Tom Pepinsky

Category: Economics

  • Papers I Will Never Write: The Euro and the Greek Crisis

    There is a very interesting piece by Kash Mansori in the New Republic on the origins of the Euro-area crisis. The main point seems to be this: the crisis cannot be reduced to policy mistakes or misbehavior by the PIGS (Portugal, Italy, Greece, and Spain). Greece, especially, had some real problems with budgeting, spending, and tax avoidance that are integral for explaining why their government has had such a tough time adjusting to the crisis, but Mansori points out that

    the very design of Europe’s common currency area not only caused, but was meant to cause the eurozone’s periphery to incur large amounts of international debt.

    His conclusion is that it’s the Euro, not just problems internal to Greece’s political economy, that led Greece to where it is today. (One important piece of supporting evidence is that countries like Spain and Ireland, models of fiscal discipline in the 2000s, are in a fix too, just like naughty Greece.) I’ve had this argument before with numerous Germans and admirers of Germany, for whom the structural problems of the Euro itself aren’t obvious (and who, understandably, are loathe to view themselves–as members of the Euro–as somehow responsible for Greece’s problems).

    But there is an interesting counterfactual question here that leads me to disagree with Mansori’s conclusions a bit. Let me try to lay it out. To what extent did the Euro versus the contemporary global financial system cause the Greek crisis? This is a paper that I will never write–not even with tenure–because it requires me to enter into a world of Greek politics and political economy that I do not know well. But I’ve spent some time thinking about this (I once had a bit of a public debate on it with Kevin Featherstone) and I think that there is something to what I’m about to write.

    My task, in this paper that I will never write, is to imagine a counterfactual scenario in which the Euro does not exist but the global economy is otherwise the same. Then compare what I anticipate would have happened in Greece in that imaginary world, and see if it’s any different from what actually took place. I contend that from the perspective of Greece (if probably not Spain or Ireland), the world would not have looked much different in October 2007 without the Euro than it did with the Euro.

    Here are some aspects of the global economy that I take to be features of a world without a Euro.

    1. Capital accounts are still very open in Europe. That is, it’s still nearly costless to move money from Germany to Greece, either to lend or to invest. The only difference is that you have to convert marks into drachmas rather than just bringing your Euros
    2. Exchange rates are fairly stable (or at least predictable, which can be shown to be the same thing for the purposes of my argument). This is probably debatable. But we do know that in one actual example of a non-Euro peripheral European economy–Iceland–exchange rates prior to the crisis were believed to be predictable. Ask English savers.
    3. The “big” northern European economies are doing well, but trend growth is lower in Germany than in the PIGS (the “convergence” of the neoclassical growth model), so there’s an incentive for investors in Germany and France to look abroad for higher rates of return.
    4. Smaller economies like Greece cannot borrow abroad in local currencies (“original sin“) but have to borrow abroad in international currencies–in this case, probably the mark and the pound instead of the drachma.

    OK, so what happens in this imaginary world? Well, to begin with, you still get capital flowing to Greece from Germany because (following 1) there are still no barriers, (following 2) there’s still not too much exchange rate risk, (following 3) the incentive to lend is still there, and (following 4) the need to borrow is still there. The same pathology of overborrowing, overspending, and ultimate overheating would ensue–implicitly, I have assumed that the imaginary Greece is no better able to manage its public sector, force its wealthy to pay taxes, or avoid “cooking the books” in national accounting than the real Greece actually is.

    The outcome from this would probably be another financial crisis that started off a lot like the one that actually occurred.

    In fact, the only real thing that the existence of the Euro itself may have done is to shape beliefs about the exchange rate between Greece and the rest of Europe. Adopting a common currency is just an extreme form of fixing your exchange rate. If traders believe that exchange rate is fixed and credible (or predictable–again it makes no difference, due to high-volume currency arbitrage [another feature of the global financial system]) then they will act as if exchange rate risk does not exist. That is what adopting a common currency did: it make European lenders and borrowers believe, it seems, that the peg between the currencies of Greece and the rest of Europe was irreversible. Without the Euro, you’d imagine that lenders and borrowers around the region would be a bit more careful. But I’d argue that’s probably not true: look at Iceland and the UK. Also, look at every other emerging market crisis in the past thirty years where you have international overborrowing (which we could equivalently call “international overlending“) following mistaken beliefs about the future path of the exchange rate. We could talk about Latin America in the 1980s. Or Mexico in the 1990s. Or Southeast Asia in the late 1990s.

    If I were to write this paper, I would argue that the actual effects of the Euro were not in causing the crisis but in exacerbating the problems that Greece faces in adjusting to the crisis. Here my argument isn’t new, it’s been told repeatedly by Krugman. Conditional on the existence of a financial crisis (which I argue might well have happened with or with the Euro) the fact that the crisis occurred with the Euro in place has probably made things worse, both for Greece and for the rest of Europe.

    One final note: it’s often the case that there is a kind of code language that political economists use. “Political economy” can mean, for example, a kind of Marxian analysis of politics to some, or it can mean the study of political constraints on economic policy from a libertarian perspective to others. Here, the buzz-phrase that some readers may want to use to divine something about my politics is “contemporary global financial system.” It’s possible to read what I’ve written to imply that I’m critiquing the modern global financial system. Not necessarily so. I do not have have an alternative global financial system that I believe is clearly better for all people or all countries at all times. Although I would probably favor a Tobin tax, and I would certainly favor better economic policymaking in countries like Greece and better financial regulation in the U.S., I’m not sure that any of that would eliminate the phenomena that I’m describing here. I simply take it as a feature of the contemporary global financial system that from time to time, there are exchange rate/debt/banking/etc. crises. We had them before the Euro, we’ll have them elsewhere without it, too.

  • Stabilization Games Revisited

    OK, since my body clock still thinks I’m in Australia, I (TP) think it’s OK to violate our no-posting-in-the-US rule for just this once, to follow up on my earlier post on the debt ceiling.

    The question here is, how did my little model do? The answer is, good not great. There are a couple of issues here. The outcome–a near complete capitulation by the Ds to the Rs–is not my final prediction, so that’s not good. But there are several reasons why a little model might not predict reality.

    • The model is wrong somehow. I don’t think is it. For what I intended the model to do, I think it stands up very well in explaining the essential logic of the debt ceiling crisis. The logic of the positions is correct, from what I can tell. It’s just that the Rs stood firmer than I anticipated, a prediction which only comes out informally at the very end of my discussion.
    • The model makes technical simplifications. This is part of it: due to the fact that I’m not any good at math I only entertained a 2×2 game structure with discrete strategies (vote yes or no), and clearly any actual debt ceiling negotiations involved negotiations allowing for continuous strategies. The model sacrifices reality to be more tractable, with obvious consequences.
    • Actual events are random draws from a distribution of possible outcomes. Maybe relevant too. This is what ever good poker player knows, and most critics of formal theories of politics forget. Think about it this way: if you’re playing no limit Hold ‘Em and find yourself raising pre-flop with pocket aces, but get beat by someone who flops a boat, you probably didn’t make a mistake by raising pre-flop, you just got a bad beat.
    • People aren’t rational. Possible. I think in the case of Obama himself, there’s evidence that he is not responding to incentives and new information about his opponents in a way that a rational Bayesian learner would. He seems to believe things about the Rs’ willingness to compromise that don’t seem compatible with reality. [ed.–Would love MGr’s and MGl’s reactions to this claim.] Beyond that, everyone else seems pretty rational to me.
    • Games are nested. I think that this the real issue. We can’t forget that the final debt ceiling crisis is part of a much larger game between the Ds and the Rs, and a lot of the relevant considerations for players calculating optimal strategies are external to the specific vote on whether or not to raise the debt ceiling and the small number of parameters I’ve included. I’ve long thought that the very fact that we had a debt ceiling crisis at all means that the Ds had already lost the ability to make and defend coherent economic policy positions. I just thought that they would stand firm.

    The good news, as I mentioned before, is that in capturing the essence of the interactions between Ds and Rs over the debt ceiling, and understanding why the crisis looked the way that it did and lasted as long as it did, my exposition does well.

    The real news now though is the market reaction (not great) and the subsequent economic data which has been released (very discouraging). What is striking to me now is a point to which I alluded earlier: the complete and utter refusal of US politicians to advocate for a coherent policy response based on basic economy theory. We used to know that when interest rates were really low but banks still weren’t lending and the economy was still stalled, governments should spend. Today, no politician–not a D, not an R, not a president–is willing to take this position. Instead, Washington is obsessed with debt and tax cuts. The reason why no politician will explain to you precisely why cutting taxes and decreasing spending over the next 20 years will help the US economy over the next 5 is because, well, it won’t.

    There are various reasons for our politicians’ current ignorance. One is the really terrible state of economic literacy among the Americans. Lots of people study business in college, fewer study macroeconomics. The really smart ones who do study macroeconomics work in the financial sector, not politics, and they are screaming for more government spending right now. One is that macroeconomics is difficult, and that leads people to try to look for analogies in how you run a national economy in how they run their household or their small business, which create a huge fallacy of composition (if your household is almost bankrupt you should stop borrowing, and that is not necessarily true if you’re a national economy). One is possibly naked greed, but I don’t think that that is it really, because a greedy person would be willing to trade a higher tax bracket for a much higher income (which a good economy will give you), and that doesn’t seem to describe the nature of the debate right now.

    But there also might be something in the way that leaders lead. I think that this is important, and not something amenable to game theoretic analysis. I can pick on Obama, but it’s not just his fault, it’s a general problem among the Ds, the party that would have the ability to advocate a classic Keynesian response to the current crisis. They seems unwilling or unable to stand up and recite the lessons of Econ 101.

    UPDATE: Another obstacle to embracing a coherent policy response to our current economic maladies might come from academic economics, in the form of real business cycle theory. For better or for worse, RBCT enjoyed great prestige in the 1980s especially, and its intellectual champions remain active and influential. Simplifying greatly, RBCT starts with the assumption that all markets for goods, labor, and capital clear, which means that the business cycle–that is, the variation around the trend in how economies perform over the long term–must be explained by random shocks (yes, literally) to the economy. You get terms like “adverse technology shocks” to explain why recessions occur (Noah Smith discusses the logical implications of this sort of view applied to the current crisis).  Sneakily, then, economists who follow this line of thinking don’t have to think carefully about the origins of recessions, because they are unanticipated and unpredictable, or else they wouldn’t be random. One additional consequence of this line of thinking is that government action (monetary policy or fiscal policy) can at best do nothing to redress the business cycle. Here is an early, devastating critique from Larry Summers.

    What makes this relevant for my discussion is that this sort of thinking is currently popular among many of the libertarian types of economists who tend to have blogs and lots of readers. The internet and libertarians go together like PB and J. It’s unlikely that many of these people strictly believe that RBCT is a good model; rather, they like the implication that government action can never be useful, and they sort of latch onto RBCT from time to time because that’s one of the things that  RBCT says. Blog readers usually don’t know that ins and outs of the models that produce these predictions but my sense is that they are still influential among the commentariat.