Tag Archives: Euro

The Fragility of Eurozone Finance

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Over at the FT, Gavyn Davies writes concerning the Eurozone,

Member states cannot print the euro, which automatically increases the risk that they will default on their debt. (Admittedly, it also reduces the risk that they will inflate their debt away. The markets are not too worried about this in these deflationary times, though one day they might be.)

I think about European sovereign debt in somewhat similar terms, but I want to elaborate on Davies’s framework a little.

First, refusing to pay up and paying up in inflated currency are both forms of default. The fact that EU member states cannot print the Euro therefore changes the form of the risk of default.

Second, the form of the risk of default matters. Think about the payout of a security under variable outcomes. When the outcome is very good, the security pays out a high amount, and when the outcome is very bad, the security pays out very little. We can imagine that in the middle of the outcome spectrum, there are a number of possible payout profiles. You can have payouts vary smoothly with outcome, or you can have a tipping point, above which the payout is high and below which the payout is low. When payouts vary smoothly with outcomes, the price of the security is not going to be very volatile. When payouts vary sharply with outcomes, the price of the security may be highly volatile when outcomes may fall on either side of the tipping point. I think this is what Nassim Taleb means when he says that debt is fragile and equity is robust: debt payouts vary sharply with outcomes and equity payouts vary gradually with outcomes.

Third, when a government can inflate away part of its debt, the real, inflation-adjusted payout can vary more smoothly with outcomes. This makes the debt a little less like debt and a little more like equity. When a government cannot inflate away its debt, the price of its securities are going to be very volatile around the outcome tipping point.

Fourth, since EU governments cannot inflate away their debt, the risk premia on their bonds are going to take a highly volatile form. This is going to lead to frequent debt crises unless the governments are highly responsible and avoid landing anywhere near the outcome tipping points.

Davies concludes his post with “Something, somewhere has to give.” I think that what has to give if people want to preserve currency union is that member countries are going to have to accept balanced budget requirements as the US states have. But at the same time, I am skeptical that the southern European countries can really be counted on to abide by such requirements if they are imposed. They failed to keep their deficits within the 3% of GDP limit the EU treaties currently require, and they have been and are going to be rewarded with bailouts.

Many commentators are talking about fiscal union, which is perhaps a subject for another post, but I am not too enamored of this option as it has many public-choicy downsides. Probably the thing to do, though difficult, is to give up on the common currency and instead focus on creating the largest free-trade and free-movement zone in the world. That is the robust road to prosperity.

Miscellaneous Thoughts on the Fed

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Everyone is interested in monetary policy and the Fed all of a sudden, so, what the hell, I’ll chime in too.

Here is my ranking of monetary regimes:

  1. Depoliticization and denationalization of money. Free banking. The market selects a currency and banking is “regulated” in court under the common law of contract.
  2. The Fed is a Sumnerian robot. It runs a market in quasi-velocity futures and a computer uses the market price to decide whether to expand or contract the money supply.
  3. The status quo.
  4. Congress itself “coin[s] money and regulate[s] the value thereof.”

Most people who want to abolish the Fed think that we can go from number 3 to number 1, but more likely, if we End the Fed, we’ll go to number 4. For all the exaggerated claims about how the Fed is turning us into Zimbabwe, number 4 would go much further in that direction than number 3 has.

If anti-Fed steps are to be taken, they should be along the lines of Ron Paul’s Free Competition in Currency Act, which weakens the Fed by eliminating legal tender laws and eliminates capital gains for alternative currencies. The capital gains issue is important because money is half of every transaction, and even if the value of money is stable such that there are minimal capital gains and losses, the amount of record-keeping that is needed to use an alternative currency is prohibitive. The bill doesn’t go far enough, though; the optimal currency may be none of the things that are exempted from capital gains taxes under the bill, and really the only solution is to eliminate taxation of capital gains entirely. Can you imagine the political uproar from our friends on the left?

People complain that since the inception of the Fed, 95% of the purchasing power of the dollar has been inflated away, but this is looking at the wrong derivative. When inflation is consistent and expected, rates of return adjust to compensate for it. As long as you are not holding most of your assets in currency or non-interest-bearing dollar-denominated accounts, steady inflation doesn’t matter. Inflation is a tax on people who hold literal dollars, which is probably not you unless you are a crime lord or a foreign dictator.

QE2 brings us slightly closer to the number 2 monetary regime above, and I support it on those grounds and those grounds only. If we had had the Sumnerian infrastructure in place in early 2008, it would be telling us to expand the money supply now, and therefore expanding it now is what we should do. I regret that it is being done on a discretionary basis, but you give policy advice in the policy environment you’ve got.

By the way, QE1 was not really QE, as Alex Tabarrok explained in 2008. The Fed started paying interest on reserves, which has the effect of massively decreasing velocity. The Fed needed to increase M to offset the decrease in V. Why the Fed would take such velocity-decreasing action in the middle of a crisis, I do not know.

Tyler Cowen writes this morning that if you want a countercyclical money supply, you must have a central bank. Tyler, this is false! I had a discussion once with a different Tyler in which we traced the effects of using shares of the S&P 500 as currency. Since the stock market is cyclical, money would appreciate in booms and depreciate in busts, just as it would if you had a decent central bank. The big downside would be a long-term deflationary trend, but nevertheless as a proof-of-concept it shows quite clearly that a countercyclical money supply is possible under a commodity currency.

For those who are opposed to monetary central planning, the real story is not QE2, but the looming disaster in the Eurozone, which is quite obviously not an optimal currency area. If they can get past the current crisis somehow, they will just be inviting the next one if they do not do something radical like banning all languages other than English. I’m still hoping that if the Greek collapse comes, it comes when I am in Greece next month.

The bottom line is that whether the Fed has been a failure depends on what you think the alternative is. The Fed made some big mistakes in the 1930s and in 2008-2009, but at least (1) we’re not Europe and (2) Congress is not in charge. I think that if we give in to populism, we are likely to get something worse than the Fed, not better, though if the populists want to start getting serious about monetary theory, I would welcome that.

The Greek Bailout

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Officials from EU governments have just now pledged to bail out the Greek government. In my view, this is a bad idea, at least for the people of Germany and France, who will bear a lot of the cost. Since I am having some trouble organizing my thoughts into fluent paragraphs, I will present them as talking points.

  • The right model for thinking about the Greek government’s large and chronic deficits is the budgetary or fiscal commons. Richard Wagner says it well (in the context of the US government): “Most collective or corporate organizations, profit-seeking and nonprofit, do not suffer from continued deficits. What distinguishes the federal government from other corporate bodies is that the federal budgetary process illustrates the ‘tragedy of the commons.’ The federal budgetary process is a natural product of common property budgeting, where choice is divorced from responsibility for the consequences of those choices.” Interest groups within Greece compete for tax revenue, knowing that if they abstain, someone else will benefit from their abstemiousness. This leads to “overgrazing” of the budgetary commons, or chronic deficits.
  • By bailing out Greece, other EU governments are extending the range of the commons. They are further divorcing choice and responsibility for decision-makers in Greece and in other profligate member governments.
  • A Greek default need not harm the Euro very much. The strength of the Euro depends most heavily on the willingness of the European Central Bank to keep inflation low, and much less on Greece’s finances. If Greece’s default causes a debt crisis in Spain, Italy, and Portugal, this could eventually weaken the Euro as the ECB would be expected to apply monetary stimulus. But letting Greece default could also force those other governments to take their finances more seriously, and in any case, the principle of triage applies to bailouts as well as medicine.
  • If the Greek government is not bailed out, as is my preference, things will sadly be very, very bad for Greece. Creditors of the Greek government would have to take a haircut; there would be no way around that. The Greek economy would suffer a long and deep depression. This would be painful for the Greek people, but the goal is to prevent something worse from happening down the road.
  • Greece should never have joined the Euro because they now have no control over monetary policy. When people discuss so-called “optimal currency areas” they rightly emphasize labor and capital mobility, and factors which affect these. Perhaps one underappreciated additional issue is fiscal responsibility. If one government in a currency union is relatively fiscally responsible and one is not, then the responsible one will always be called upon to bail out the irresponsible one. If the bailout occurs, this is bad because it extends the fiscal commons, as discussed above. But if the bailout does not occur, the irresponsible government is harmed by more than it would have been if it had its own currency and monetary policy. Note that this logic applies to currency pegs as well, as Argentina learned.
  • It is dangerous to anthropomorphize governments, but putting this concern aside, the right metaphor for better policy is not “austerity” but “enlightened self-interest.” The key question facing the Greek government is Can you solve the fiscal commons problem? Solving a commons problem is not about ascetic self-denial, but about far-sighted self-improvement: building the institutions that will make the country better off in the long run.
  • In general, I think it would be a good thing if investors looked at sovereign debt more skeptically. First, sovereign debt is subject to the “Black Swan” problem. Second, bond markets are one of the major constraints governments face. (As James Carville said, “I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.”) It would be better if the bond market intimidated the government sooner rather than later on the road to insolvency.
  • I worry a lot about a US sovereign debt crisis. With such a big economy, the fiscal commons problem is in many ways more severe. I think Congress could overcome the commons problem in order to avoid a debt crisis, but debt crises have a very quick onset. By the time people realize it is happening, it may be too late.