Wednesday, October 5, 2011

A misbegotten Union

The people who supported the euro, and particularly UK entry into the euro, were wrong. Not arguably wrong, not partially wrong; just flatly, unequivocally, completely wrong. Rarely in the history of public policy has one side in a public policy debate been so swiftly, and so comprehensively, vindicated.

A tale of two islands
The debacle is so complete that citing specific evidence seems unnecessary but we merely have to compare Iceland with Ireland. Iceland decided that a small island of 320,000 people had some niche advantage in grand finance. It was hubristic nonsense that went horribly wrong. But Iceland had two saving graces in the disaster. First, it realised that it was far too small to guarantee the banks and did not do so, thereby failing to saddle its taxpayers with enormous liabilities. Second, it was not in the euro so could let its exchange rate reflect the change in its economic circumstances.

Contrast this with Ireland. The “Celtic Tiger” bought into the nonsense that is land-rationing and suffered the normal penalty of land prices surging way beyond likely income returns as expectations of capital gain fed themselves, helped by cheap credit. (I say ‘land prices’ because houses are large decaying physical objects, it is the land a house is on which shoots around in value.) When it all came tumbling down, the Irish Government made things worse by guaranteeing the banks (who therefore had much less incentive to change behaviour or fix their own problems) saddling the hapless Irish taxpayers with huge liabilities. Ireland was also stuck with the euro, so could not let its exchange rate reflect the change in its economic circumstances, thus becoming a test case in exactly what was wrong with the euro. Hence Ireland's drop in employment has been considerably worse than Iceland’s.

Looking at the graph of 2007 to 2010 changes in employment for OECD countries, Australians can note what a different place we have been in compared to the US and most of Europe: for us, the Great Moderation is still going (particularly clear if you move the start year back to 1959). While any Australian who has been paying attention over the last 30 years can appreciate the useful role of a floating exchange rate as economic “shock absorber”. That is what countries in the euro now lack.

ECBing downwards
The European Central Bank (ECB), with its trumping focus on maintaining price stability, has made things worse. The point of the euro was, in effect, a deutschmark-for-everyone, just sign up. The ECB has pursued a policy that makes some sense for the German economy and no sense for anyone who is not. In a weird historical resonance, the ECB is playing a similar role in our period of the Global Financial Crisis and the Great Recession that the Bank of France did in the 1928-1932 period (pdf): driving down expectations of the path of money supply and spending, so having a depressing effect on economic activity—just the thing to make a debt crisis worse (pdf).

Once as tragedy, then as farce
In another weird historical resonance, while many Americans seemed to have thought they were elected a new FDR, what they ended up with is a new Herbert Hoover—someone with a high reputation for intelligence and energy, willing to break from the “stale” patterns of the past, who engages in a lot of activity (pdf) which is either pointless or actively counter-productive while failing to pay attention to the Fed’s disastrous monetary policy. Kevin Baker offered the Obama-as-Hoover analogy early but it is now in some danger of becoming conventional wisdom.

The historical resonances continue, as the Fed has engaged in a mix of passive (and not so passive) monetary tightening intermixed with feeble and temporary easings—the net effect being to drive down expectations of the path of money supply and spending, which encourages people to hold onto money, given falling inflation and economic activity expectations, causing a downward spiral in transactions, pushing the US economy well below its trend growth path. Yet people babble on about inflationary risks, just like the 1930s. (Alas, much of the economics profession seems clueless, the key central banks seem to be running on myths, worrying about inflation is popular, though misguided, even as financial markets have very low inflation expectations, which is not helping asset markets while international prudential bank regulation is set to make things worse.)

A paper on who went protectionist in the 1930s and why (pdf) helps explain why we are having these historical resonances. Just as a lot of the problem now is people reacting to the stagflation of the 1970s, so the problem then was people reacting to the post WWI inflations, including the notorious German hyperinflation. In both periods, people's fears about returning to past inflationary episodes encouraged inappropriately tight monetary policies.

A recent post points out (scroll down to the version in English) that a striking historical resonance is that the countries which had problems with the gold standard during its 1873-1895 deflationary period included Greece, Italy, Spain, Portugal: the same countries which are now having problems with the ECB’s tight money policies.

Euro nausea
As the euro disaster unfolds, it is worth remembering what is at stake. There are more euros (banknotes and coins by value) in circulation than US dollars. The euro is the second largest reserve currency and second most traded currency. The question increasingly becomes, not whether Greece will default, but where the process of default will stop and how much of the financial system is at risk of collapsing as sovereign bonds fall to, and then beyond, “junk” status. With the IMF issuing serious warnings about the global implications. As does George Soros while the co-author of the classic study of financial panics This Time is Different: Eight Centuries of Financial Folly thinks the situation is (fairly but not absolutely) dire.

Now, it is true that Greece is a deeply fiscally dysfunctional polity. But that is the point: Greece should never have been part of a common currency with Germany. There was simply never enough economic commonality among the members for the thing to work (a problem expressed nicely here). But, here’s the thing: the attempt to do what could not be done made things worse. This is not a crisis that the poor euro got caught up into, this is a crisis that not only has the euro made worse, it is one that it (and especially the ECB’s management thereof) did a significant amount to cause.

[Read the rest at Critical Thinking Applied, or a slightly earlier version at Skepticlawyer]

3 comments:

  1. "Not arguably wrong, not partially wrong; just flatly, unequivocally, completely wrong."

    With the benefit of hindsight, yes. But I don't think it was so unequivocal beforehand. Those who opposed the Euro were right, but I have yet to see a fully convincing argument, backed by solid evidence, made beforehand. If they had been able to mount such an argument, the Euro would never have happened. It's a bit like the Efficient Markets Hypothesis. It's always easier to say the market was inefficient than to say it is inefficient right now.

    "While any Australian who has been paying attention over the last 30 years can appreciate the useful role of a floating exchange rate as economic “shock absorber”. That is what countries in the euro now lack."

    I think that's half of it. And that half was foreseen by the critics of the Euro. The other half is that they lack an effective lender of last resort. And that half wasn't foreseen (as far as I know) by the critics of the Euro.

    "Now, it is true that Greece is a deeply fiscally dysfunctional polity. But that is the point: Greece should never have been part of a common currency with Germany."

    I remember thinking the same about Argentina, 10 years ago. One needs a monetary system that is robust in the face of policy mistakes, because stuff happens. Especially in some countries.

    Man, you run a good blog here, Lorenzo!

    ReplyDelete
  2. Nick: if you read either of the longer versions, you will see that I quote a certain Canadian economist about not overstating how much the problems were foreseen. So, yes, I agree (in fact, I agreed with you before you posted the above comment). My point is not that euro-sceptics were "obviously" correct ex ante (however obviously so they are ex post), but that the euro-confident were so dismissive: they displayed rather more premature certainty than their opponents and much more inappropriately.

    Nice point about the lender of last resort,

    Thanks for the blog praise: high praise, given the source :)

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