. And then the EU can let the Greek government default if it wishes.  Saving the banks might be a lot cheaper than saving the Greek government and the banks.

There are two original sins in the euro, neither having to do with fiscal union. The first is that each country has its own banks, and each government uses its banks as piggybanks to stuff with government debt. European bank regulators and Basel regulations treat sovereign debt as risk free. Then, if the government defaults, the whole banking system is dragged down with it. The second is the endlessly repeated fallacy that government default means the country must change the units of its currency. If Chicago defaults on its debts, nobody thinks it must introduce a new currency, or that Chicago's banks will fail.

A currency union needs a banking union, or at least banks that are not stuffed with government debt. A currency union needs to let sovereigns default without changing currencies or paralyzing the banking and payments system. A currency union needs a banking union.

What next?

Source: Deutsche Bank Research 

The lovely flow chart comes from Deutsche Bank Research

It emphasizes the central point I am taking from all this -- how Greek banks are hostages in this negotiation. With banks closed and capital controls, the Greek economy can't function.

Can Greece Leave?

Is Grexit even possible?

It strikes me that the best Greece can do with a Drachma is to create a two-currency system, sort of like Cuba or Venezuela, or at best Argentina; countries whose politics the Greek government seems to admire, and whose economies its may soon resemble.

If the government brings back the Drachma  as a way to pay pensions, government salaries, and bank accounts, Euros will still circulate in Greece.

18% of Greek GDP is tourism. That number may be understated -- I don't know if it includes tourist spending at restaurants, stores, transport, and other places that mix tourists and locals. Tourists will spend Euros, not Drachmas. So hotels, gas stations, restaurants, grocery stores, clothes stores, airlines, car rentals, etc. will likely still gladly take euros and euro credit cards, and from locals as well as tourists.

I looked up Greek GDP at the OECD.  Of 157 billion euros value added, agriculture is a tiny 6, industry 18, of which manufacturing 13.  However, services are 130, 80% of the total.  Here, the big items are  "distribution, trade, repairs, transportation accommodation and food" 41, real estate activities 34, and public administration 39.   Exports and imports are each about 60 out of 180 billion euros.

Now, anyone exporting -- 60 out of 157 -- has access to euros and likely invoice in euros thank you very much. Anyone importing will need to get their hands on those euros.

(Interestingly most exports are services, most imports are goods. I can't get a handle on what services Greece exports, and thus whether devaluation would make much difference.)

The 41 billion of "distribution, trade, repairs, transportation accommodation and food" services will surely take euros as above, to convenience the tourist trade.  I can't fathom how 34 billion euros are real estate services -- not construction -- so I can't guess really if that is euros or Drachmas.  The 39 billion of public administration gets Drachmas.

So, the Drachmaized Greece that I see is not the cleanly devalued newly competitive powerhouse that some on the left seem to envision.  Instead I see a two-currency economy. Pensioners and government workers and anyone unlucky enough to still have a Greek bank account get Drachmas. Hotel owners, restaurant owners, and exporters get euros, above or under the table.

In this scenario, I can't imagine a freely convertible currency. Will the government really give 100 Drachmas to someone who used to get 100 Euros, with an exchange rate below half? The point of not cutting salaries was political. So we are almost sure to see capital controls, exchange controls, and a fictional overvalued exchange rate, so Greece can pretend to pay pensioners and government workers.

It's not a pretty thought. Sticking with the euro seems a far better option, just like sticking with the meter.

Kashyap on Greece

Anil Kashyap has an excellent summary of the Greek debt crisis.

He sees government printed IOUs as a much better solution to the banking and payments crisis than for Greece to exit the euro and try to reestablish the Drachma. I agree entirely.

His summary goes back to the beginning, and reminds us that Greece did not get bailed out; Greece's creditors (mainly european banks) got bailed out.

Betting on Grexit

A capital flight mechanism I hadn't thought of, from  Hans-Werner Sinn (HT Marginal revolution)

Basically, Greek citizens take out loans from local banks, funded largely by the Greek central bank, which acquires funds through the European Central Bank’s emergency liquidity assistance (ELA) scheme. They then transfer the money to other countries to purchase foreign assets (or redeem their debts),... 

 In January and February, Greece’s TARGET debts increased by almost €1 billion ($1.1 billion) per day, owing to capital flight by Greek citizens and foreign investors. At the end of April, those debts amounted to €99 billion. 

I knew Greeks are taking money out of bank deposits, and parking it abroad, and that in the end this money came from the ECB. When a Greek depositor wants his or her money, the Greek bank gets it from the Greek central bank, who gets it from the ECB, which prints it (metaphorically). It had not occurred to me that of course borrowing every cent you can from a Greek bank and parking it abroad is just as smart.

Of course, If Greece leaves the Euro, the Greek central bank goes bust, the ECB loses and Greek borrowers or ex-depositors keep their euros.

Hans-Werner seems to think capital controls are a good idea to stop this run. I think the likely imposition of capital controls is just why people are running in the first place. Similarly, if both Greece and Europe were to credibly say that Greek government default will not mean leaving the euro that would also stop the run.

But news for the day is this interesting run on the borrowing side, not just the depositor side.

SNB, CHF, ECB, and QE

The last two weeks have been full of monetary news with the Swiss Franc peg, and the ECB's announcement of Quantitative Easing (QE). A few thoughts.

As you have probably heard by now, the Swiss Central Bank removed the 1.20 cap vs. the euro, and the franc promptly shot up 20%.

To defend the peg, the Swiss central bank had bought close to a year's Swiss GDP of euros (short-term euro debt really) to issue similar amounts of Swiss Franc denominated debt.

This is a QE -- a big QE. Buy assets, print money (again, really interest-paying reserves). So to some extent the news items are related. And, it's pretty clear why the SNB abandoned the peg. If the ECB started essentially the opposite transaction -- buying debt and selling euros -- the SNB would soon be awash.

A few lessons:


A peg depends on credibility. The dollar is pegged to 4 quarters. The Fed is not racking up huge dollar for quarters QE, because everyone knows it will always be thus. The fact that the SNB had to buy euros at all is a great signal that everyone knew the peg was temporary. As, in fact, the SNB had made pretty clear. Sometime or other, probably when it's most important, investors thought, Swiss Francs will shoot up again. Might as well buy more of them.

An exchange rate peg is fiscal policy.  Really, the "credibility" a country needs is fiscal credibility.

The peg fell apart because the SNB was trying to do it alone. On the day of abandonment, the SNB lost about 20% of its balance sheet, since it owns Euros and owes Swiss Francs. Had things gone on any more before the plunge, they would have had to go begging to the Treasury for a recapitalization. "We just lost 20% of GDP, could you please send us some fresh government bonds to back our CHF debt issues?" That works seamlessly in economic models, but would be a political nightmare for a central bank.

So, if you want to run a peg, it should be done jointly with the Treasury. The central bank buys euros, sells francs, but immediately swaps the euro debt to the treasury for CHF debt. That at least is removes the first fragility, by taking the fiscal risk off the central bank balance sheet.

From the point of view of the nation as a whole, a strong demand for your government debt (that's what this is) is an invitation to profligacy, not a fiscal danger. That's why pegs usually break in the other direction: The central bank tries to peg a currency, let's call them pesos, against another, let's call them dollars. (Or gold.) People start to ask for dollars in exchange for pesos, the central bank starts to run out of reserves. At this point the treasury has to either tax, reduce spending, or credibly promise future taxes or spending reductions to borrow some dollars, and given them to the central bank in exchange for the bank's government debt. When that can't happen, the peg breaks. The essential problem is fiscal.

Switzerland had this in reverse: The Swiss were too darn thrifty.  Americans and Greeks know what to do if world capital markets come knocking and want to buy boatloads of your government debt. Print debt, give it to them, and send us Walmarts full of goods, or driveways full of Porsches.  Norway had a similar issue, with the world wanting to buy its oil. Norway decided not to go on a consumption binge, so their sovereign wealth fund buys equities; rights to future consumption.

Switzerland could have done the same: sell CHF bonds, use the proceeds to go on a consumption binge or buy about a year's GDP of foreign stocks. Instead, a referendum threatened a return to the gold standard.

Or, they could have said, "and by the way, we declare that we have the right to pay off our government debt in euros at 1.20, or to swap CHF debt for euro debt at that rate." Now that would have really enforced the peg. Devaluing the currency means engineering a partial default on government debt. Its fiscal policy and can't be done by the central bank alone.

QE and the ECB

Ben Bernanke famously said that QE works in practice but not in theory.  What that means, of course, is that the standard theory is wrong, and to the extent it "works" at all, it works by some other mechanism or theory. Permanent price impact by changing the private sector portfolio composition is the "theory" that Bernanke acknowledges really makes no sense. So why might a QE work?

In the US case, QE was arguably a signal of Fed intentions. Buying a trillion dollars of bonds and issuing a trillion dollars of, er... bonds (reserves are floating-rate debt) is a way for the Fed to tell markets that it will be years and years before interest rates go up. As I chat about QE with economists, this pretty much surfaces as the most plausible story for QE effects (along with, there weren't any long lasting effects.) Greenwood,  Hanson, Rudolph, and Summers make this point nicely, showing that Fed-induced changes in maturity structure have about twice the effect that Treasury selling more bonds does -- though exactly the same portfolio effect.

But what is the signal in ECB QE? Well, a decidedly different one. The signal is, I think, not about interest rates, but that the ECB will buy government debt. "What it takes" is now taken. Yes, there is this lovely pretense that national central banks buy the bonds, so the ECB doesn't hold credit risk. But if a country defaults, where is the national central bank going to come up with funds to pay the ECB?

So, when we think of what expectations people derive from ECB QE, and with that how it might or might not "work," the obvious conclusion is that the Eurobonds are now being printed. Like all bonds, they will either be repaid, inflate, or default.

Torsten Slok sends on this interesting graph. 80% of Greek debt is now in the hands of "foreign official." Now you know why nobody is worrying about "contagion" anymore. The negotiation is entirely which government will pay.

Autopsy

Autopsy for Keynesian Economics. (I don't get to pick the titles BTW) A Wall Street Journal Oped. I'm trying for something cheery at Christmas, and a response to the many recent opeds that ISLM is just great and winning the battle of ideas.  As usual, the whole thing will be here in a month.

This year the tide changed in the economy. Growth seems finally to be returning. The tide also changed in economic ideas. The brief resurgence of traditional Keynesian ideas is washing away from the world of economic policy.

No government is remotely likely to spend trillions of dollars or euros in the name of “stimulus,” financed by blowout borrowing. The euro is intact: Even the Greeks and Italians, after six years of advice that their problems can be solved with one more devaluation and inflation, are sticking with the euro and addressing—however slowly—structural “supply” problems instead.

Read more at WSJ...

Update: Hoover has an ungated version here;  Cato has an ungated version here.

Who is afraid of a little deflation? Op-Ed

This was a Wall Street Journal Op-Ed from a month ago. Now I can post the whole thing in case you missed it then.

Who is Afraid of a Little Deflation?

With European inflation declining to 0.3%, and U.S. inflation slowing, a specter now haunts the Western world. Deflation, the Economist recently proclaimed, is a “pernicious threat” and “the world’s biggest economic problem.” Christine Lagarde , managing director of the International Monetary Fund, called deflation an “ogre” that could “prove disastrous for the recovery.”

True, a sudden, large and sharp collapse in prices, such as occurred in the early 1920s and 1930s, would be a problem: Debtors might fail, some prices and wages might not adjust quickly enough. But these deflations resulted directly from financial panics, when central banks couldn’t or didn’t accommodate a sudden demand for money.

The worry today is a slow slide toward falling prices, maybe 1% to 2% annually, with perpetually near-zero short-term interest rates. This scenario would unfold alongside positive, if sluggish, growth, ample money and low credit spreads, with financial panic long passed. And slight deflation has advantages. Milton Friedman long ago recognized slight deflation as the “optimal” monetary policy, since people and businesses can hold lots of cash without worrying about it losing value. So why do people think deflation, by itself, is a big problem?

1) Sticky wages. A common story is that employers are loath to cut wages, so deflation can make labor artificially expensive. With product prices falling and wages too high, employers will cut back or close down.


Sticky wages would be a problem for a sharp 20% deflation. But not for steady 2% deflation. A typical worker’s earnings rise around 2% a year as he or she gains experience, and another 1%—hopefully more—from aggregate productivity growth. So there could be 3% deflation before a typical worker would have to take a wage cut. And the typical worker also changes jobs, and wages, every 4½ years. Moreover, “typical” is the middle of a highly volatile distribution of wage changes among a churning job market. Ultimately very few additional workers would have to take nominal wage cuts to accommodate 2% deflation.

Curiously, if sticky wages are the central problem, why do we not hear any loud cries to unstick wages: lower minimum wages, less unionization, less judicial meddling in wages such as comparable worth and disparate-impact discrimination suits, fewer occupational licenses and so forth?

2) Monetary policy headroom. The Federal Reserve wants a 2% inflation rate. That’s because with “normal” 4% interest rates, the Fed will have some room to lower interest rates when it wants to stimulate the economy. This is like the argument that you should wear shoes two sizes too small, because it feels so good to take them off at night.

The weight you put on this argument depends on how much good rather than mischief you think the Fed has achieved by raising and lowering interest rates, and to what extent other measures like quantitative easing can substitute when rates are stuck at zero. In any case, establishing some headroom for stimulation in the next recession is not a big problem today.

3) Debt payments. The story here is that deflation will push debtors, and indebted governments especially, to default, causing financial crises. When prices fall unexpectedly, profits and tax revenues fall. Costs also fall, but required debt payments do not fall.

Again, a sudden, unexpected 20% deflation is one thing, but a slow slide to 2% deflation is quite another. A 100% debt-to-GDP ratio is, after a year of unexpected 2% deflation, a 102% debt-to-GDP ratio. You’d have to go decades like this before deflation causes a debt crisis.

Strangely, in the next breath deflation worriers tell governments to deliberately borrow lots of money and spend it on stimulus. This was the centerpiece of the IMF’s October World Economic Outlook antideflation advice. The IMF at least seemed to realize this apparent inconsistency, claiming that spending would be so immensely stimulative that it would pay for itself.

4) Deflation spiral. Keynesians have been warning of a “deflation spiral” since Japanese interest rates hit zero two decades ago. Here’s the story: Deflation with zero interest is the same thing as a high interest rate with moderate inflation: holding either money or zero-interest rate bonds, you can buy more next year. This incentive stymies “demand,” as people postpone consumption. Falling demand causes output to fall, more deflation, and the economy spirals downward.

It never happened. Nowhere, ever, has an economy such as ours or Europe’s, with fiat money, an interest-rate target, massive excess bank reserves and outstanding government debt, experienced the dreaded deflation spiral. Not even Japan, though it has had near-zero inflation for two decades, experienced the predicted spiral.

There are good reasons to believe it can’t happen. Most of all, government solvency fears that don’t matter for 2% deflation kick in and stop a deflation spiral. If prices fall 20%, or 30%, bond-holders will see that governments cannot pay back debts. They try to get rid of their bonds before the coming default. They buy things or other currencies, nipping the deflation spiral in the bud.

There is an unsettling feature of the current inflation situation, however. Clearly, our central banks want higher inflation, and the current slow decline was unintended. So, just as clearly, central banks have a lot less understanding of and control over inflation and deflation than most people think.

According to the conventional worldview, the economy is inherently unstable. Central banks control inflation the way you balance an upside-down broom, with interest rates on the bottom and inflation on top. Central banks have to actively move interest rates around to keep inflation and deflation from breaking out. And if they want more inflation, they must temporarily move interest rates the wrong way, let the inflation increase, and then move quickly to stabilize it.

Hence the zero-bound worry. When interest rates hit zero and the Fed can’t move the broom handle any more, the top of the broom must topple into deflation. Except we hit the zero bound, and almost nothing happened. Maybe the economy isn’t so inherently unstable and in need of constant guidance after all.

Bottom line? Relax. Every few months we hear a new “biggest economic problem” from which our “policy makers” must save us. Wait for the next one.

Mr. Cochrane is a professor of finance at the University of Chicago Booth School of Business, a senior fellow at the Hoover Institution and an adjunct scholar at the Cato Institute.

Sequester and vortex redux.

I posted this last week, but I was unaware at the time of the Paul Krugman's "Keynes is slowly winning" post; Tyler Cowen's 15-point response, documenting not only Keynesian failures but more importantly how the policy world is in fact moving decidedly away from Keynesian ideas, right or wrong (that was Krugman's point); and Krugman's retort, predictably snarky and disconnected from anything Cowen said, changing the subject from Keynesian ideas are winning to the standard what a bunch of morons they're not Keynesians though I keep telling them to be. (I like Krugman's chart though. I see a glass half full -- look at all those nominal wage cuts, even in Spain! And look how many people got raises.)

In that context, I added two "Facts in front of our noses." Keynsesians, and Krugman especially, said the sequester would cause a new recession and even air traffic control snafus. Instead, the sequester, though sharply reducing government spending, along with the end of 99 week unemployment insurance, coincided with increased growth and a big surprise decline in unemployment. And ATC is no more or less chaotic than ever. Keynesians, and Krugman especially, kept warning of a "deflation vortex." We and Europe still don't have any deflation, and even Japan never had a "vortex."  These are not personal prognostications, but widely shared and robust predictions of a Keynesian worldview. Two strikes. Batter up. 

The original: (This is a re-post if you saw it the first time around, but easier to copy and paste than link.) 

 

Multiplier? What multiplier? 

Wall Street Journal, November 26 2014:

The economy expanded at its fastest pace in more than a decade during the spring and summer,... Gross domestic product...grew at a seasonally adjusted annual rate of 3.9% in the third quarter... combined growth rate in the second and third quarters at 4.25%, affirming the best six-month pace since the second half of 2003." 

The upward revision to overall growth, driven by [sic] stronger consumer and business spending and a smaller drag from inventory investment, surprised economists... 

Paul Krugman, February 22 2013, "Sequester of Fools"

The sequester, by contrast, will probably cost “only” around 700,000 jobs.

New York Times, Februrary 21 2013, "Why Taxes Have to Go Up"

Democrats and Republicans remain at odds on how to avoid a round of budget cuts so deep and arbitrary that to allow them now could push the economy back into recession. The cuts, known as a sequester, will kick in March 1 [my emphasis]

Paul Krugman, March 10, 2013: "Sequester Cuts Will Be Felt in Time"

..it will start to build, and it won't just be White House tours, it will be air traffic delays, ...as the effects kick in, it will remind people why we actually need a government that does its job.

(Actually,  manifest failures of government to do its job lately are pretty depressing. But not for lack of money.)

Meanwhile back in the worryzone

Deflationary Vortex?

Paul Krugman Sept 4 2014 "The Deflation Caucus"

Europe, which is doing worse than it did in the 1930s, is clearly in the grip of a deflationary vortex,

Really, "worse than the 1930s???" We're watching different versions of the History Channel.

Paul Krugman, undated,

... if the economy ... has excess capacity, and also ...i = 0 ...- it cannot get out. The output gap feeds expectations of deflation, and since the nominal interest rate cannot fall this implies a rising real interest rate, worsening the output gap. The economy, in short, falls into a deflationary spiral.

This prediction of a "deflation spiral" once we hit the zero bound with huge "output gaps" has to stand as a stark failure of Keynesian economics, on a par with its grand failure to predict inflation in the 1970s. Only, predicting a catastrophe that did not happen doesn't attract quite as much attention as failing to predict one that did.

If you're not getting the point, look at the graph. Let me remind you "deflation" means numbers less than zero, a lot less than zero. And "spiral" or "vortex" means getting steadily more negative, not asymptoting to zero. And if you patch a model ex-post and ad-hoc not to produce a spiral, then that model no longer predicts that inflation is a danger.

To be sure, I am being inconsistent today -- I have staunchly maintained that "models" must exist on paper or in computers, in objectively verifiable forms, with "predictions" that any operator can make, not in soothsayer's heads.  I have staunchly maintained that evaluating economic theories by pundit prognostication is completely meaningless.

But I also don't make it my business to vilify other people from misquoted opinions on current dangers. (Though I'm indeed pulling Paul's leg a bit, please notice the absence of "evil," "vile," "mendacious idiot," "corrupt," "stupid," "doesn't know economics," and so on from this post.)

So just this once I will give in to grumpy temptation.

Heretics

Low inflation is back in the news.  The Wall Street Journal covers the latest decline in European inflation. Peter Schiff has a nice article explaining that inflation is not such a great thing, unless of course you're a government that wants to pay back debt with cheap money. I dipped into this heresy in an earlier post, explaining that maybe zero rates and slight deflation just represent the arrival of Milton Friedman's optimal quantity of money.

But this news also brings to mind some thoughts on the second heresy -- maybe we have the sign wrong, and we're getting low inflation or deflation because interest rates are pegged at zero, and maybe the way to raise inflation (if you want to) is for the Fed to raise interest rates, and leave them there. (Earlier posts on this question  here and here)

Back in 2010, Narayana Kocherlakota explained the basic idea

Long-run monetary neutrality is an uncontroversial, simple, but nonetheless profound proposition. In particular, it implies that if the FOMC maintains the fed funds rate at its current level of 0-25 basis points for too long, both anticipated and actual inflation have to become negative. Why? It’s simple arithmetic. Let’s say that the real rate of return on safe investments is 1 percent and we need to add an amount of anticipated inflation that will result in a fed funds rate of 0.25 percent. The only way to get that is to add a negative number—in this case, –0.75 percent.

To sum up, over the long run, a low fed funds rate must lead to consistent, but low, levels of deflation.”

It's really simple. One of the most fundamental relations in economics is the Fisher equation, nominal interest rate = real interest rate plus expected inflation. Real interest rates can be affected by monetary policy in the short run. But not forever. So if the Fed raises the nominal interest rate and leaves it there, expected inflation should eventually rise to meed that nominal rate.


In conventional thinking, no. There is an instability in the system in conventional thinking, so that raising the nominal rate raises the real rate, sends output down and inflation declining. While the equation is a "steady state" it's an "unstable" one.  So, interest rates have to be like a sheep dog corralling sheep -- go way off to the right to move them left, then go way off to the left to move them right, and so on.

Well, maybe not. Maybe it's more like "Babe" and just calmly heading for the pen will work.

Stephanie Schmitt-Grohé and Martín Uribe's  The Making Of A Great Contraction With A Liquidity Trap and A Jobless Recovery is a new paper investigating to this point. They study a pretty complicated model, with employment dynamics, sticky wages, and long-run expectations. But the bottom line is interesting.

The paper... shows that raising the nominal interest rate to its intended target for an extended period of time, rather than exacerbating the recession as conventional wisdom would have it, can boost inflationary expectations and thereby foster employment

Here is the central figure making the point. The solid lines are the model's dynamics replicating where we are now. The dashed line shows what they think would happen if the Fed were to peg the interest rate at 6% and leave it there.

Source: Stephanie Schmitt-Grohé and Martín Uribe

In the model (as I understand it, which is not well) the basic problem is that long-run inflation expectations can get stuck too low, or revert back to a higher level. By pegging the interest rate at a higher level and just leaving it there, the Fed communicates that expected inflation had better rise in the Fisher equation. 

This may be a case of the difference of new vs. old Keynesian models. The unstable intuition is how Friedman's 1968 address and old style Keynesian models work, because expectations are backward looking. In new Keyensian models, if the Fed can change expected inflation -- by, in this case, a rock-solid peg -- then interest rates can rise quickly and actual inflation will adjust to expected inflation. 

(If commenters understand the story behind Stephanie and Martín's graph and equations better than that, post away!) 

Optimal quantity of money, achieved?

Here are three graphs, presenting inflation, long-term interest rates and short-term interest rates in the US, Germany and Japan.

Now, suppose you just returned from a long trip in outer space, started around 1979. What would you say of these three graphs?

If you didn't "know" anything and just look at these graphs, your response would most likely be, "Hoorray!,"at least if you blasted off somewhere near the University of Chicago.  It looks like our economies vanquished inflation and are all on a steady global trend towards the Friedman "Optimal  Quantity of Money."

You might sensibly forecast that the trend, so clearly established for 2 to 3 decades, will continue. Inflation will continue to trend down, to zero or slightly negative values. The short term nominal rate will stay at zero, or maybe rise to at most a percent or two.  Long term rates, read as expected short rates plus a risk premium, signal this future and might end up slightly positive.

You might suppose our central bankers are all off retired to write memoirs at think tanks, enjoying the accolades of a grateful public, and cutting ribbons at statues being built to their honor. You would be wrong, but that's another story.

The Friedman Optimal Quantity and Financial Stability

Milton Friedman long ago wrote a very nice article, showing that the optimum state of monetary affairs is a zero short-term rate, with  slow deflation giving rise to a small positive short-term real interest rate.

Friedman explained the optimal quantity in terms of "shoe-leather" costs of inflation. Interest rates are above zero,  people go to the bank more often and hold less cash, to avoid lost interest. This is a socially unproductive activity.  Bob Lucas once added up the area under the money demand curve to get a sense of this social cost, and came up with about 1% of GDP. Not bad, but not earth-shattering.

As I think about it, however, there are financial stability benefits to zero rates  far beyond what Friedman imagined.  This thought reoccurred this morning as I was thinking about Dan Tarullo's testimony on capital requirements.

Why do banks load up on debt? Well, one answer, interest payments are tax free and dividends aren't, so the "tax shield" leads to excessive debt. But if interest rates are zero, the value of the tax shield is zero, and this incentive to undercapitalization vanishes! 

Positive inflation induces all sorts of pointless tax arbitrage. Close to home, universities issue tax-free bonds, and invest in hedge funds.  But the whole profit-non-profit distortion in investing vanishes if interest rates are zero. If interest rates are zero, and you earn money from deflation, all interest is tax free.

The real costs of inflation are not shoe-leather trips to ATM machines. They are the fragile structures of overnight funding, which built up before the financial crisis, and crashed spectacularly, much of it designed to make sure "cash" earns interest. At zero rates, it is all needless.

Zero interest rates. Zero or slightly negative inflation. It's hard to tell just where long-term inflation is anyway. Would you really trade your imac for 1,000 Apple IIs? What's not to like?

Why not? 

So, why do so many people look at my graphs with deep foreboding and a sense of something wrong? Why is the "optimal quantity of money" and the "non-distorting interest rate" suddenly the "zero bound," as welcome at macroeconomic discussions as an ebola patient in an emergency room? What's wrong with an economy that has zero or slight deflation, and zero or very low interest rates? Why are central banks fighting so desperately to avoid their apparent victory?

One view, espoused frequently by Paul Krugman, sees the quiet approach of zero inflation or deflation with great foreboding, as it puts us in danger of "deflation spiral" or "vortex" about to break out at any time.   A little extra deflation raises real rates, which lowers "demand," which through a Phillips curve leads to more deflation, and the whole thing spirals out of control.

But it never happened, not even in Japan, though feared for nearly 20 years now. I don't know of a single historical event where a deflation "spiral" ever happened. (Deflation has happened, as in the US in the great depression. But it did not "spiral" out of control. It looked a lot like money demand went up, money supply didn't the price level fell, end of story.) And in my view of the world it can't happen. Real rates lowering "demand," are a tenuous idea, the Phillips curve is a correlation not a theory of price level determination specifying cause and effect from output to prices, and a serious deflation means governments must raise taxes to pay off higher real values of debt, which simply is not going to happen.

Another view is that we stand on a cliff of monetary-policy induced inflation or hyperinflation about to break out.  The zero bound is being held too long. Reserves have exploded from $50 billion to $4 trillion. Just wait.

The long trend and calm behavior of the data belie this view too.

A more nuanced view holds that we need positive inflation and positive rates so that the Fed has room to lower rates to ward off deflation spirals, as well as to counteract recessions. I'm dubious. This is like the view that you should wear shoes that are too tight, so it feels good to take them off at night.  A few monetarists have called for deliberately stifling financial innovation so the Fed could control the money supply. The high inflation target so we can lower rates is is the Keyensian (or interest-rateian) analogue. But do we really need to lose 1% of GDP in Lucas shoe leather costs, and the far larger financial stability costs that artificially high rates imply, just so the Fed can jigger around rates when it wants to do so?

At least for inflation, the graphs do not scream the necessity of this view. They certainly do not endorse the view that the disinflationary trend was caused by a Taylor rule: You do not see interest rates moving 1.5 times as much, or in response, to inflation, and you do not see rates dropping more than 1.5 times inflation to ward off deflation.  Producing a coefficient above one takes a lot more fiddling with a regression. You see pretty much a Fisher rule -- interest rates move one for one with inflation. The graphs are just as consistent with the story that talk policy somehow "anchored expectations" and then central banks slowly lowered rates.

Our astronaut, on hearing all these views, might well conclude that none has a good handle on just why inflation is falling to zero, what central banks or other parts of the government actually did to bring about these great trends. And he would be correct. But that emptiness surely means that chicken-little "the sky is falling" about this three-decade trend suddenly exploding is overstated.

(Someone will quickly point out that I too have worried about inflation. But my worries have nothing to do with monetary policy or the level of nominal rates. My worry has to do with fiscal policy, and is more like a worry that low mortgage backed security rates in 2006 could not last. )

What about wage stickiness? A standard answer to "what's wrong with slow deflation" is "wages are sticky so you'll get a secular stagnation." Now, wages arguably are sticky at the 1-6 month horizon, and when we're talking about large, say, 20% shocks, like if a country's banking system implodes.

But that's not what we're talking about here. Does wage stickiness really get in the way of 1-2% steady deflation?

Now, nobody likes to have their wages cut.  But nobody has to. As Alex Tabarrok points out in a splendid Marginal Revolution post, half of US employees have changed jobs since the bottom of the Great Recession.  This is one of many ways in which the popular imagination of having one job all your life butts up against the reality of huge churn in the labor market.

Now stickiness fans will come up with some new story about people not wanting to take lower wages at new jobs, or social limitations to hiring new people at lower wages and so on. But that's a new and different story than "employers don't want to cut people's wages." Again, we're thinking about the long run here, not recessions.

Moreover, each individual can ascend an age-earnings profile while wages overall are declining. And productivity growth adds to the spread between wages and inflation.  If each individual's wages grow 2% per year as they age and move up the ladder, if aggregate productivity grows 2%, then we can have 4% deflation before anyone takes a wage cut.

So what is the problem? Yes, the reduction in inflation is associated with slower growth, see again Japan. But it's far from settled that zero inflation, butting against some sort of stickiness, caused the slow growth and everything else in Japan was a smoothly functioning market.  Anil Kashyap thinks Japan had zombie banks. Fumio Hayashi and Ed Prescott point to low TFP growth.  And similarly with us.

Bottom line

So, back to our graphs and returning astronaut. If you just look at the graphs, I think our astronaut would think there is a good chance this trend continues.  And, perhaps, we should see a long period of zero rates and slight deflation as a great achievement in monetary policy.  If only we honestly understood why it happened and therefore had more faith that it will continue.