Whither the Euro?

An excellent paper by Kevin O’Rourke (All Souls College, Oxford) in Finance and Development (IMF, March 2014).

Excerpts:

“Historians may wonder how it came to be introduced in the first place.

The euro area economy is in a terrible mess.”

Indeed, the eurozone GDP still 3 percent lower in 2013 than in the first quarter of 2008 while in the United States it was 6 percent higher, and the zone unemployment exceeding 12 percent, “are not minor details, blemishing an otherwise impeccable record, but evidence of a dismal policy failure.

The euro is a bad idea, which was pointed out two decades ago when the currency was being devised. The currency area is too large and diverse – and given the need for periodic real exchange rate adjustments, the anti-inflation mandate of the European Central Bank (ECB) is too restrictive. Labor mobility between member countries is too limited to make migration from bust to boom regions a viable adjustment option. And there are virtually no fiscal mechanisms to transfer resources across regions in the event of shocks that hit part of the currency area harder than others.

 Problems foretold

All these difficulties were properly pinpointed by traditional optimal currency area theory.”

Readers please note: it was “the theory” that predicted these difficulties before the fact, not individual economists! So judgment and clear understanding of theory and facts count for nothing … What about the (majority of) economists who neglected the teachings of OCA theory?

Maybe this curious conception of economic analysis has something to do with the author’s confession, later in the paper, that:

“I and many others have made such arguments (for “more Europe” rather than less) over the past five years. But as time goes on, it becomes more and more difficult to do so with conviction.”

His confession of guilt is welcome. But he could add the few names (there weren’t many!) of the economists who were right from the start, Martin Feldstein for example. And one that, spectacularly, had his theory right from the start but his analysis dead wrong, Robert Mundell!

Fortunately O’Rourke has some interesting things to add:

“..it is becoming increasingly clear that a meaningful banking union, let alone a fiscal union or a safe euro area asset, is not coming anytime soon. For years economists have argued that Europe must make up its mind: move in a more federal direction, as seems required by the logic of a single currency, or move backward? It is now 2014: at what stage do we conclude that Europe has indeed made up its mind, and that a deeper union is off the table? The longer this crisis continues, the greater the anti-European political backlash will be, and understandably so: waiting will not help the federalists. We should give the new German government a few months to surprise us all, and when it doesn’t, draw the logical conclusion. With forward movement excluded, retreat from the EMU may become both inevitable and desirable.”

O’Rourke however relapses in “eurospeak” when he concludes that the demise of the euro “would be a major crisis” and would require “capital controls, default in several countries, (and) measures to deal with the ensuing financial crisis.”

This standard pessimistic outlook has been repeatedly made by euro sectarians, including Barry Eichengreen who has even claimed that while it was possible to become a member of the Eurozone, it was radically impossible to get out (despite abundant contrary evidence on a number of exits from fixed exchange rates arrangements, as well as currency zone dissolutions) because it would create “the mother of all financial crises” – whatever that means!

Common sense, on the contrary, tells us that if the real exchange rates are deeply misaligned within the shared currency (because of implied nominal exchange rates fixed “forever”) and since the misaligned exchange rates are the cause of deep structural imbalances in the national economies of the area, a return to equilibrium exchange rates should favor a resumption of growth an prosperity. Once this burdensome handicap is removed, the economy should return to a “natural rate of growth”, especially so because of the accumulated slowdowns of the past two decades.

A final interesting consideration. Since our techno-monetaro-economists are so deeply ignorant of political realities and public choice theory, they should read the following sentence of O’Rourke:

“During the interwar period, voters flocked to political parties that promised to tame the market and make it serve the interests of ordinary people rather tha the other way around. Where Democratic parties, such as Sweden’s Social Democrats, offered these policies, they reaped the electoral reward. Where Democrats allowed themselves to be constrained by golden fetters and an ideology of austerity, as in Germany, voters eventually abandoned them.”

Politicians beware ...

Gilens and Page, Economic Elites, and American Oligarchy

A John Cassidy post in the New Yorker, here.

The Too Big To Fail Subsidy Debate Is Over

Simon Johnson reports on the conclusion of a recent International Monetary Fund publication which “nails the issue of whether large global banks receive an implicit subsidy courtesy of the American government.” And European governments are doing even worse. Read the post here.

Anglo-EU Translation Guide

Do you know the difference between what the British say, what the British mean, and what others understand? Then, have a look at Cheap Talk, a blog about "economics, politics and the random interests of forty-something professors", here.

  

Financial Markets Are Still Efficient (Approximately).

A brilliant post by guest blogger Scott Sumner on Econlog (Econolog.econolib.org, April 21, 2014) : "Why the EMH is truer than supply and demand."

It is well worth reproducing it in full: 

"My previous post discussed the strangeness of the efficient markets hypothesis. Here I'll defend its utility.

In the field of economics, all models represent simplifications of reality. Thus when we consider whether the EMH is true, it makes no sense to compare it to something like Newtonian physics. Yes, even Newtonian physics is only approximately true, but the approximation is much better than almost anything we observe in economics. So let's compare apples with apples.

Supply and demand has become the archetype model of economics. It's a workhorse widely used to explain the behavior in all sorts of markets, from haircuts and dry clearers to automakers and PC producers. Of course if you read the fine print the model is, strictly speaking, only applicable to a very restricted set of markets, essential grain producers. But almost all economists use it in a much wider range of applications, with justification. It's really, really useful.

But is it true? One of the most important implications of S&D is that producers are price takers. This assumption is what underlies the existence of a supply curve. If firms are not price takers then no supply curve exists. You can't have a supply and demand model without the assumption of firms being price takers.

But are they price takers? Not really. The vast majority of firms, even in highly competitive industries such as laundromats, dry cleaners and pizza shops, could raise prices by 5% and still hold on to a substantial share of their customers. Exxon might not be able to do so, but most small businesses could. This means the supply and demand model is not literally "true."

Fortunately, S&D is incredibly useful, even if not strictly true.

I would argue the EMH is truer that the S&D model. And by EMH I am actually only talking about the assumption that asset price deviations from trend are essentially unforecastable. Specific versions such as the CAPM may be flawed in other ways. However I believe the random walk model is truer than S&D, and also quite useful. But how can we test the EMH?

Many academics look for "anomalies." This is asking both too much and too little. Contrary to widespread belief, the EMH does not claim that a search of 20 million statistical patterns would fail to identify 1 million anomalies that show non-random price movements at the 5% level, or 200,000 at the 1% level. On the other hand, I'd also argue that it's asking too much of academics to suggest they need to find get-rich-schemes that violate the EMH, it should be enough to prove that at least someone has done so (say Warren Buffett.)

As an analogy, an economist looking for signs that the most famous secret in alchemy--turning lead into gold--had been discovered should not have to identify the magic formula, but rather merely show that gold prices are behaving in a way consistent with the fact that someone had discovered this sort of chemical process.

Eugene Fama understood that the only meaningful test of the random walk was to look for evidence that others had found anomalies. The initial tests showed no evidence; mutual funds excess returns were serially uncorrelated, whereas they would be correlated if a subset of investors had found the magic formula. Later work with Kenneth French slightly modified that conclusion. There was some evidence of stock picking ability, but too small to overcome the expense ratios of mutual funds. So now the EMH is only approximately true. But since it's a part of economics, we should have known that all along. No economic model is precisely true.

OK, but is it useful? I see three uses:

1. For ordinary investors, it suggests you'd want to stick to indexed funds.

2. For academics, it suggests that asset prices contain the optimal forecasts, and hence you should use something like TIPS spreads rather than the output of VAR models when trying to identify the optimal forecast of inflation. And you should use the response of asset markets to monetary policy announcements to evaluate the effectiveness of programs like QE, not subsequent movements in the economy.

3. For policymakers, it suggests that central banks and/or bank regulators should not try to identify bubbles. And that central banks should create and subsidize NGDP future markets. And that SEC officials should actually pay attention when whistleblowers bring in evidence that hedge fund returns are inconsistent with the predictions of the EMH (i.e. the Madoff case.)

To conclude, the EMH is a very useful model. It's also more true than the S&D model, as the pricing power of firms in so-called "competitive industries" where S&D is widely applied is actually much greater than the excess returns identified by Fama and French.

From now on any commenter who tells me the EMH is not true, should also tell me whether they think S&D is true, and if so, why it's true."

What I Have Been Reading

 Europe: The Struggle for Supremacy, 1453 to the Present by Brendan Simms, professor of the History of International Relations at the University of Cambridge.

The author recounts “the story of highly competitive and mutually suspicious monarchies and republics; of empires, revolution, rivalry, unification and utopias”. The idea of a European success story due in the main to the competition between states and nations is not new, as readers of Eric L. Jones’ The European Miracle know since this latter book publication in 1981.

Neither is the other central geopolitical idea according to which whoever controls the core of Europe controls the entire continent, and whoever controls all of Europe can dominate the world, as Charles V, Cromwell, Pitt and other British rulers, Napoléon, Bismarck, Hitler, Stalin and Roosevelt clearly realized. Halford John Mackinder new as much as early as 1904 when he wrote “The geographical pivot of history” for The Geographical Journal.

Simms emphasizes the continuing fractured nature of the continent as well as the central role of Germany, under the guise first of the Holy Roman Empire, and later as the Second and Third Reich, which has been a constant preoccupation of Europeans because of its geography, its power, and its policies.

Europe indeed is a good read, and Simms strategic and geopolitical approach is illuminating. The enthusiastic comments on the book, however, seem to me a bit exaggerated. What I really enjoyed, among other brilliant insights, is the following analysis of the euro crisis (pp. 527-528):

“If Greece and Ireland actually defaulted, this would cast doubt on the value of previously sacrosanct government bonds and precipitate a general collapse in Spain, Portugal and Italy as investors fled the state bond market. It might even destroy the entire euro-system itself and tip the whole continent and thus probably the entire world into recession. For this reason, the EU and the IMF sought to prop up Irish and Greek finances through a series of largely German-funded ‘bailouts’, which lent money  -- often at high interest rates – to cover the shortfall, in return for a commitment to further austerity measures to bring the national finances in order. The central actor here was Germany, where a struggle erupted between the establishment, which feared that a Greek or Irish default would destroy their own banking system, which was heavily invested in the relevant bonds, and the population at large which was increasingly weary of funding yet another ‘bailout’ for improvident peripheral economies and was registering that fact in the regional elections. By the middle of 2011, in order to avoid further electoral losses, Chancellor Merkel had retreated from her original joint position with Paris in defence of the bondholders, towards an insistence that international investors would have to share some of the losses. This stance, however reasonable in itself, not only infuriated the French, whose banks were even more exposed to Greek debt, but also increased the chance of an escalating sovereign default across substantial parts of the Union.

Taken together (with deep divergences regarding international relations and military interventions, JJR), all this amounted to a severe and possibly terminal challenge to the European project. At the time of writing (2013, JJR) Europe remains in one of its deepest crises since the Second World War.”

(…)

And as “Germany was becoming a more ‘normal’ and thus more ‘assertive’ nation, as it left the past behind it … a ‘central secession’ from the EU, by which Germany simply washed its hands of Europe, and reintroduced the Deutschemark, could no longer be completely excluded.”

As I wrote in a previous post, Germany, indeed, is the key to the solution of the “Euro problem”. This should mean, according to the Simms's analysis, the coming breakup of the euro that is more openly discussed in Germany nowadays.