Friday, 26 March 2010
Fiscal austerity will now be reinforced by the IMF. In an earlier post, I raised some questions if that is going to work -- it's a bit like root-canal work without anaesthesia. Everybody else is trying to spend more, in a bid to ward off depression. If budget cuts are too big, you get more recession. Today brought the news that Ireland's GDP fell even more in Q4 than in Q3, which puts it on a very different trajectory from everybody else. This tells you that very severe budget cuts can backfire, as Chancellor Brüning of the late Weimar Republic could also tell you. Given the size of the adjustment needed in Greece, I doubt that public finances can be cut back to health.
So, just before we all despair, four German economists writing in the FT come up with a real solution (indirectly). They remind us that the German constitutional court put a lot of emphasis on the no-bailout clause in the Stability Pact; its last ruling said that, if violated, Germany would have to leave the Euro. Should aid to Greece really go ahead, I expect someone to sue the German government. Sure, German lawyers and judges sometimes find ways of bending the law if it suits those in power (just try watching Roland Freisler in action, or reading "Der Führer schützt das Recht", a treatise by the brilliant Carl Schmitt on why Hitler's massacre of the Nazi Party's left wing was perfectly legal). Today's bunch will of course do nothing so outrageous (and I am not trying to say that declaring "too bad" and ignoring earlier EMU rulings would be comparable to Schmitts and Freisler's transgressions. I am just trying to point out that creative lawyers and judges can justify anything -- they did award Freisler's widow a bigger pension after she sued, because he would have had a brilliant career in West Germany had he not been killed by a bomb in 1945). So there is a non-zero chance, given its earlier rulings, that the Constitutional Court would actually oblige the government to either stop support to Greece, or get out of the Euro. If you take a deep breath for a minute, and dispassionately think about the consequences, this may be actually good solution for everyone (except, perhaps, the ECB bankers who would presumably have to move away from Frankfurt). The new Deutschmark would probably revalue by a lot. The soft-currency countries who now dominate EMU would get their beloved pesetas, francs, and escudos back, but with a common design on the pieces of paper. Policy could be as loose as Spain, Portugal, Greece, Italy, France, and Cyprus like; Germany could engage in its preferred policy of reducing unit labor costs, and running big current account surpluses. Every time they get too big, the Euro would devalue against the DM, the way the lira et al. used to. Everyone is happier. Probably, countries like Holland and Austria would shadow the new DM, as they did before EMU. Now, to be realistic ... if history teaches you something, it's that countries will stick to a silly monetary standard for way too long, especially if it's seen as the ultimately proof of adulthood in terms of currency. Just think of how long it took countries to abandon the gold standard in the 1930s... and as a beautiful paper by Sachs and Eichengreen showed many moons ago, you can explain most of the variation of when countries exited the Great Depression by when they abandoned gold.
Wednesday, 17 March 2010
Monday, 1 March 2010
Overall, I fear this is a no-hoper unless the EU rides to the rescue on a white stallion. Fiscal consolidation on the scale required of Greece is beyond even the most cohesive states. I cannot think of countries other than after a major war producing such a shift in their public finances. Germanyin the early 1930s under Brüning tried to engineer a swing in the public accounts that was of a similar magnitude (it reduced nominal spending by about 1/3 from 1928-32). The budget cuts were so severe that Brüning became known as the ‘Hunger Chancellor’. Many believe that the program of fiscal consolidation enacted by his government undid the Weimar Republic.
Let’s get back to the little table. I think that a range of 5-9% for the interest rate is pretty optimistic, too – as creditors start to worry that Greece may not repay, they will demand ever higher interest rates. This creates a self-fulfilling dynamic, of the type that some politicians have branded “speculative attack”. It is, of course, nothing of the sort – nobody is manipulating markets here, rising interest rates just mean that, as a borrower looks ever worse, creditors are not keen to refinance them. Kehoe and Cole have a very nice paper, inspired by the Mexican crisis, on self-fulfilling sovereign debt crises, and Wei Xiong of
So what should be done? Many equate default with a cataclysmic meltdown. This is not entirely without reason. As Rogoff, Reinhart, and Sevastano show in their paper on serial defaults, these can seriously damage your “fiscal health” – the state institutions you need to build a modern tax state. On the other hand, there is pretty convincing literature arguing that, since governments rarely sell contingent debt, defaults are a way to achieve market completeness. Investors de facto anticipate that things can go wrong, and the higher interest they receive beforehand compensates them for the risk. Defaults are when countries collect on the ‘insurance’ they bought before. Theories in the ‘excusable default’ vein (Grossman-Van Huyck, say) require that defaults happen in verifiably bad states of the world, and are driven by exogenous events. Half of that at least applies to