Archive for June, 2010

A spectre is haunting Europe

Philip Arestis | June 15, 2010

This posting is by Levy senior scholar Philip Arestis, University of Cambridge and University of the Basque Country, and Theodore Pelagidis, European Institute, London School of Economics and University of Piraeus.

A spectre is haunting Europe—the spectre of austerity. All the powers of old Europe have entered into an unholy alliance to exercise this spectre, about which all of us should be depressed. Europe probably will be soon enough.

Why this sudden emphasis on austerity, when the well-known lessons of history are that in times of recession fiscal stimulus is the best medicine? Some European countries are chronic over-spenders of course, but others with strong balance sheets have announced austerity programs as well. Why? The short answer is that it is all about the banks.

Europe’s financial institutions are loaded with potentially toxic sovereign debt issued by Greece and other shaky countries around the European periphery. French banks are said to be loaded with 75 billion euros of toxic Greek bonds; one can now understand President Sarkozy’s furious campaign to rescue Greece. Taken together, Spain, Greece and Portugal are believed to have planted a 2.2 trillion euro time bomb on the balance sheets of European banks.

The value of these assets has already plunged, threatening bank solvency, choking off lending and leaving the taxpayers of such solvent nations as Germany with Hobson’s choice: foot the bill for the prodigality of Greece and other euro area nations in similar positions, or bear the expense of bailing out their own banks. Doing neither, for now at least, appears to be unthinkable.

Thus the continent-wide turn toward austerity. If state budgets are restricted, so the magical thinking goes, wonderful things will happen. Sovereign bond prices will rise, rescuing imperilled banks. Moribund interbank lending will be resuscitated. Government borrowing costs will decline. Economies will be reinvigorated. The embrace of austerity is also easier to understand in a political context. It is clear that European politicians are incapable of directing stimulus to productive ends, and the public continues to reject tax increases to cover the future deficits that today’s stimulus would create.

The problem is that embarking on austerity now will only make a bad situation worse. In fact austerity increases the risk of a great many dreaded outcomes in Europe, including negative GDP growth, sovereign default, political instability and shuttered capital markets. These things make bank failures more likely, not less. It is actually the lack of a more powerful and more systematic stimulus that raises the risks of a double-dip recession. In Europe in particular, the near absence of a stimulus has brought the euro area very close to dissolution. It is the deep and prolonged recession that finally revealed member-states’ huge public debts, and made borrowing so expensive for most of the member-states and unbearable for others (Greece). Banks suffer by keeping trillions in devalued sovereign bonds hidden on their balance sheets; and nobody really knows which and how many banks are in this tragic situation. Would draconian cuts in the context of Europe’s fragile growth rate solve the problem? Surely not.

What is needed right now is spending, not saving, particularly in Germany. It is noteworthy that in the U.S., this kind of Keynesianism—mixing consuming and investment budgetary expenses with some tax credits—saved the system from collapse in 2009 and retained, to a great extent, a certain satisfactory level of economic activity.

The ‘over-borrowing’ of Greece and other European countries in a similar position should not be attributed to naïve Keynesianism. The real problem is that these countries, by joining the Euro, have deprived themselves of an appropriate domestic monetary policy. An extremely hard euro policy combined with cheap credit quickly eroded domestic competitiveness while raising demand for imports, which had become cheaper. The result was a ballooning current account deficit that reached 14% of GDP in Greece (2008), a deficit that requires corresponding capital inflows. Given declining domestic competitiveness, these flows could not be foreign direct investment. Thus, the government had to take over and sell bonds to finance a fast-deteriorating current account.

So if austerity is not the answer, what should be done to help the weakest Mediterranean countries stabilize their economies and thereby avoid a painful dissolution of the European Monetary Union? Aside from the perennial problem of Greece, where governments always lie about deficits and citizens always lie about their income, we should not forget the responsibilities of the EMU itself. It should have acted differently long ago, but it is not too late for it to change course in time to avert disaster. There are three important steps to be taken, all of them at odds with what the G20 decided in the first week of June.

First and foremost, the European Central Bank should buy as many toxic sovereign bonds as necessary to stabilize the market. Second, ECB should lower interest rates close to zero, as has been done in the United States. Last but not least, countries with huge surpluses, such as Germany, should be convinced to spend more and tax less, which means smaller current-account deficits for the weaker EMU partners and possibly a little more inflation for Germany. It is completely absurd for any surplus country within a monetary union to implement austerity measures while maintaining a current account surplus.

In sum, if contractionary policy prevails globally and especially around Europe, Greece and similar countries might find it even harder to drive their economies through an export-led recovery. It would then be easy to predict what will happen to those banks keeping toxic skeletons in their closets.


Forget about deficits. Fix the banks

Daniel Akst |

Levy senior scholar James K. Galbraith argues in the Los Angeles Times this morning that deficit hawks are pursuing the wrong prey. In a nutshell:

The real cause of our deficits and rising public debt is our broken banking system. The debts our economic leaders deplore were largely due to the collapse of private credit, and to the vast giveaways the federal government made to banks to prevent their failure when credit collapsed. Yet those rescues have failed to reanimate private credit markets and job creation, as the latest employment reports show. And so long as that failure persists, public deficits and rising public debt must remain facts of life.

Are broken banks a national security threat? Let’s avoid going that far. But the only way to reduce public deficits eventually is to revive private credit, and the only way to do that is build a new financial system to replace the one that has failed. The “national security” case for cutting Social Security and Medicare is bogus. In economic terms, it’s just a smokescreen for those who would like to transfer the cost of all those bank failures onto the elderly and the sick.


Wynne Godley, continued

Daniel Akst | June 14, 2010

The Economist’s obituary for the late Wynne Godley generated a couple of worthwhile letters. A key passage:

Your obituary of Wynne Godley (May 29th) did an injustice to his considerable intellectual achievements in macroeconomics and his courage in going against the orthodoxy that has ruled the economics profession for the past three decades.

You can read the rest here.


Review: Plumbing the Squam Lake Report

Yeva Nersisyan |

The Squam Lake Report (Princeton University Press) is a set of recommendations by 15 leading economists on reforming the financial system. Considering the magnitude of the recent financial crisis, it is surprising how little change the book proposes.

Certainly, the first step in devising a set of recommendations for reform is to understand what went wrong, something the authors set out to do in their first chapter. They list a number of factors that may have contributed to the crisis but take no stand on their relative importance. They believe that their recommendations will help make the system more stable, although not crisis-proof, even if they don’t completely understand the origins of the current crisis. While a few of the recommendations are intended for guiding the financial system towards stability, most are only useful for when a financial crisis has already erupted.

Perhaps the best recommendation is for a systemic regulator with an explicit mandate of maintaining financial stability. As financial institutions are increasingly involved in activities outside their traditional domain, having a systemic regulator makes sense. But the report recommends that the central bank be that regulator—which is logical, since the Fed’s discount window gives it a good view of financial institution balance sheets. The problem, at least in case of the U.S., is that the Federal Reserve had the authority to regulate key aspects of the financial system when the last meltdown occurred, but chose not to exercise that authority. For instance, the Fed had had the power to regulate all mortgage lenders since 1994.

The question now is whether the culture of deregulation that has prevailed at the Fed for at least the past 25 years will allow it to transform itself into a good regulator. The FDIC has a better track record of being tough on the financial sector, and may well be better suited for the job.

The report is also big on transparency. For instance, it proposes that large financial institutions, including hedge funds, “report information about asset positions and risks to regulators each quarter.” Having better-informed regulators is certainly important but only goes so far. The magnitude of fraud during the last crisis demonstrates the difficulty of relying on information reported by the institutions themselves and underscores the importance of active regulation (The Repo 105 transactions used by Lehman, Citibank and Bank of America were merely the tip of the iceberg in the accounting gimmicks used by these institutions to mask their true positions.) The authors don’t seem to recognize the role of fraud in the financial sector and offer no recommendation on how to deal with it.

A whole chapter of the Squam Lake Report is devoted to regulating retirement savings, which is timely and appropriate considering that pension funds have been among the biggest losers in the current crisis. The crux of the Squam Lake proposal is to require investment products offered in defined contribution plans to have a standardized disclosure of costs and risks, to increase deductions from workers’ pay and to restrict default investment alternatives to low-fee, diversified products. These are sensible ideas but won’t insulate retirement savings from a crisis, because in a crisis asset classes (except for Treasuries) tend to crash in unison. At such times, diversification doesn’t help.

Furthermore, diversification (already required by federal pension law) was a major contributor to the bubble economy of the past decade as pension funds hunted for financial products uncorrelated with stocks. Overall, I don’t see merit in their pension reform proposal. The best solution would be to eliminate tax advantages for pension plans and instead boost Social Security to ensure that anyone who works long enough to qualify will receive a comfortable retirement. See Nersisyan and Wray (2009) for more on the trouble with the pensions.

The report also calls for higher capital requirements for major institutions, another reasonable idea that wouldn’t have helped much last time around, when the market for asset-backed securities froze and their prices collapsed. Under such circumstances, only impractically high capital requirements would have made any difference. Besides, an institution can face liquidity issues even if it’s highly capitalized. Bear Stearns, before its collapse, had enough capital but couldn’t finance its asset positions for want of willing lenders.

The report also recommends that financial institutions issue long-term debt instruments that convert into equity under specified conditions. This would automatically recapitalize banks if they got into trouble. But again, higher capital levels cannot prevent a crisis. Besides, one of the proposed conversion triggers is the declaration by the systemic regulator that the financial system is in a crisis. But a crisis is not always so easy to spot. When Bear Stearns failed, some people said the problem wouldn’t spread. Later, the consensus was that it wouldn’t go beyond subprime mortgages. If the regulator proclaims at soe point that there is a risk of a systemic crisis, this itself might freeze the markets and make institutions unwilling to lend to each other. Giving the disease a name, in other words, might well kill the patient.

Although a whole chapter of the book is devoted credit default swaps (CDS), there is no recommendation that would make CDS safer for the financial system. The authors oppose limiting CDS trades to entities that hold the underlying security on the basis that this will make derivative markets less liquid, raising costs. They propose merely to encourage financial institutions to clear CDS and other derivative contracts through clearinghouses as well as to trade them in exchanges (rather than making such arrangements mandatory).

Again, the response seems wholly inadequate to the scale of the hazard. Derivatives create counterparty risk out of thin air and vastly magnified the recent crisis. Without CDS the subprime mortgage industry couldn’t have grown to the proportions it did. Getting rid of CDS would make it hard for financial institutions to hide risks from regulators, and make investors more cautious when investing in asset-backed securities.

Despite their deliberations, the Squam Lake economists overlook some important aspects of the financial structure that ought to be reformed. Securitization and off-balance sheet activities that were largely to blame for the current debacle are not even mentioned. It wasn’t until securitization that the shadow banking sector exploded. Securitization creates major incentive problems by separating risk from responsibility. Off-balance sheet activities allow financial institutions to avoid capital requirements and use more leverage. And while the authors seem to recognize the costs associated with having too-big-to-fail institutions that are systematically dangerous, they have no prescriptions for what needs to be done about them.

The authors are acutely conscious that regulation often has unintended consequences, yet as they implicitly recognize (by proposing regulations), this doesn’t mean there shouldn’t be rules. What should these rules look like? continue reading…


Greek default widely expected

Daniel Akst | June 9, 2010

Bloomberg polled international subscribers to its Bloomberg Professional Service and found that 73 percent expect a Greek default. These subscribers are described as decision-makers in finance, economics etc. The full story is here. You can also read the poll and results for yourself by clicking on the “attachment” tab at the top of the window. This will take you a pdf that is unfortunately missing the file extension. Just rename it to add .pdf to the end and it will open normally.


Wynne Godley was right

Daniel Akst |

In a sobering column in the Financial Times, Edward Chancellor reminds us that the late Wynne Godley was right in predicting that large private deficits in the U.S. would lead to trouble–and that the Eurozone, when it was formed, might become a tragic disinflationary trap. The end of the column is particularly noteworthy:

He went on to caution that without a common European budget, there was a danger that “the budgetary restraint to which governments are individually committed will impart a disinflationary bias that locks Europe as a whole into a depression that it is powerless to lift”.

Rob Parenteau, a fellow Levy Institute scholar, has recently applied Prof Godley’s analysis to the eurozone periphery. Germany wants countries, such as Spain, to get their public finances in order. Yet if Spain is to reduce its fiscal deficit without too much pain, two conditions are necessary. First, the country’s trade position must shift into surplus. This is problematic since labour costs are high relative to Germany and Spain cannot devalue its currency. Second, the private sector must move back into deficit. Yet it is difficult to see Spanish households and companies wanting to borrow more given the ongoing problems caused by the collapse of the property bubble.

There is a danger the proposed fiscal tightening in the eurozone will lead to further deflation and economic collapse. The Spanish government faces what Mr Parenteau calls “the paradox of public thrift”: the less it borrows, the more it will end up owing. It is unfortunate that it has taken a severe global recession to vindicate Prof Godley’s macroeconomic analysis. If economic policymakers start to pay more attention to financial balances, they might forestall the next crisis. European politicians might also understand the potentially dreadful consequences of their new-found frugality.

You can read some of Rob’s analysis for yourself here. Chancellor, by the way, is the author of a good book called Devil Take the Hindmost: a History of Financial Speculation.


When do deficits matter?

Dimitri Papadimitriou | June 8, 2010

Nervous financial markets and waves of fiscal austerity spreading across Europe raise an important question: when does a country’s budget deficit become a problem?

The easy answer, of course, is that a deficit is too large when it can no longer be financed. But by that time it’s too late, so it’s important to ask if there is a good way to tell before things get that bad.

Carmen Reinhart and Kenneth Rogoff, in a recent paper called Growth in a Time of Debt, found that when government debt reaches 90 percent of GDP, economic growth is seriously retarded.

But rules of thumb are by their nature imperfect, and it’s difficult to apply the 90 percent formula across the board. The U.S., for example, is not Greece—it’s closer to being the anti-Greece, in fact. Greece is a tiny, uncompetitive country that does not control its own currency. The business climate there is terrible. America is a vast, competitive, adaptable nation that not only controls its own monetary policy, but is blessed with the world’s reserve currency. The climate for business is favorable, abetted by large reserves of cultural and intellectual capital.

So we shouldn’t conclude that just because the Europeans are suddenly cutting public spending, we ought to as well. Since deflation looks more threatening than inflation, it seems sensible, for now at least, for America to borrow and spend. Washington’s cost of money is close to zero, and the multiplier effect (for which this blog is named) means that pumping funds into the economy is likely to pay growth dividends, especially if the money is directed at those likeliest to spend it.

Countries almost always run deficits and, despite the ardent wishes of fiscal conservatives, they probably always will. The problem, when debt accumulates, is that it can make you vulnerable to investors who may become impatient or even irrational. If these are the people who have the money you need to finance your deficit not in your own currency, you may find yourself in the position of several Eurozone countries now, who are forced to embrace austerity at the worst possible time. Perhaps the lesson is not to run up large deficits in good times, as Greece, Portugal, Spain and Ireland, so that in bad times you can get credit when you need it.


Maybe Keynes hasn’t been translated yet

Daniel Akst |

The Germans too are embarking on a fiscal austerity program, and consumers aren’t spending there either.


Austerity Britain

Daniel Akst | June 7, 2010

David Cameron, the new PM, warns that the nation’s fiscal hole is even deeper than it seemed, and that savage spending cuts will be required. An important union leader calls Cameron’s speech “a chilling attack on the public sector, public sector workers, the poor, the sick and the vulnerable.”

The full (and sobering) story is here.


Men not working

Kijong Kim | June 4, 2010

The Bureau of Labor Statistics released its May employment situation report today and the news was mostly grim. Sure, unemployment dropped to 9.7 percent from 9.9 percent. But don’t get too excited, because almost all the new jobs created in May were for census-takers, and these folks will be unemployed again soon.

In more bad news masquerading as good, the so-called mancession appears to be easing. Most developed countries are beset by one of these male recessions, with men suffering the brunt of job losses due to their much greater representation in construction and manufacturing—both of which are hard-hit almost everywhere. In this country, at least, the mancession looks like it’s easing—until you look a little closer and realize that this is only the case because men leaving the labor force increased by 4.7 percent over last year, an increase twice that of women. In other words, men aren’t gaining jobs. They’re giving up.

What shall we do with the horrendous number of idle men? Their skills may not be valued in industries that have done better than traditional men-industries. Training for new kinds of work is one possibility, but demand for new workers may not be there yet; relocation to other states may be out of the question if your mortgage is underwater; and the Euro crisis is a pinch of salt on the slow-healing wound of recession.

For a great many men, this Father’s Day is unlikely to be a happy one.