Eurozone: the End of the Beginning

In its “Charlemagne’s notebook” titled “A Greek bailout, and soon?” The Economist’s journalist writes:

“the question asked about a bailout of Greece used to be: are European Union governments willing to do this? Now, I can report, the question among top EU officials has changed to: how do we do this?”

Since heads of government cannot wait “forever” to take decisions, it means that it is going to be made in “the next few months, at most”. And European leaders will be meeting for an informal economic strategy summit in Brussels on february 11th, while the amount of aid required is not that important compared to the GDP of the 16 countries together.

With the current crisis, the governments of the eurozone already gave up, de facto, the application of the Growth and Stability Pact deficit criteria. Now they prepare to renege on the agreed obligation not to bailout a bankrupt member state. There has been much talk among economists of the moral hazard resulting from bank bailouts, but States are not immune either to that type of perverse incentives. We should watch out for interesting developments that could follow within the zone.

As Winston Churchill said in more serious circumstances, this is not the beginning of the end, but it is the end of the beginning for the euro.

Haiti and the Dominican Republic: Jared Diamond’s Explanation

Haiti and the Dominican Republic may share one island but their histories unfolded quite differently. According to the Jared Diamond's analysis in his book Collapse, environmental differences did contribute to the different economic trajectories of the two countries.

Moreover, France was able to invest in developing intensive slave-based plantation agriculture in Haiti, which the Spanish could not or chose not to develop in their side of the island. Hence Haiti had a population seven times higher than its neighbor during colonial times, which, combined to a lower rainfall, was a main factor behind the rapid deforestation and loss of soil fertility.

And these conditions also explain in part the lower attraction of Haiti on European qualified immigrants and investors than was the Dominican Republic.

Read the article in The Globalist.

Hat tip to Mark Toma

Transatlantic Debate on the Euro

I often chided in this blog European economists for their uncritical endorsement of the euro and the centralization of monetary policy in the European Union. Now two European economists, Lars Jonung (Research Adviser, Directorate General for Economic and Financial Affairs of the European Commission, Brussels) and Eoin Drea (Senior Economist, Tom Phillips and Associates, Dublin) publish, in Econ Journal Watch, a survey of the U.S. economists’ analyses of the EMU and the euro. In it, they take in particular U.S. economists to task for being excessively pessimistic about the euro:

“In short, by adopting the optimum currency area theory as their main engine of analysis, U.S. academic economists became biased against the euro” they conclude, and they add that:

“it is surprising that (…) living in a large monetary union and enjoying the benefits from monetary integration, (they) were - and still remain - skeptical toward the euro. To our knowledge no U.S. economist, inspired by the optimum currency area approach, has proposed to break up the United States into smaller regional currency areas.”

On this point they are wrong since a few U.S. economists did raise the question of the non optimality of the dollar area, and suggested that substituting several “regional dollars” for the current federal one could be an economically superior solution. More recently David Beckworth did answer that criticism in his blog, Macro and Other Market Musings.

Read “The Optimal Eurozone and the Optimal Dollar zone” (January 12), and “Euro Skeptics: Bad Analysis or Bad Timing?” (January 22), as well as his complete analysis "One Nation under the Fed? The Asymmetric Effects of U.S. Monetary Policy and Its Implications for the United States as an Optimal Currency Area”.

Beckworth reply is that the current crisis “only serves to confirm the concerns of the Euro skeptics that Eurozone is not an OCA and thus one-size-fits-all monetary policy simply does not work. (…) Even if these countries (Greece, Ireland, Portugal, and Spain) survive the immediate crisis there would still be real questions as to whether they could survive the next few years as noted by Martin Wolf and Martin Feldstein. So maybe all those U.S. Euro skeptics were not wrong but merely had bad timing.”

I would like to add that past experience also proved that European governments and monetary authorities were perfectly able to pursue unrealistic policies for quite a long period, as they did with the “Growth and stability pact” supposed to constrain national budget deficits even when facing recessions. It amounted to suppressing the only shock absorber that was left to national governments to dampen business cycles. That regulation was much criticized by economists (foreign ones, that is, because European economists were forbidden by the authorities to even discuss the Pact) and, despite censorship, was swiftly abandoned as soon as difficulties with monetary management and economic growth became serious.

The lesson is that governments can indeed adopt non optimal policies and institutions if they wish, but then the constraints of reality are to be felt more strongly with the passage of time. I personally did not doubt at all that the euro could be put in place in 1999, even though it was an economic mistake (see my 1998 book). Maybe the U.S. economists had a more optimistic view of the political process and thought that rational governments would not do so, and in that they were wrong when they wrote that “it could not happen”.

It was clearly a bad policy move in economic terms (an even Jacques Delors later recognized that, while another former President of the European Commission, Romano Prodi, publicly said that the Growth and Stability Pact was “an absurdity”) but such a consideration would not deter any politician to enact it if he could envision a political profit from it. Indeed politicians maximize political profit, not always congruent with economic wellbeing, just as bankers maximize banks’ - and their own - profit, not necessarily to the aggregate economic advantage. And economists too are often players in that game.

Richard Posner writes in “A Failure of Capitalism” (p.259):

“Business economists – consultants, and employees of business firms or trade associations – emphasize economic forecasting, and often have industry-specific knowledge and data, but many are compromised by their business status. One does not expect economists employed by real estate companies or by banks to be talking about housing and credit bubbles.”

Nor should one expect economists employed by central banks or federal institutions to be talking about the drawbacks of centralizing currencies and monetary management.

Just as finance professors entwined with the finance industry, they cannot criticize the industry for hubris, or they may become black sheep and lose lucrative consultantships and/or positions. In Europe where most economists are government employees and where the main demand for their work comes from governments and central banks, this is a real risk.

But returning to fundamentals, there is also an economic reason for U.S. economists to disregard the possibility of breaking up the dollar zone: the U.S. is in a much better position regarding the OCA criteria than Europe is. The mobility of labor and capital is higher on the other side of the Atlantic, and the federal tax system is working as a shock absorber for unequally distributed negative shocks among states, where Europe has no such compensating device.

And, last but not least, central banking, the Federal Reserve System, has been created a long time ago (1913), in a period of general centralization (the “Schumpeter and Chandler era”), while the euro and the ECB have been created in a period of general decentralization (the late XXth century), against the organizational trend of the time.

Given the established existence of a political unity in the U.S. (which was obtained at the enormous price of the civil war), given the characteristics of the economy which are much closer to those of an OCA, and the existence of a compensating shock absorbers in the federal fiscal system, the opportunity cost of a non optimal monetary zone is much lower in the U.S. than in Europe, while the political opportunity cost of getting out of it is probably much higher in terms of the disruption of long established institutions. The cost/benefit ratio of exit is quite different on both sides of the Atlantic and this can explain why few U.S. economists considered the option.

If a break up of currency unions happens, it will more likely happen in Europe first and maybe in the US too, but later, or never (in terms of usual human forecasting horizon, that is).

World Poverty is Falling

Maxim Pinkovskiy (MIT) and Xavier Sala-i-Martin (Columbia University) write in Vox that world poverty is disappearing faster than what was previously thought.

Here is a striking illustration of their research on the world distribution of income, flatly contradicting earlier worries.

Hat tip: Tyler Cowen (Marginal Revolution).

Towards Classical Banking Reform

U.S. president Barack Obama will propose giving bank regulators the power to limit the size of the nation’s largest banks and the scope of their risk-taking activities, according to the New York Times .

“The proposal will put limits on bank size and prohibit commercial banks from trading for their own accounts – known as proprietary trading.” This is the approach long championed by Paul A. Volcker, and by Bank of England governor Mervyn King.

Indeed, it has become clear that the banking sector has been run as an oligopoly, which explains the extraordinary profits and bonuses of the last few years.

As the Financial Times editor Philip Stephens writes (January 18): “Institutions in the vanguard of spreading liberal market economics around the world were all the while making fortunes in markets that were rigged to their advantage.”

The U.S. proposal is a step in the right direction, that of more competition in the financial sector.

David Stockman on the Banking System

While lower taxes are a growth tonic, if you want less of something, tax is more. Read his New York Times op-ed .

Government Debt: the 90% Threshold

Carmen Reinhart and Kenneth Rogoff analyze international historical experience with public debt in their new paper “Growth in a Time of Debt” (NBER working paper No. 15639, January 2010).

Using a dataset of 3,700 annual observations covering a wide range of political systems, institutions, exchange rate arrangements, and historic circumstances, they find that below this debt/GDP threshold the relationship between government debt and real GDP growth is weak , while above 90% growth rates fall.

Emerging markets face lower thresholds for external debt (60% of GDP) beyond which growth rates fall by two percent, and even more for higher levels.

And “there is no apparent contemporaneous link between inflation and public debt levels for the advanced countries as a group”. For emerging markets, however, inflation rises sharply as debt increases.

What Makes Suicide Bombing So Popular ?

Andrew Leigh reviews a book by economist Eli Berman , Radical, Religious and Violent: The New Economics of Terrorism, a rational, cold-blooded look at one of the hottest policy question today.

Chicago Economists Interviewed

Raghuram Rajan, Kevin Murphy, James Heckman, Gary Becker, John Cochrane, Eugene Fama, Richard Posner, explain their work and their analysis of the crisis. An outstanding series of interviews posted by John Cassidy on his New Yorker blog “Rational Irrationality”.


A must read for economists of all stripes.

A Best-Practices « Constitution » for Big Banks

Roy C. Smith and Ingo Walter suggest in Roubini Global Economics that big banks and financial conglomerates take initiative in coming to terms with the general public, their regulators, and their own investors, or be prepared to submit to a deluge of regulations “limiting risk-taking, increasing capital requirements, shrinking and breaking-up financial supermarkets, charging surviving banks for the failure of their cohorts, restricting compensation of senior managers and risk-taking bankers, providing consumer protection from incomprehensible and abusive products, regulating derivatives and hedge funds, and many more.”

The largest banks should voluntarily agree to abide by the principles proposed time and again by people like former US Federal Reserve Chairman Paul Volcker to remedy their main failings that led people to think bankers paid themselves too much and turbocharged their incentivized risk taking, regulators to conclude that bankers were too reckless in creating massive amounts of systemic risk exposure which would ultimately have to be borne by society at large, and investors to believe that bankers and their consultants have been flogging a broken business model – the financial conglomerate – far too long.

All of them are perfectly right, of course, and one wonders whether bankers will be able and wise enough to self-regulate this way ... Maybe so, if they consider that investors will pay higher prices for shares of more secure financial intermediaries, especially after a decade of focusing on increasing size, complexity and market share, - a strategy which resulted in much shareholder value being destroyed.

Strengthening a big banks cartel however entails many other risks and could prove to be a dubious recipe for taming bankers’ greed. A new banking law making the main elements of the Roy-Walter proposal compulsory would provide a safer and more efficient means for reforming the financial industry.

Explaining Haiti’s Poverty

The apparently intractable long term problem of extreme poverty in Haiti is a challenge to development economists. Here is an encompassing analysis from Bob Corbett, a director of People to People, a charitable organization, well worth reading.

Hat tip Tyler Cowen and a Marginal Revolution commentator, Bobabdil.

The Non-Reform Banking Club

Is the banking industry a subsidiary of big government? Read the Wall Street Journal article on why the banking industry hasn’t been subject to most radical reform.

Unsurprisingly (see previous posts about the “Classical Banking Club” on this blog), after governments’ bailouts, banks have rapidly returned to business as usual and the pressure for drastic reform seems to have cooled. The WSJ suggests a public choice explanation. Excerpt:

“Those who have had powerful positions in the public sector tend to move on to a later, and often more lucrative, role in banking.”

The French, who have an extensive experience of this system, also have a word for it: “pantouflage”, and one is reminded of the well-known theory of George Stigler: the capture of regulatory authorities by business interests.

This makes the current criticism of the alleged excesses of “liberal” (in the European sense), or “free market”, or competitive capitalism’s responsibility in the financial crisis, irrelevant. The current reality is one of a collusive, public-private, symbiotic capitalism.

The solution then is not to be found in an additional extension of the public sector and public spending, but in establishing a clearer frontier between public and private, business management and the bureaucratic-political class.

And take note: the new book by Laurence J. Kotlikoff, the leading proponent of “limited purpose banking” (or “narrow banking”, or else “classical banking”) is to be published in March. The title: “Jimmy Stewart is Dead, Ending the World’s Ongoing Financial Plague with Limited Purpose Banking”.

Currency Unions Survival Values

As is well known, a currency union survival depends on its being an “optimal currency area” (OCA), which means that a common monetary and exchange rate policy is not detrimental to growth and employment, compared to bespoke national ones. In other words, it can be durable when “one size fits all.”

David Becworth reminds us here , that it is the case if various member countries (1) share similar business cycles and/or (2) have in place flexible wages and prices, factor mobility, fiscal transfers, and diversified economies.

Applying these classic criteria to the United States various regions (states) raises the question of the optimality (or not) of the dollar zone. If not, “dissimilar business cycles among the regions make a national monetary policy destabilizing – it will be either too stimulative or too tight – for some regions unless they have in place the above listed economic shock absorbers.”

The punch line: the “disparate responses to U.S. monetary policy shocks suggests that some parts of the U.S. economy may not (be) part of the dollar OCA” (i.e. Optimal Currency Area).

Note, however, that the U.S. can count on “shock absorbers” that do not exist in the case of the European economies. The eurozone is thus much more vulnerable to shocks, and as a consequence, the euro is more destabilizing for its member states economies than the dollar can be for some U.S. regions.

For an early and “ex ante” analysis along these lines see my 1998 book (in French) “L’Erreur Européenne” (Grasset) and various articles on my homepage (http://jjrosa.com). For a concise and similar analysis, see the Paul Krugman post “How Many Currencies?” in yesterday’s New York Times.

All Signs Point to a Greek Exit from the Eurozone

“Greece Will Have to Leave the Eurozone” writes Desmond Lachman for the American Enterprise Institute (AEI Today, January 12).

According to his experience at the International Monetary Fund where he has seen many “supposedly immutable fixed exchange rate arrangements come unstuck”, and especially that of Argentina a decade ago, Greece is approaching the final stage of its currency arrangement. “There is every prospect that within two or three years, after much official money is thrown its way, Greece’s euro membership will end with a bang.”

Global Money and Asset Bubbles

A new real estate bubble is feared in China. Read the Washington Post story . But would the bursting of a Chinese bubble produce the same international repercussions than the American housing and financial crashes?

Hat tip to Tyler Cowen (Marginal Revolution).

Krugman, Europe, and Social Democracy

In a post on his blog « The Conscience of a Liberal » January 9, Paul Krugman assails Jim Manzi’s essay “Keeping America’s Edge” published in National Affairs (Winter 2010).

The reason? “Manzi asserts that having a European-style social democracy is terrible for growth” writes Krugman, arguing that Manzi has presented incorrect data, especially because he included the USSR in his broad definition of Europe.

Krugman quotes the following paragraph from Manzi :
“From 1980 through today, America’s share of global output has been constant at about 21%. Europe’s share, meanwhile, has been collapsing in the face of global competition – going from a little less than 40% of global production in the 1970s to about 25% today. Opting for social democracy instead of innovative capitalism, Europe has ceded this share to China (predominantly), India, and the rest of the developing world.”

Note that this paragraph is the only passage in Manzi’s long article addressing the problem of the comparative growth of European and U.S. economies. The paper, in fact, is a rather balanced conservative reform manifesto, weighing the respective priorities of economic dynamism and innovation on the one hand, and of social cohesion on the other.

What infuriates Krugman,apparently, is the attack on social democracy (high taxes and high government spending) as an obstacle to growth, at the very moment when the Obama administration is nationalizing many big firms (the largest auto company, General Motors, the largest insurance company, American International Group, and largest bank, Citigroup), and pressuring the second largest bank, Bank of America, to purchase the country’s largest securities company, Merrill Lynch. Simultaneaously, the government current spending policy is such that it will most probably entail higher taxes in the future, in the form of an intriduction of the value-added tax.

That’s why the counter-performance of European high tax economies suddenly becomes a hot topic for debate in the U.S., and that’s why the American economists who favor more government spending and more taxes – such as Krugman – argue that such a counter performance does not exist.








Other evidence, for instance data from Mark Perry quoted on Mankiw's blog on November 23, and presented here, confirm Manzi's assertion.








Moreover, there is no doubt that GDP per capita are much lower in Europe compared to the U.S. (see the post of Greg Mankiw today, giving the IMF data) and that growth rates of European countries have been progressively slowing down since the early 1970s, as described in my paper “Comment Gagner Plus” (yes, in French, downloadable on my homepage) and in the references quoted in it including work by Alesina, Glaeser and Sacerdote, by Prescott, and by Aghion, Cohen and Pisany-Ferry for the French government). There is no doubt at all that even if Manzi’s data are not the best ones, they do reflect the underlying reality of comparative performance evolution on both sides of the Atlantic.

That’s why Krugman minimizes the European difficulties in today’s New York Times.

But he cannot completely obfuscate economic data and he thus cannot do otherwise than recognize in yesterday’s New York Times that:

“It is true that the U.S. economy has grown faster than that of Europe for the past generation. Since 1980 – when our politics took a sharp turn to the right, while Euope’s didn’t – America’s real GDP has grown, on average, 3 percent per year. Meanwhile, the E.U.15 – the bloc of 15 countries that were members of the European Union before it was enlarged to include a number of former Communist nations – has grown only 2.2 percent a year.”

He tries however to blur the matter by pointing that the per capita real GDP has risen at about the same rate in America and in the E.U.15: 1.95 percent a year here (America); 1.83 percent a year there (Europe)due to a faster population growth in the U.S..

But what he does not say is that the only slightly lower European growth rate applies to a much lower level of per capita GDP in Europe as Mankiw reminds us. And he does not mention either that while Europe was rapidly catching up on the U.S. from 1945 to 1975, it was the “left at the station” as Robert J. Gordon aptly wrote, when taxes went up and up during the 1970s 1980s, and still in the 1990s, while total working hours of Europeans kept falling, and as unemployment stayed at a high level, most often almost the double of U.S. rates.

The conclusion is that European catchup growth, which was a quite normal state of affairs in countries whose per capita income was much lower than the U.S. one, did stop after 1975, when social democratic and interventionnist policies were in full bloom. There is no other reason indeed why real income level should stay permanently lower than the U.S. one in these advanced economies. Arguing that Europeans have a "preference for leisure" will not do since in fact they used to work more, longer hours than Americans during the thirty high growth years 1945-1975.

The debate is serious, on both sides of the Atlantic. But it merits more than shrill criticism and arrogant half-truths from a good mathematical economist, but biased journalist, such as Krugman.

The Euro Overvalued by 35% Against the Dollar

The Economist has been publishing for many years its “Big Mac Index” of the various currencies undervaluation or overvaluation against the dollar. The Big Mac index is based on the theory of purchasing-power parity (PPP): exchange rates should equalize the price of a same basket of goods in different countries.

The January 6^th issue shows that the Chinese yuan is undervalued by some 49% while the euro is overvalued by 35%.

A Realistic Assessment of the Euro, Long Overdue …

Martin Wolf discovers, in the Financial Times (“The eurozone’s next decade will be tough”, January 5) that the eurozone is not an optimal currency area. Better later than never…

But coming from a financial establishment newspaper such as the FT, which has consistently been in favor of the euro , this awakening means that the deciders' opinion is changing.

Interest Rates, Leverage, and Bubbles in 2010

A must read post by Joe Gagnon on Econbrowser . Leverage is more to be feared than low interest rates.

Why Economists Overestimated Soviet Growth

Here is how Paul Samuelson presented his forecast of Soviet growth in his best selling textbook Economics. And many other well known textbooks erred similarly. Surprised?

The picture comes from Alex Tabarrok ("Soviet Growth and American Textbooks", Marginal Revolution, January 4) who has a very good post on how economists, even the best ones, blind themselves by restricting their analyses to a narrow set of tools. Using competitively several models at the same time may improve their view of the real world, while relying exclusively on one set of tools can lead you astray even more than political bias would.

He quotes a paper by David M. Levy and Sandra J. Peart, available on SSRN, on the textbook presentations of the Soviet growth compared to the US performance.

The punch line: “Applications to the financial crisis are apposite.”

Financial fragility and deglobalization

In a lucid article, Harold James warns that while the “1929” problem has been solved, in the US at least, by the combination of Keynesian spending and monetarist money creation, the “1931” balance sheet problem of financial distress which requires micro-economic restructuring, not macro-economic stimulus and liquidity provision, is much more difficult to tackle and that the solution cannot be imposed from above by an all-wise planner.

Moreover these problems are easier to grapple with in large states, but smaller, more open countries such as Greece and Ireland, or even Taiwan, Chile, New Zealand, and others, find it harder to apply Keynesian fiscal policies, or pursue autonomous monetary policies. And especially, I would like to add, when they voluntarily renounced such policies by entering the eurozone. A return to financial nationalism - deglobalization - is thus to be feared.

And as a consequence, international economic dynamism has shifted to the newly “Big Really Imperial Countries” (BRIC): Brazil, Russia, India, China.

The whole paper is well worth reading in the Financial Times .

Feldstein and Others Debate Fiscal Policy in 2010

Will the economy run out of steam later this year? Was the stimulus helpful? Is the debt-to-GDP ratio too high? How to improve the net effect of the deficits? These are the question debated yesterday at the annual meeting of the American Economic Association in Atlanta. Unsurprisingly, there was some disagreement about the answers among participants …

Read the Wall Street Journal story .