2011, the Year of All Dangers for the Euro

A quick look at the graphics gallery from the Spiegel Online (The Euro Crisis in Numbers) highlights the problem.

The amounts of government bonds coming due in 2011 will be peaking in Portugal, Spain, and Italy, and will reach short term new highs in Ireland and Greece: here, here, here, here, and here.

Further rises in bond rates are to be expected in the above countries, weighing even more on budgets and economic activity, increasing the demands for financial transfers and thus the tensions between the zone members. Add to that the 2011 elections in Germany and the prospect of the 2012 elections in France and all the elements of a deepening crisis appear to be present.

The Excess Supply of PhDs

From The Economist:

“A PhD may offer no financial benefit over a master’s degree. It can even reduce earnings”.

I wonder if that means that a destruction of human capital is taking place in the course of prolonged studies. A quick look at the sorry state of the excess production of new economic articles in peer-reviewed journals may lend credibility to that conclusion.

Read more.

The European Quandary: Michael Spence

I liked his clear and condensed analysis of the EU's central problem in a recent Project Syndicate post:

“Europe struggles to find a solution to its deficit and debt problems by treating them with short-term liquidity fixes whose purpose is to buy time for fiscal consolidation and, in the absence of the exchange-rate mechanism, some kind of deflationary process to restore external competitiveness. Success is by no means assured, and the most likely outcome is a sequence of contagion events and a broader loss of confidence in the euro. The core issue is burden-sharing across bondholders, citizens of the deficit countries, the EU, and, indeed, the rest of the world (via the International Monetary Fund).”

Euro Defaults or Euro Exit?

“Far from being irrational, markets are quite right this time to be concerned about the current crisis in the euro area” writes Elena Carletti, a professor of economics at the European University Institute un Florence, in Bloomberg.com.

As an alternative to sovereign default, she comments, a country could simply leave the currency union. “This would also need to be done quickly to avoid massive capital outflows. A government would have to redenominated overnight all contracts into a new currency, presumably at a 1-to-1 ratio with the original euro amounts. There would still be a market-determined exchange rate between the new currency and the euro.”

Would the following depreciation of the new national currency increase the burden of the foreign held government debt? Not necessarily.

“Most emerging-market sovereign debt was written under U.K. or New York law. In the euro area, much of it is under domestic stature. In Greece, about 90 percent is subject to local legislation.”

Presumably the euro denominated debt could be redefined as a national currency denominated one. But anyway, in my opinion, an exit by a single country would be much more costly both to the economy of that country and to big European banks if not preceded by a coordinated, and substantial, depreciation of the euro that would make a large devaluation of the new national currency unnecessary. And in any case, as I see it, (partial) default (or “restructuring”) and exit are not alternative solutions but could well prove to be complementary.

Differential Effects of British and French Colonization

The case of Cameroon that was divided between Britain and France following the German defeat in WWI, to be reunited only much later, at independence in 1960, highlights the effects of colonial rules and legacies on present day economies.

A new research by Alexander Lee ad Kenneth Schultz of Stanford shows that rural households on the British side still have, today, higher levels of wealth and are more likely to have access to improved sources of water (a locally provided public good).

They remain cautious, however, about the relative importance of the factors that can explain these differences:

“The exact origin of the British advantage are impossible to determine with certainty, but we hypothesize that it is caused by a combination of ‘hard legacies’ (lack of forced labor, more autonomous local institutions) and ‘soft legacies’ (common law, English culture, Protestantism). The relative role of these two types of influence is a fruitful topic for future study.”

Read more, here .

Hat tip: Laura Freschi (AidWatch).

How Ants Solve the Shortest Path Problem

A Scientific American article reports the results of a new study of the techniques used by ants to quickly find routes in a changing maze that could be useful to systems engineers.

“In the wild, ant scouts deposit pheromones along the trails between food and the nest. Nest mates then follow the trail, laying their own pheromones, amplifying the markings along the path. Because the pheromones gradually evaporate, longer trails--on which ants are spread more thinly--carry lower pheromone concentrations than short trails. Since pheromone strength is what draws an ant to follow a specific path, longer trails that have weaker pheromones are abandoned in favor of shorter ones. (…)

Many computerized systems, such as those that route telephone calls through busy networks while minimizing connection times, already solve shortest path problems by deploying virtual ants that explore all possible routes in a system and deposit virtual pheromones on each route they travel.”

This technique however implies that when a new obstacle blocks a well traveled path they should turn around and go all the way back to their nest along the most traveled path, in order to start a new search.

The study reported in the Journal of Experimental Biology, shows that Argentine ants (Linepithema humile), do not just retrace their steps when presented with a barrier--as might be expected. Instead, the ants begin a localized search that seems to take into account the direction in which they were planning to go.

The discovery indicates that Argentine ants use more than just the simple trail pheromone to find their way. "The individual ants appear to have internal compasses and odometers that allow them to guide their search," says Chris Reid, a behavioral biologist at the University of Sydney in Australia, the lead author of the study.

David Broomhead, director of the Centre for Interdisciplinary Computational and Dynamical Analysis at the University of Manchester, UK, adds that "it would be really interesting to see if we can get a computer to do what these ants are doing."

Hat tip: Big Think.

Slavemaker Ants Are Von Neuman-Morgenstern Rational Agents

Ants enslave the strong not weak report Ella Davies in BBC Earth News (November 8).

Excerpt:

“Slavemaker ants prefer to target the strong over the weak when seeking new servants, researchers have found.
Ants were observed actively choosing to attack larger, better defended colonies over smaller, weaker ones.
Scientists suggest that the intelligent ants identify strong defences as a sign of a strong population.
By conducting fewer raids on strongly defended targets, the slave-making ants actually limit the risks and come away with the most pupae to enslave.”

The reason is, according to a research conducted by Sebastian Pohl, a biologist, and his colleague Susanne Foitzik, a professor of behavioral ecology, both at Ludwig Maximilian University (LMU) in Munich, Germany, reported in a recent issue of the journal Animal Behaviour, that it is essential that scouts make the right decision about suitable raid targets or "host colonies" without being discovered and attacked.

"Losing a single (scout) worker might very likely be synonymous with losing half of the colony members," Mr Pohl told the BBC. Therefore, a smaller number of scouting events and subsequent raids present the lowest risk to the slavemaker colony. However, the colony still needs new slaves to be able to survive to the next season.

From their behaviour, researchers suggested that the scout ants associated strong colonies with high numbers of pupae and a high benefit. The tactic of fewer raids on stronger targets consequently offered the best risk to benefit ratio.

My comment: This behaviour is typical of Von Neuman and Morgenstern rational agents! In other terms they maximize expected, risk-adjusted utility in an uncertain and dangerous world.
Now if ants can be that sophisticated, why couldn’t human beings be at least as rational?

Schumpeter, Information, and the Great Recession

Mike Mandel ( Innovation and Growth) believes the information economy recession that started with the beginning of the current century and explains the depth of the “great recession”, is over now.

Excerpt:

“Is the long information sector job drought finally over?

(…) our information industries have mostly been shrinking from 2000 until very recently. This was one of the great disappointments of the past decade, and one of the big reasons why the 2000s were an economic disaster. (…)

Here are the numbers: In 2000 the information sector employed 3.6 million workers. By 2007, just before the recession started, the number was down to 3 million, and in 2009, the information sector had shrunk to 2.8 million. That’s a 23% decline in 9 years. By comparison, the whole private sector is only down about 2% over the same stretch.”

My comment: I, too, believe that the unusual severity of the current recession results from the downside of the extraordinary innovation cycle (a Schumpeterian one) that started in the mid-1970s. The heated debate about the efficiency (or inefficiency) of macroeconomic policy (mostly in the US) is due to the fact that the marked slow down of information innovations and related investment opportunities, that sustained the remarkable growth of the 1980s and 1990s, precludes a vigorous pick up in investment and growth. Government deficits and money creation can damp down the recession but cannot by themselves generate a new expansion comparable to that of the previous two decades.

Growth in consequence will stay sluggish until the next innovation wave (that may be already be under way without our knowing it …). Most commentators have been focussing the analysis on the financial sector that indeed contributed to amplify the crisis, but financial excesses themselves had their origin in the perspective of unusual (and highly uncertain) real returns in the new technologies, just as in the booming 1920s. That's also why, following a similar path, we often find the present situation so similar to that of the 1930s.

How to Quit the Euro Zone

The euro debate is evolving along a well-known path. Individuals and governments confronted to major difficulties tend to start with a denial: the problem does not exist. Then the conservatives claim: yes, there is a problem but not as serious as what you pretend. In the third stage, they recognize that the problem is serious indeed, but a radical change is impossible, they maintain. In the fourth stage, the radical change becomes possible but horribly costly. And in the fifth stage, no real change having been tried, it proves eventually even more costly to maintain the existing system than to opt for a radical break with the past.

The third stage has been dominating the debate for about three years since the American economist Eichengreen claimed that he had found the definitive argument against a break-up of the Euro: it would unleash the “mother of all financial crises” since it would lead to bank runs that would destroy the banking systems in Europe and possibly elsewhere.

Now, interestingly, The Economist is proceeding to stage four in its December 2 edition, with a paper titled “Don’t do it: The euro is proving horribly costly to some. A break-up would be even worse”, here and also here.

But the analysis is seriously flawed. Here are some excerpts from the paper, and a different and critical point of view in favor of an exit.

“A break-up might happen in one of two ways. One or more weak members (Greece, Ireland, Portugal, perhaps Spain) might leave, presumably to devalue their new currency. Or a fed-up Germany, possibly joined by the Netherlands and Austria, could decide to junk the euro and restore the D-mark, which would then appreciate.

In either case, the costs would be enormous. For a start, the technical difficulties of reintroducing a national currency, reprogramming computers and vending machines, minting coins and printing notes are huge (three years’ preparation was needed for the euro).”

But remember that at the time of the launch of the euro, the official claim in the deluge of publicity aimed at the public opinion of future member countries, was that these costs were small, or even negligible. And keep in mind that the national central banks are still in place and working today so that no new institutions are needed to recreate national currencies.

“Any hint that a weak country was about to leave would lead to runs on deposits, further weakening troubled banks.”

As I explained previously, the “Eichengreen impossibility” does not hold if there is a large euro depreciation prior to the exit of new national currencies. In that case no further depreciation would be needed for these new currencies, or in some cases a minor depreciation would be enough.

“That would result in capital controls and perhaps limits on bank withdrawals, which in turn would strangle commerce. Leavers would be cut off from foreign finance, perhaps for years, further starving their economies of funds.”

Really? Are currency union exits always leading to durable economic and financial catastrophe? Is that what happened to the following countries that chose to exit from a currency union: Bahrain (1973), Bangladesh (1965), Barbados (1975), Botswana (1977), Cape Verde (1977), Cyprus (1972), Dominican Republic (1985), Ghana (1965), Guatemala (1986), Ireland (1979), Israel (1954), Jamaica (1954), Kenya (1978), Kuwait (1967), Malta (1971), Mauritania (1973), Mauritius (1967), Morocco (1959), New Zealand (1967), Nigeria (1967), Pakistan (1949), Reunion (1976), Singapore (1967), South Africa (1961), Tanzania (1978), Tunisia (1958), Vanuatu (1981), among many others, including the countries that regained their independence from the Soviet Union since 1991 in Eastern Europe and Central Asia, and, last but not least, Argentina.

“The calculation would be only slightly better if the euro escapee were Germany.”

Not true. In that case, if the euro becomes the currency of the southern European countries, it will depreciate substantially, thus alleviating the cost of exiting from it, as explained above. While a “euro-south” would not be viable since it would present the member countries with the same “one size fits none” than the present euro, it would be a useful transition for the euro countries that today need a depreciation most, to exit in an orderly manner, and without an unbearable increase in the external debt due to a large depreciation of the national currency vis-à-vis the surviving euro.

“Again, there would be bank runs in Europe as depositors fled weaker countries, leading to the reintroduction of capital controls. Even if German banks gained deposits, their large euro-zone assets would be marked down: Germany, remember, is the system’s biggest creditor. Lastly, German exporters, having been big beneficiaries of a more stable single currency, would howl at being landed once again with a sharply rising D-mark.”

Not true if the euro, whether still including Germany, or without Germany, is sufficiently weakened in foreign exchange markets before the exit of national currencies.

The punch line: Stage five may be closer than we think.

Pro-euro Eichengreen Joins the Euro-criticism Bandwagon

Kevin O’Rourke (The Irish Economy) has translated Eichengreen’s paper in today’s Handelsblatt.


Excerpt:

« I’m probably the most pro-euro economist on my side of the Atlantic. Not because I think the euro area is the perfect monetary union, but because I have always thought that a Europe of scores of national currencies would be even less stable. I’m also a believer in the larger European project. But given this abject failure of European and German leadership, I am going to have to rethink my position.
The Irish “program” solves exactly nothing – it simply kicks the can down the road. A public debt that will now top out at around 130 per cent of GDP has not been reduced by a single cent. The interest payments that the Irish sovereign will have to make have not been reduced by a single cent, given the rate of 5.8% on the international loan. After a couple of years, not just interest but also principal is supposed to begin to be repaid. Ireland will be transferring nearly 10 per cent of its national income as reparations to the bondholders, year after painful year.
This is not politically sustainable, as anyone who remembers Germany’s own experience with World War I reparations should know. »


My comment: It is easy to blame politicians now that things are turning so wrong, as correctly forecast from the start by euroskeptic economists, but wrongly denied by pro euro promoters, among whom Eichengreen and the (ECB funded) CEPR clique in Europe. But the current difficulties were unavoidable, independently of the quality of European leadership, given a strong macroeconomic shock, and that conclusion was well known long before the launching of the euro. Thus, shouldn’t economists who consistently advocated the creation of the euro, applauded politicians for doing so, and fostered illusions about its sustainability for years, consistently misleading the public opinion, share a large responsibility for the coming disaster?

Furthermore, Eichengreen also recognizes, belatedly, that (a) austerity further deteriorates the economy and the fiscal position of countries that adopt it, and (b) a depreciation of the euro is absolutely necessary and would improve the Irish situation. An analysis that the readers of this blog have been exposed to for quite a while.

Excerpt:
« Nor is the situation economically sustainable. Ireland is told to reduce wages and costs. It must engage in “internal devaluation” because the traditional option of external devaluation is not available to a country that lacks its own national currency. But the more successful it is at reducing wages and costs, the heavier its inherited debt load becomes. Public spending then has to be cut even deeper. Taxes have to rise even higher to service the debt of the government and of wards of the state like the banks.
This in turn implies the need for yet more internal devaluation, which further heightens the burden of the debt in a vicious spiral. This is the phenomenon of “debt deflation” about which the Yale economist Irving Fisher wrote in a famous article at the nadir of the Great Depression.
For internal devaluation to work, therefore, the value of debts, expressed in euros, has to be reduced. »

As explained in this blog, a large enough depreciation of the euro would then permit an exit of national currencies from the euro straitjacket without the apocalyptic consequences that Eichengreen has predicted, even pretending – wrongly again - that it was just « impossible » to exit from the European currency after entering the zone.

By the "rethinking of his position", Eichengreen is just the first to try avoiding a well deserved blame. Let's wait now for Wyplosz, Giavazzi, Pisani-Ferry, Sinn, and other euro supporters including in particular almost all the French economists, to try both to totally reverse their long held dogmatic position while avoiding at the same time a total loss of credibility. Quite a challenge, indeed.

Theories of What Causes Economic Downturns

Macroeconomists should use all five of them, alternatively or as complements to each other claims Brad DeLong, in order to explain current events. A much needed pragmatic and empirical-historical approach.

Missing in his list, however, is the Real Business Cycle explanation relying on technological shocks, unless he considers it a part of the Austrian theory.