Friday, April 30, 2010

Greece Will Default : Feldstein

I agree. Read the paper here .

The Folly of Currency Pegs

John H. Makin has an excellent post with that title in the May issue of the American Entreprise Institute Outlook Series. He draws an apt parallel between the current crisis of the Euro, and the demise of the Bretton Woods system, and finds that it gives the European economies good reason for hope, if only their governments accept to recognize the facts.


“The current flap over the sustainability of Greece's membership in the European Economic and Monetary Union (EMU) is reminiscent, in many ways, of the events leading up to the collapse of the Bretton Woods system--another ultimately untenable currency regime--which was put into place after World War II and terminated by the break of the dollar's link to gold after August 1971. The period of increased exchange-rate flexibility that followed the demise of the Bretton Woods system turned out to be beneficial. The same possibility exists with respect to the aftermath of the current currency crisis in Europe.”

Makin further notes:

“The abandonment of fixed exchange rates--although it was not realized at the time--was fortunate. The oil-price shocks of 1973-74 would have blown apart any system of fixed exchange rates in the midst of a highly disruptive crisis environment that required substantial exchange-rate adjustments. Today, substantial exchange-rate adjustments are required in the EMU in the aftermath of the 2008 financial and economic turbulence caused by the bursting of the housing bubble.
Since the 1970s, among the most ill-founded currency pegs are those involving Argentina, Greece, and China. Argentina's peg to the U.S. dollar lasted from 1991 through 2001 and ended with a debt default by Argentina and, of course, a break in the exchange-rate peg of the Argentine peso to the dollar.”

His conclusion:

“The obvious fact is that the eurozone, with its single central bank and sixteen separate national treasuries, will not survive the aftermath of the 2008 bursting of the financial bubble. The corollary to this is that, given the persistent recurrence of such bubbles, currency pegs are inadvisable ex ante and even more damaging ex post while governments are wasting resources and delaying necessary adjustments by lending to accommodate fixed exchange-rate regimes that will ultimately break own.
… Let us hope that the Europeans see the light before even heavier costs and distortions are visited on Europe to support the fantasy that it constitutes an optimum currency area. As Greece, Ireland, Spain, and Portugal are discovering the hard way, it does not.”

The complete paper is first rate and well worth reading. It is the best one I have seen recently.

Paul Krugman also reaffirms in the New York Times his former euro-skeptical analysis – he writes that it is vindicated, and I agree -, and honestly recognizes that he was wrong to follow Barry Eichengreen’s assertion that exit was impossible.

My comment: I really can’t understand this kind of ultra conservative argument that since some (international) arrangement has been created, it can’t be changed afterwards. Don’t these people read history, including ancient and contemporary monetary history?

Thursday, April 29, 2010

How Reversible is Krugman on the Euro?

The Euro crisis is currently deepening, with concern about Spain seriously mounting, as we forecast (with my co-author Philippe Villin) would be the case, in a paper published in the French daily Le Figaro in February (downloadable on my homepage here).

Analysts are now busy constructing exit scenarios as does for instance the staunch pro-euro Wolfgang Munchau, in a briefing note Eurozone meltdown on his website, Eurointelligence. Even Paul Krugman, who, from the start, was quite critical of the euro but lately deemed exit impossible, following Barry Eichengreen , is now reconsidering his position.


“… as Eichengreen argued, any move to leave the euro would require time and preparation, and during the transition period there would be devastating bank runs. So the idea of a euro breakup was a non-starter.

But now I’m reconsidering, for a simple reason: the Eichengreen argument is a reason not to plan on leaving the euro — but what if the bank runs and financial crisis happen anyway? In that case the marginal cost of leaving falls dramatically, and in fact the decision may effectively be taken out of policymakers’ hands.

Actually, Argentina’s departure from the convertibility law had some of that aspect. A deliberate decision to change the law would have triggered a banking crisis; but by 2001 a banking crisis was already in full swing, as were emergency restrictions on bank withdrawals. So the infeasible became feasible.

My comment: I never believed that exit was impossible. First because many countries did exit from monetary unions over the years (see the paper by Andrew Rose who counted that in the postwar period seventy countries exited from currency areas while only sixty remained continuously within unions), and second because, following Herbert Stein’s Law “when something can’t continue indefinitely, it will stop”. As the saying goes, nothing human is irreversible, except death and taxes.

More seriously, as Krugman argues, there is a point where the economic damage from maintaining a far from equilibrium exchange rate exceeds the possible damage incurred by exiting from a non-optimal currency area. And the damage to European economies could grow considerably in the near future if vulnerable European banks are hit by government defaults.

Monday, April 26, 2010

Europe Lackluster Perspective: It is the Tax Cost of Labor and the Bureaucracy, Stupid!

For a very good analysis of the prospect for Europe after the partial Greek default that is to come, read Irwin Stelzer’s article in today’s Wall Street Journal Europe.


“It is now fashionable to say that the southern euro zone consists of profligate, laggard economies such as Greece, Spain and Italy, while the northern euro zone is home to sound, efficient economies.

There is some truth to that, but only some. The northern tier is indeed efficient by comparison with the southern tier. But, the current recovery in France and Germany notwithstanding, no one expects euroland as a whole to grow at a long-term annual rate close to that of the U.S. and China. Europe’s failure to reform its labor markets and welfare states will inevitably become an irresistible drag on growth.

Doubt that and consider a new study by James Heckman and Bas Jacobs, professor of economics at the University of Chicago and professor at the Erasmus School of Economics in the Netherlands, respectively. In their careful and equation-laden study (“Policies To Create And Destroy Human Capital In Europe”), prepared for the nonpartisan National Bureau of Economic Research, they find, “High marginal tax rates and generous benefit systems reduce labor force participation rates and hours worked and thereby lower the utilization rate of human capital.”

A better description of conditions in most European countries would be difficult to find. So it seems likely Europe will be an economic laggard long after the Greek problem is solved, if the injection of new layers of bureaucracy and the imposition of deflationary policies can be classified as a solution.”

Note that the Heckman-Jacobs study vindicates the diagnosis of Edward Prescott on the effect of labor tax on European labor supply and demand that I used in my paper (in French) “Comment gagner plus” (downloadable on my homepage here .

There are two, and only two, decisive policies for stimulating durably European growth: get rid of the euro, or at least depreciate it relative to the US dollar by some 30 or 35% , and second, reduce the tax on labor by limiting it to the amount necessary for maintaining the current vertical transfers between high wages and low wages, but in the form of a health insurance voucher scheme instead of imbedding it in a compulsory monopoly, and tax financed, state insurance. This would preserve the generosity of the present social policy while reducing the current tax on labor for health care by 2/3.

See also my post of June 19, 2009, “U.S. Beware: Don’t Go European on Health Care Costs”.

Sunday, April 25, 2010

The US Trade Deficit and the Financial Sector Expansion

Mike Mandel has an interesting post on the topic, and offers a rather convincing explanation. Now the trade deficit has to be explained too, and the Bretton Woods II system of quasi-fixed (and disequilibrium) exchange rates, coupled with the extraordinary expansion of emerging economies, could be a main part of the story.

Thursday, April 22, 2010

2012, the Next Greek Crisis

According to The Economist, the bail-out for Greece has merely bought time, for about about three years. An eventual restructuring of Greek debt remains highly likely.


“The bail-out, which was certainly bigger than the markets had expected, has all but eliminated the risk of default this year. But Greece still faces a deep medium-term solvency crisis. …

The rescue package has merely bought time—three years, in effect, to contain the adverse consequences of a possible Greek default. …

Even on optimistic assumptions, we reckon Greece will need €67 billion or more of long-term official loans in the next few years. Its debt burden will peak at 150% of GDP in 2014, a level exceeded now only by Japan. …

… the history of emerging-market debt crises, especially Argentina’s in 2001, suggests that, if default is overwhelmingly likely, it is better to get it over with rather than put it off with quixotic rescue packages. But this is not true in the Greek case, for two reasons that have less to do with Greece than with the rest of the euro area.

First, a Greek default now would carry a serious risk of triggering debt crises in Portugal, Spain and even Italy, the other euro-area countries suffering from some combination of big budget deficits, poor growth prospects and high debt burdens. The EU does not have the firepower to cope with these.

Second, a default now could also have calamitous effects on the fragile European banking system. Euro-area banks hold €120 billion of exposure to Greece, of which we reckon perhaps €70 billion is Greek sovereign debt. French and German banks account for 40% of the total. Many European banks might well require more government help if they lost a lot on Greek debt. Indeed, the sums involved might easily be greater than the German and French contributions to the Greek rescue loans. And if contagion then pushed Spain and Portugal to a crisis, the entire European banking system could implode."

Read the article here .

Wednesday, April 21, 2010

“I, not Alfred P. Sloan, invented the M-form organization” - Napoléon –

In his celebrated work on the era of the large-scale firm – The Visible Hand (1977) - that I call the “first twentieth century”, the late Alfred D. Chandler attributes a central role to the long time manager of General Motors, Alfred P. Sloan, in the invention of that type of business organization.

But read the following historical description:

“Having taken over from Carnot as the “organizer of victory,” Napoleon used the full power of the police to break such opposition to conscription as still existed. Not only was the imbalance between men and arms soon corrected, but the result was to provide the French state with forces larger than any since Herodotus had Xerxes lead a million and a half men into Greece in 480 BC; however, there was nothing mythical about the Grande armée. Instead of marching in a single block, as had been standard practice from the day of the Greek phalanx to that of Frederick the Great, willy-nilly the French troops had to be spread out over a much wider front in order to live and move. The construction of such fronts both demanded and was made possible by the organization of the forces into corps d’armée. First proposed by the National Convention in 1796, each corps or “body” possessed a permanent commander in the person of a maréchal de France, a title which Napoleon did not invent but to which he gave a new, more precise significance. Each had its own staff and its own proper combination of the three arms (infantry, cavalry, and artillery), as well as its own intelligence, engineering, and logistic services. Each one constituted a miniature army in its own right, one which, as common wisdom went, was capable of performing its mission independently of the rest and of holding out for two or three days even in the face of a superior force attacking it.” (Martin Van Creveld, The Rise and Decline of the State, Cambridge University Press, 1999, p. 246).

This structure is precisely that of the multidivisional firm, the M-form, that has characterized, as Chandler claimed, the rise of the modern giant business, and for the same reasons: the growing number of employees and volume of production of giant firms that accompanied the second industrial revolution.

If, arguably, the East India Company was the forerunner of modern firms, the Grande armée then was the first example of the M-form company.

Sunday, April 18, 2010

The Euro at $ 1.60 ?

According to Martin Feldstein the euro is not overvalued and a further downward slide is unlikely. On the contrary:

« Looking ahead, the euro is more likely to climb back to the $1.60 level that it reached in 2008. »

There are two main reasons: the first is that Germany, Europe’s largest exporter, has a very large trade surplus with the rest of the world, a surplus equivalent to nearly 6% of GDP. And a surplus, Feldstein believes, that would remain high even if the euro appreciated substantially from its current level.

Moreover, global economic conditions require the euro zone to have a substantial trade and current-account deficit so that it becomes a large importer of funds from the rest of the world. Mostly because oil producing countries and China will continue to export more than they import, and because these surplus countries will diversify their investments away from the US and into the euro zone that provides the only large capital market other than the US for such investments.

Central banks in Asia and the Middle East will do the same with their foreign-exchange holdings, and this will inevitably cause the euro to rise relative to the dollar.

My comment: Feldstein’s argument really is about who should bear the burden of the realignment of the dollar-yuan exchange rate. The Chinese government is reluctant to revalue the yuan vis-à-vis the dollar, and if he does so he would not like to revalue at the same time its currency against its other major zone of exports, Europe. It follows also that the US would find it much easier to devalue the dollar both relative to the yuan and relative to the euro. In that way the effort required from China, and from the US, would be less and the euro zone, a global net exporter, would bear part of the burden.

This makes sense for Germany of course. But is is nonsense for other members of the euro zone that are currently net importers. Their activity would be further depressed by the move. And the political tensions within the zone would be much increased, with some countries considering exiting the zone even more seriously that they currently do. A problem that Feldstein analyzed in a previous column “Can the Euro Zone Survive Economic Recovery?” (November 25, 2009).

The balance of costs and benefits of being a member of the zone will thus be further affected by the dollar-yuan realignment, and the very survival of the euro possibly jeopardized.

Friday, April 16, 2010

Comparing 1929-1933 and 2007-2009

The Great Recession is the worst financial disruption since the Great Depression, but the current economic contraction has been mild compared to that of the 1930s, as we claimed in this blog from the start of the crisis.

The following table from David C. Wheelock (“Lessons Learned? Comparing the Federal Reserve’s Responses to the Crises of 1929-1933 and 2007-2009”, Federal Reserve Bank of St. Louis REVIEW, March/April 2010), clearly summarizes the evidence.

According to the author, the modern Fed appears to have learned the main lesson from the past: central banks should respond aggressively to financial crises to prevent a collapse of the money stock and price level.

Tuesday, April 13, 2010

A Dismal Perspective

Kevin Drum, writing in Mother Jones lists the reasons why the economic outlook is still bleak:

“1. This is a balance sheet recession, not a Fed-induced recession. Paul Volcker caused the 1981 recession by jacking up interest rates and he ended it by lowering them. That’s not going to happen this time.

2. In fact, there won’t be any further stimulus from lower interest rates. They’re already at zero, and Ben Bernanke has made it clear that he doesn’t plan to effectively lower them further by setting a higher inflation target.

3. Consumer debt is still way too high. There’s more deleveraging on the horizon, and that’s going to make consumer-led growth difficult.

4. The financial sector remains fragile and there could still be another serious shock somewhere in the world.

5. There are strong political pressures to reduce the budget deficit. That makes further fiscal stimulus unlikely.

6. Housing prices are still too high. They’re bound to fall further, especially given rising interest rates combined with the end of government support programs.

7. Our current account balance remains pretty far out of whack. Fixing this in the short term will hinder growth, while leaving it to the long term just kicks the can down the road.

8. The Fed still has to unwind its balance sheet. That has the potential to stall growth.

9. Oil prices are rising. This not only causes problems of its own, but also makes #7 worse.

10. Unemployment and long-term unemployment continue to look terrible. Yes, these are lagging indicators, but still.”

He concludes, however: « I don’t expect all of this stuff to be as dire as it sounds, and overall I suspect that we are indeed going to see steady if unspectacular growth over the next few years. »

My conclusion: All this looks quite like the thirties, ten years of uncertain growth after a deep financial crisis, following a decade of exuberant growth and innovation (the 1920s), even though the 2008-2009 crisis has been much less severe than the 1929 one …

Hat tip : Tyler Cowen.

Friday, April 9, 2010

Is the US Going the European Way ?

That’s what I claimed in several posts on this blog.

Now Jonah Goldberg writes in National Review Online that the US cannot become more like Europe, a "high tax-high transfers" zone, because no one then would be left to spend enough money on defense to protect both sides of the Atlantic against a potential third party aggressor.

I am afraid, however, that the trend is already well under way, as I mentioned in my February 28 post illustrated by the following graph.

Defense spending as a percentage of GDP

The recent nuclear disarmament treaty between the US and Russia shows that the US indeed is betting on a future no-war environment. And in that case it is to be expected that the welfare state spending share in the federal budget will take the place of defense spending.

The risk however is that the bet could be proved wrong. The US is thus likely to accept more risk by reducing its supply of international security (a public good), limiting the European free ride, in order to develop its welfare state supply of bureaucratically provided private security.

Wednesday, April 7, 2010

The Age of Nations

I argued in “The Second Twentieth Century” that the current era, since the mid-seventies of the last century, was characterized by an IT revolution-induced fragmentation of all large hierarchies – private as well as public – and, as a consequence, by a return of nations versus international or global organizations.

If true, this would mean the end of the utopia of a united Europe as a potential federal state having a powerful say in world affairs.

Now The Economist publishes in this week’s issue a paper by “Charlemagne” titled: Even if it spoke with one voice, how much would Europe really count? .

“John Hulsman, an American writer on foreign policy, recently noted that rising powers such as China, Russia, India and Brazil are, if anything, even more hostile to the idea of binding rules or treaties that impinge on their sovereignty than the Americans are. Citizens of these powers “see much of the current international architecture as a confidence trick designed to keep their country from assuming its proper place in the world,” Mr Hulsman commented.

The rise and fall of little voice

Does this mean the Euro-establishment is wrong about the benefits of speaking with a coherent message and forming alliances to get things done? That would be to go too far. If Mr Obama finds multilateralism hard work, that does not necessarily mean that unilateral swagger would be more effective. Nor would cacophony give the EU more clout than speaking with one voice. But Europeans need to be less starry-eyed about what they can achieve through dialogue and political integration. Some still dream that the EU’s pooled sovereignty can serve as a “model” for systems of global governance, transcending the nation-state. Right now, that looks like a fantasy. The 21st century is instead shaping up to be a brutal testing ground for relative power.”

As I claimed in the conclusion of the book:

“The abundance of information determines its diffusion. Information diffusion decentralizes power and weakens hierarchies. It frees the individuals. Or best hope can thus only be that the second twentieth century tendencies will be vindicated and extended as far as possible, well into the coming decades of the twenty-first century.”

It appears that they are.

Monday, April 5, 2010

Banking Consolidation Is Not Natural

Public policies have been encouraging concentration in the sector since the 1980s, in complete opposition to the general downsizing trend followed by most other firms. An early warning was issued by John H. Boyd and Stanley L. Graham back in 1991. Here is the summary of their paper, “Investigating the Banking Consolidation Trend”, in the Minneapolis Fed Review:

“This paper examines whether the U.S. banking industry's recent consolidation trend—toward fewer and bigger firms—is a natural result of market forces. The paper finds that it is not: The evidence does not support the popular claims that large banking firms are more efficient and less risky than smaller firms or the notion that the industry is consolidating in order to eliminate excess capacity. The paper suggests, instead, that public policies are encouraging banks to merge, although it acknowledges that other forces may be at work as well.”

Read the complete article here .

A Communications Recovery?

Mike Mandel sees a communications boom coming. According to “Mandel’s Second Law of Booms and Busts”: “Industries which recover first in a bust tend to drive the next boom”. Internet publishing and search should lead the expansion phase.

Read his post here.