Ferguson on the Coming European Defaults

Niall Ferguson has many interesting things to say about Europe, and particularly this :

« You cannot base fiscal federalism exclusively on a pact – a kind of pact of death that nobody ever runs a budget deficit. »

And this:

“There are, in fact, three ways out of an excessively large public debt. One is that you default … the second is that you inflate it away … a third way … is that you grow your way out of it. That’s rare. … the default scenario is the most likely of the three, simply because to inflate the debt away is something that the ECB is prohibited from doing. And as for growth, well, if austerity is the only solution in German minds, you can forget that.”

Read the interview in Business Insider.

Euro-Crisis, Bargaining, and Unpredictability

A good post in The Monkey Cage by political scientist Henry Farrel who compares the  Cuban crisis competition in risk taking and the current euro crisis with the help of Nobel Prize winner Thomas Schelling’s analysis.

The risk of one actor going too far in the current game of chicken and thus precipitating breakdown by accident “is all the higher given the importance of market reactions in determining success or failure, and the inability to predict with even the faintest degree of confidence how markets might react to this or that move (it is clear from previous iterations of this game that the key political actors’ ability to model market reactions to their proposals is … limited).”

I came to a similar conclusion by a different reasoning in my book on the topic: there are so many different combinations of national strategies, and conflicting interests, in this oligopolistic game that predictability of the issue is nil. The only conclusion that seems to me reasonably likely is that the outcome will not be consensual. It will be arrived at by acute confrontation and partial or total breakdown, not by a new unanimous agreement.

Read the whole post here.

Eurozone About to Unravel

"Is Europe About to Unravel?" asks Tim Duy here.
Excerpt:
“Even the illusion of political unity in Europe appears to be dissolving before our eyes.  This, of course, should come as no surprise to anyone watching the European crisis unfold.  The key problem always was the internal imbalances, a problem for which European policymakers have never offered a credible solution.  They simply don't have such a solution in the context of a system of fixed exchange rates.  I believe that currency devaluation is the only option that will change relative competitiveness in any reasonable timeframe and restore internal balance. But that option is unavailable for Euro members. 

Lacking currency devaluation as a tool to resolve imbalances, European policymakers turned to fiscal austerity.  That plan has failed, pushing nation after nation into ever deepening recession.  With Greece going on its fifth year of recession, I imagine by now that Portugal, Spain, and even Italy now see the writing on the wall for themselves.  Sadly, however, the alternative is exiting the Euro, which almost certainly means financial chaos for the Continent as a whole.  

The Eurozone is like a roach motel.  You can get in, but you can't get out.

Still, peripheral nations can only accept so much pain before the costs of being in the Euro outweigh the costs of leaving.  And Italy is now sending Berlin a clear warning that such an endgame is approaching.” 


My comment:

Except for the “you can’t get out” false assertion, Duy’s is an accurate description of the “euro error”. I disagree also on the idea that devaluation is unavailable for Euro members. Depreciation of the euro would be a good first step, even though it does not solve the problem of cross national prices divergence within the zone. But the latter difficulty could indeed be solved more easily by exits from the zone once the value of the euro  vis-à-vis the dollar and other currencies has been seriously curtailed, and only a marginal correction of intra european exchange rates remains to be done.

Hierarchical, or Managerial, Capitalism

John Kay endorses in a Financial Times column ("Business leaders of today are not capitalists") an analysis of contemporary “capitalism” that I developed in “The Second Twentieth Century: Decline of Hierarchies and the Future of Nations” (Hoover Press, 2006) and extended in an article in the French review “Commentaire” (“La crise des capitalismes hiérarchiques”, Hiver 2006-2007).

While in XIXth century capitalism “the economic and political power of business leaders derived from their ownership of capital and the control that ownership gave them over the means of prouction and exchange”, “the business leaders of today are not capitalists in the sense in which Arkwright and Rockefeller were capitalists. Modern titans derive their authority and influence from their position in a hierarchy, not their ownership of capital. They have obtained these positions through their skills in organizational politics, in the traditional ways bishops and generals acquired positions in an ecclesiastical or military hierarchy”.

What Kay does not mention however is that they often got their position through progress in the political system, and thanks to the support of the state hierarchy.

This system is still capitalist in the sense that managers need the consent of shareholders, even if it is only formal. But it is more accurately described as “managerial” (the power is detained by salaried managers), hierarchical, and corporatist (there is a deep collusion between political managers and business managers).

What Kay does not mention either is that, as I explain in my analysis, the extent of hierarchies in society is governed by the abundance or scarcity of information. As explained by Ronald Coase a long time ago, productive hierarchies (business firms) exist in order to economize on information, relative to a decentralized mode of production operating through individual craftsmen intensively using market exchanges (in the polar case).

And market exchanges are much more intensive in information than hierarchies, thus an increase in available information (a decrease of its cost) leads to a shrinkage of hierarchies and a development of markets.

The result is that in a period like ours, at a time when there is an extraordinary abundance of cheap information (the IT revolution), hierarchies tend to shrink while markets expand.

And this is the source of the present crisis of hierarchical, or managerial, or corporatist capitalism, a regime inherited from the previous period of high production and scarce information, extending from the last quarter of the XIXth century (the second industrial revolution) to the last quarter of the XXth century. This was the apex of the hierarchical capitalism, an organizational regime that produced the Rockefellers but also the Lenins and other totalitarian dictators, while empires expanded as never before.

The current trend is one of complete reversal of these organizational structures. And the problem for managerial capitalisms (and their managers) is how to get out of the previous system, and reorganize production, both public and private, along more markedly markets lines. How to break up big structures to bolster productivity again.

To conclude, there is one last thing that Kay does not mention: it is my book, even though it has been translated into English! Come on John, be a little more generous next time …

S&P’s Diagnosis

Here it is, in a nutshell, as summarized by  The Economist:

“According to S&P, EU leaders have misdiagnosed the euro-zone crisis. They have focused too much on tackling the increase in governments’ budget deficits, which is only part of the problem. As a result, they did not pay enough attention to the deeper causes of the crisis: the divergence in competitiveness between the euro-zone’s core of strong economies and its struggling “periphery” as well as the huge cross-border debts that stem from this gap. Reforms based solely on fiscal austerity could easily become self-defeating, notes S&P.”

They are perfectly right of course, and of course also fiscal austerity has already proved to be self-defeating (in Greece for instance). But the reason for this misdiagnosis of European leaders is that the fundamental problems of the euro-zone so well described by the rating agency are inherent to the very existence of a single currency, forced upon very dissimilar economies. 

The financial mechanism resulting from the euro is by nature destabilizing: a single interest rate boosts activity and bubbles in countries that have an above average inflation rate, while it further depresses activity in those that have an under average inflation rate (probably resulting from under average activity level). The divergence is built in and cumulative.

Moreover, a single interest rate and structurally fixed (or suppressed) exchange rates boost capital flows from higher income countries towards lower income economies, the “huge cross-border debts” problem signaled above.

Realizing that leads inevitably to a disturbing diagnosis: the source of the problem is the euro itself, and thus what is required is a policy of euro exit. The governments concerned are not ready yet, politically, to face such a reality. A deeper crisis is needed before they do. 

Big Mac and Currencies

The Economist’s “Big Mac Index” of currencies’ over or under valuations is back in this week’s “Daily chart” here. 

The Swiss Franc is the most overvalued currency relative to the US dollar (by more than 60 %), beating Norway, Sweden and Brazil. The most undervalued national currencies are those of India (by 60 %), Ukraine, and of Hong Kong. China comes fifth.

But why, oh why, are the intra eurozone real exchange rates over or under valuations not published? Given the current debate on potential euro exits it would provide a measure of relative competitiveness that could be compared to the conventional user cost of labor data.  

Fukuyama on European Identities

An interesting analysis of diverse European experiences in The American Interest.

France is best and Britain worst … for once …

Read it here.

Argentina 2001 versus Europe 2011

The Argentine economy actually recovered quickly from a massive sovereign debt default in December 2001. Why could not some European countries do the same now?

Read John B. Taylor’s (of "Taylor's Rule" fame) post here.

Evans-Pritchard on 2012

A view of the world, and of Europe, that markedly differs from all the official babble. Not really optimistic, to say the least, but plausible! I am not, however,  able to attribute any appropriate probability coefficient, and even less a probability distribution, to these anticipations …

Read the Telegraph article here.  

Political Malaise in the West

“The West in political crisis has echoes of 1930s” writes Stella Dawson for Reuters, here.

Excerpt:

“The global financial crisis that began four years ago has morphed into a political crisis for United States and Europe.  

… The shifting international economic order toward developing countries is nothing new. But it has been happening at a faster pace than expected, accelerated by what analysts have begun describing as Western democracy in crisis.

They see a government credibility problem in the United States and European Union, stemming from a perception that the political elite is too closely tied to the financial elite in the West, and their collusion caused the financial chaos of 2007 and 2008 and its messy aftermath, leaving the average citizen burdened with higher public debt, higher taxes, unemployment and austerity programs.”

My comment:

Quite true. But the problem predates the 2000s. It comes, in my opinion, from the globalization process of the last few decades. Not that globalization per se is a bad thing. On the contrary, it helped develop trade and specialization, thus increasing productivity everywhere. And anyway it is an inevitable consequence of the greater ease of transportation and communication (the information revolution).

But the increased mobility of factors (labor and capital) tends to reduce the fiscal power of territorial states through an increased competition between national governments. Thus a structural cut in public spending, a “downsizing” of states, was required, on top of the general downsizing trend affecting all hierarchical organizations, including commercial firms (see my co-authored paper on “the shrinking hand” on my website, to be presented next week at the American Economic Association meetings in Chicago).

Faced with these growing constraints most western states tried to cut their expenditures but did not succeed, not trying hard enough given the demands of their various electoral clienteles confronted with several financial and economic shocks. That’s why most governments came to rely more and more on debt to replace tax finance.

This changing financial structure of governments has produced two effects: first, politicians have come to rely more on the finance business and banks, which are channeling funds from capital markets to the governments treasuries. Hence the increasing collusion between demanders (governments) and suppliers (banks) of funds. And second, the new “capital structure” of governments, with less taxes and more debt, gives more importance to capital markets (the so-called “bond vigilantes”) and less to voters and taxpayers, hence the regression of democracy.

He who pays the piper calls the tune.

What is needed now, and urgently, is an across the board decline in public spending and in taxes on labor to stimulate supply at the same time. But this requires first a return to growth and a reduction of the bloated public debts (a public deleveraging). That’s why monetary policy and exchange rates are so important at this point. One has to remember that the first countries to exit the gold standard and devalue their currencies in the 1930s were those that returned to growth earlier than the laggards. Many analysts decried the “currency wars” then, but they were in fact currencies in search of new equilibrium prices.

However, as shown by several studies, a currency depreciation requires a cut in public expenditures to produce its positive effects. And there are no serious structural programs of government reform capable of stimulating supply (rather than just contracting demand, which is self-defeating) in view on either side of the Atlantic (except maybe the payroll tax reduction in the US, but it is temporary). 

Hence the low ratings of politicians in opinion polls and their generally low credibility.  Let’s hope nevertheless for some realistic fundamental reform proposals – at last – in 2012. Just the reverse of the New Deal is needed: a fall in the “churning”, inefficient from a redistributive point of view, public spending that taxes middle class income in order to ... subsidize middle classes, and a major cut of the taxes on labor (in order to raise wages,) instead of an increase in transfers and taxes (that reduce earned real wages). Also required is a shrinking of administrative and political hierarchies instead of an expansion of already excessive administrative employment, in order to reduce the overhead cost of government … Let’s call this a “second new deal”.