Anil Kashyap on Greece

Probably the best analysis so far. Mostly, it is a recap of the past. But in talking about the pending referendum, he writes,

if the public sides with Tsipras government, then there will be a very sharp recession over the next few months. Tax collection is likely to collapse. The Tsipras government is unlikely to survive the economic collapse.

He also writes,

Greece should have defaulted in 2010. Its debt burden then was unsustainable and nothing since then has changed this. It is true that financial markets were much more jittery at that time, but the money that was raised to pay off the creditors in that bailout could have been diverted to support Greece and other weak countries. Once the bad rescue of 2010 was undertaken, it was inevitable that some form of debt relief was going to be necessary.

Imagine how different the political dynamics in Europe would have been if the German and French banks had been explicitly bailed out.

Pointer from John Cochrane (and from Greg Mankiw and James Hamilton). Of course, I think that explicit bailouts are exactly what the political system will not allow. Even going forward, I still think that “opaque bailout” is the most likely outcome. But I also think that there are some lessons for us.

1. At some point, you do run out of other people’s money (that is actually more true for us than for Greece, because we are bigger and therefore harder to bail out).

2. When you run out of other people’s money, political tensions rise considerably. See my essay Lenders and Spenders.

When Economists Were Right, Allegedly

Richard Baldwin writes,

Barry Eichengreen added specificity to this in January 2009 with his insightful column “Was the euro a mistake?”, noting: “What started as the Subprime Crisis in 2007 and morphed in the Global Credit Crisis in 2008 has become the Euro Crisis in 2009. Sober people are now contemplating whether a Eurozone member such as Greece might default on its debt.” He wrote that the alternative to default was “fiscal retrenchment, wage reductions, and assistance from the EU and the IMF for the cash-strapped government.”

He predicted – again dead on – that “[t]here will be demonstrations against the fiscal cuts and wage reductions. Politicians will lose support and governments will fall. The EU will resist providing financial assistance for its more troublesome members. But, ultimately, everyone will swallow hard and proceed … In the end, the EU will overcome its bailout aversion.” The farsightedness is astounding. In January 2009, few knew the Greeks had a problem serious enough to require debt restructuring.

Pointer from Brad DeLong, via Mark Thoma.

That sounds impressive. He also cites other economists. But a couple of cautionary notes.

1. The best way to develop a reputation as far-sighted is to make many vague, conditional predictions. Later, you call attention to those that sound correct, and if necessary you wiggle out of those that sound incorrect by pointing out the conditions or taking advantage of their vagueness. I am not accusing Eichengreen of doing this. I have others in mind. But what might Baldwin have found had he had searched through past articles and looked for bad predictions?

2. How best to generalize this point? My guess is that “Economists’ predictions should always be taken as gospel”

3. Is the correct lesson that we should pay attention when economists warn about sovereign debt issues? Consider that many of us have issued warnings about the United States.

Opaque Defaults

James Hamilton writes,

The bottom line for me is that Greece’s current debts and any new loans that get extended from here are not going to be repaid in the present-value sense defined above. The current debt load and its associated interest bill are simply too big. The only solution is default on a significant portion of outstanding Greek debt. Indeed, significant debt restructuring is a necessary step for Greece to move forward, whether within the euro or based on a new currency. My view is that any realistic negotiations at this point simply have to take those facts as given.

My bottom line is to suggest that in forecasting the outcome of sovereign debt crises, assume that everyone’s goal is to make defaults as opaque as possible. For a small country like Greece, there ought to be many ways to do this. When the crisis hits Japan, it will be more difficult. When it hits the U.S., it will be more difficult still. But by then the international technocrats will have had a lot of practice.

Axel Leijonhufvud vs. Calomiris and Haber

Leijonhufvud writes,

The financial structure inherited from the 1930s divided the system into a number of distinct industries: commercial banks, savings and loan associations (S&Ls), credit unions, and others. It also divided it spatially. Banks located in one state could not branch across the line into another. This structure of the financial sector gave it great resilience. On another occasion I used the metaphor of a ship with numerous watertight compartments. If one compartment is breached and flooded, it will not sink the entire vessel.

This is directly the opposite of what Calomiris and Haber argue. They say that American cultural hostility to large banks produced an overly fragmented system, and that this fragmentation is the root cause of the peculiar instability of American finance.

Leijonhufvud elaborates,

At the time, the abolishment of all the regulations that prevented the different segments of the industry from entering into one another’s traditional markets was seen as having two obvious advantages. On the one hand, it would increase competition and, on the other, it would offer financial firms new opportunities to diversify risk. Economists in general failed to understand the sound rationale of Glass-Steagall. The crisis has given us much to be modest about.

In other words, economists championed open competition without thinking about how this would turn idiosyncratic risk into systemic risk.

The thing is, I was following these regulatory issues at the time, and I do not think that economists were as influential as we would like to believe. I think that the driving factors were computer technology, inflation, and massive lobbying. With high inflation, the regulatory ceilings on deposit interest rates that were a vital part of the regulatory structure became untenable. Moreover, with computer technology, it became easy for Wall Street to “disintermediate” banks using money market funds and securitization. These forces produced an inevitable turf battle between commercial banks and investment banks, which took years to resolve, as everybody lawyered up on the lobbying front. There were multiple possible political/regulatory outcomes, but hanging on to Glass-Steagall was not one of them.

Another Leijonhufvud quote:

Deregulation. . .allowed the great investment banks to incorporate and one by one they all did so. . .Incorporation meant limited liability for the investment bank and no direct liability for its executives. The incentives for executives in the industry changed accordingly. . .Now they are seen as jet-setting high rollers. Economists in general failed to predict this change in bankers’ risk attitudes. We have much to be modest about.

I cannot disagree with that.

However, I would instead put most of the emphasis on the regulations that directly affected housing finance. The pressure to lend with little or no money down and the designation of highly-rated mortgage securities as low risk for bank capital purposes are the main villains in the story as I tell it.

Public Availability of Freddie, Fannie Loan Performance Data

Todd W. Schneider has a write-up and some analysis.

I decided to dig in with some geographic analysis, an attempt to identify the loan-level characteristics most predictive of default rates, and more. As part of my efforts, I wrote code to transform the raw data into a more useful PostgreSQL database format, and some R scripts for analysis. The code for processing and analyzing the data is all available on GitHub.

I recommend reading the entire post.

Payroll Taxes in Europe

In France, the rate is 42 percent; in Germany, it is 39 percent; in Italy, 40 percent; and in Spain, 37 percent.

That is from Diana Furchtgott-Roth and Jared Meyer Disinherited: How Washington Is Betraying America’s Young. I see it as saying “left-wing economics is bad for children and other living things,” but they are trying to position it differently. In any case, they are suggesting that we could be headed for much higher payroll taxes ourselves.

I had not realized that these tax rates are so high. I find it hard to reconcile Germany’s relatively low unemployment rate with this high payroll tax rate.

John Cochrane vs. Financial Intermediation

He writes,

just why is it so vital to save a financial system soaked in run-prone overnight debt? Even if borrowers might have to pay 50 basis points more (which I doubt), is that worth a continual series of crises, 10% or more downsteps in GDP, 10 million losing their jobs in the US alone, a 40% rise in debt to GDP, and the strangling cost of our financial regulations?

My take:

1. As I have said before (scroll down to lecture 9), the nonfinancial sector likes to hold riskless, short-term assets and issue risky, long-term liabilities. Financial intermediaries emerge to take the other side.

2. When governments run deficits, they need help from banks, which hold government debt. It used to be that governments ran deficits to finance wars. Now they run deficits routinely.

3. Banks have an easier time convincing customers that bank liabilities (i.e., the funds customers hold on deposit) are riskless if government will provide implicit or explicit guarantees.

From (2) and (3), we see that banks and government are co-dependent. This co-dependency makes it unlikely that we will find a free-market banking system.

We can expect government policy to be ambivalent with respect to the financial sector. On the one hand, it wants the financial sector to thrive, so that deficits can be financed and the economy has plenty of credit available. That argues for lots of guarantees with limited regulation. On the other hand, it wants to restrain the moral hazard that leads banks to take on too much risk and make the system prone to crises. That argues for limited guarantees and lots of regulation.

Policy makers do not deal rationally with this ambivalence. Instead, over time both guarantees and regulation tend to increase. For instance, in the wake of the financial crisis the government has extended both its guarantees (money market funds) and its regulation (non-banks that are “systemically important”). It is true that some types of financial regulation, such as restrictions on interstate banking, interest-rate ceilings, or other anti-competitive rules, have declined over time. But in the area of safety and soundness regulation, over the years the effort has been to make regulation more sophisticated and effective. That this has not been successful is due in part to the greater prevalence of guarantees and also to what I call the regulator’s calculation problem.

Government Debt, Off Balance Sheet

John Cochrane writes,

Guaranteeing more than half of financial sector liabilities is impressive. But most of us don’t know how large financial sector liabilities are. GDP is about $17 Trillion. $43 Trillion is a lot.

This is only financial system guarantees. It doesn’t include, for example, the federal debt. It doesn’t include student loans, small business loan guarantees, direct loan guarantees to businesses, the ex-im bank and so on and so forth. It doesn’t include non-financial but likely bailouts like auto companies, states and local governments, their pensions, and so on.

He cites analysis from the Richmond Fed.

Not to worry, of course. Debt is just something we owe to ourselves.

Steven Pinker on Money as a Consensual Hallucination

He writes,

Life in complex societies is built on social realities, the most obvious examples being money and the rule of law. But a social fact depends entirely on the willingness of people to treat it as a fact. It is specific to a community, as we see when people refuse to honor a foreign currency or fail to recognize the sovereignty of a self-proclaimed leader. And it can dissolve with changes in the collective psychology, as when a currency becomes worthless through hyperinflation or a regime collapses because people defy the policy and army en masse.

That is from p. 65 of The Blank Slate, which I am re-reading.

I would quibble that you do not get hyperinflation from a sudden loss of confidence in the currency. You get it when the government spends more than it taxes and loses the ability to borrow, so its only choice is to print money–and then people lose confidence in the currency.

The important social reality is that people are willing to lend to the government at affordable interest rates. That is what has the potential to suddenly change (see Greece) and that is why large deficits create potential instability.

Bernanke vs. Warren-Vitter

He writes,

The problem is what economists call the stigma of borrowing from the central bank. Imagine a financial institution that is facing a run but has good assets usable as collateral for a central bank loan. If all goes well, it will borrow, replacing the funding lost to the run; when the panic subsides, it can repay. However, if the financial institution believes that its borrowing from the central bank will become publicly known, it will be concerned about the inferences that its private-sector counterparties will draw. It may worry, for example, that its providers of funding will conclude that the firm is in danger of failing, and, consequently, that they will pull their funding even more quickly. Then borrowing from the central bank will be self-defeating, and firms facing runs will do all they can to avoid it. This is the stigma problem, and it affects everyone, not just the potential borrower. If financial institutions and other market participants are unwilling to borrow from the central bank, then the central bank will be unable to put into the system the liquidity necessary to stop the panic. Instead of borrowing, financial firms will hoard cash, cut back credit, refuse to make markets, and dump assets for what they can get, forcing down asset prices and putting financial pressure on other firms. The whole economy will feel the effects, not just the financial sector.

Pointer from Mark Thoma.

In effect, Bernanke is saying that you have to make firms that get into trouble want to be bailed out. If you make bailouts too painful for them, then “financial firms will hoard cash, cut back credit, refuse to make markets, and dump assets.”

I am not impressed by his reasoning. What he calls “stigma” is not a bug of the Bagehot principle. It is a feature.