The European Debt Crisis–Not Quite Over

Theodore Pelagidis writes,

The latest polls put Syriza ahead by 5-7 points, as angry voters from across the political spectrum get behind the party. It’s not surprising. This “supermarket” party promises almost everything to anyone, masking its policies with romantic pledges to stop humanitarian crises, to make the black market and bureaucracy disappear, to increase the minimum wage and minimum pension by around 40 percent (despite the fact that the social security system is in bad shape) and, last but not least, to negotiate a huge amount of debt forgiveness, mainly by having–sorry, ordering—the European Central Bank to buy most of it.

Have a nice day.

Europe Still in Trouble

Barry Eichengreen and Ugo Panizza write,

For the debts of European countries to be sustainable, their governments will have to run large primary budget surpluses. But there are both political and economic reasons to question whether this is possible. The evidence presented in this column is not optimistic about Europe’s crisis countries. Whereas large primary surpluses for extended periods of time did occur in the past, they were always associated with exceptional circumstances.

Pointer from Mark Thoma. Read the whole thing. Shorter version: Have a nice day.

Cyprus: Have a Nice Day

The New York Times reports

In the early hours of Saturday morning, after 10 hours of talks, finance ministers from euro area countries, the International Monetary Fund and the European Central Bank agreed on terms that include a one-time tax of 9.9 percent on Cypriot bank deposits of more than 100,000 euros, and a tax of 6.75 percent on smaller deposits, European Union officials said.

Pointer from Tyler Cowen, who thought it worthy of a follow-up. A couple of further thoughts:

My understanding is that the depositors would receive bank equity in exchange for debt. No one believes that this will make them happy. (Perhaps the depositors should be asked to read Admati and Hellwig?) In fact, every economist I have read has pretty much the same reaction as mine to this policy.

While a surprise tax on bank deposits may seem like the best idea that the eurocrats could come up with under the circumstances, it might not bode well for the longer term. In terms of the two drunks model, this looks like both drunks falling down without making it home.

Consider: Suppose that you hold bank deposits in a bank in a fiscally troubled country, such as Italy, Portugal, Spain, or Japan. You are deciding whether to keep those deposits there. Until Friday, you had not considered that the government might confiscate a portion of your deposits. Now, how much assurance do you need that your deposits will not be suddenly taxed in order to keep you from running to your bank and shifting your funds elsewhere? Solve for the equilibrium, as Tyler would say.

Banks and Government

The second of my essays on the function of banks. In this one, I talk about their relationship with government.

Think of two friends who walk to a neighborhood bar every Saturday night. On a given Saturday, the first friend may be too drunk to walk without assistance, and he may have to lean on the second friend in order to make it home. The following Saturday, it could be the second friend who needs to be supported in order to get home. However, if both of them get too drunk and try to lean on one another to get home, they may collapse together.

This is how I picture the current situation in Europe. Many European banks are unsteady. They need government guarantees and capital injections in order to stay in business. At the same time, many European governments are heavily indebted and running large deficits. They need banks to continue to lend to them in order to fund their spending.

Read the whole thing. My prescription for addressing the relationship between banks and governments is to try to apply the approach of “limited guarantees, for limited purposes.”

The Greek Phillips Curve

Tyler Cowen writes,

Prices are sticky, AD is falling, and almost all of the adjustment is in quantities. Yet this still doesn’t explain why prices are inching up, and furthermore it is grossly at variance with the actual empirical literature on price stickiness (much neglected in the blogosphere I should add), which is not nearly as strong as wage stickiness.

This is one of several explanations Tyler finds unsatisfactory for the fact that unemployment is so high in Greece and yet inflation is still greater than zero there. In a follow-up, he writes,

For a simple point of comparison, the rate of U.S. price deflation in 1932 was greater than ten percent with overall deflation running at about twenty-five percent over a period of a few years. More recently, Japan had nine straight years of core CPI deflation and Greece cannot even manage anything close to that. Just what is the Greek Phillips Curve supposed to look like?

I recommend a recent article by Marga Peeter and Ard den Reijer. I may be confused about what I am reading, but it appears to me that the Phillips Curve in Greece shifted adversely over a period of a decade. To put this another way, the natural rate of unemployment in Greece may be quite high.

If my reading is correct, then aggregate demand policies, including converting to a cheaper currency, would not do much for Greece. If workers’ reservation wages are high relative to productivity, you are going to have a lot of unemployment.

A Solution Exists…I Can Quit Any Time

Tyler Cowen writes,

Unfortunately, longer-lasting solutions require coordinated agreement among many euro-zone nations and, possibly, the broader European Union. That would include significant debt write-offs (as the International Monetary Fund is suggesting), quick moves toward better-integrated European banking institutions, and a general agreement that the European Central Bank unconditionally support troubled debt securities without trying to manipulate home governments’ policies.

I would say that a longer-lasting solution has to include adopting sustainable fiscal policies. Read the whole column. Another excerpt:

Unfortunately, the relevant governments — and their citizens — still don’t seem close to accepting the onerous financial burdens they need to face. And when those burdens are unjust to mostly innocent voters, no matter whose particular story you endorse, acceptance becomes that much tougher.

Still, we shouldn’t forget that a solution exists.

Meanwhile, back in the United States, Jonah Goldberg writes,

You could confiscate 100 percent of income over $1 million, and it would cover about a third of the deficit (and crush the economy in the process). You’d still have to deal with spending, particularly entitlement spending.

But the Democrats want to do . . . nothing. Or at least that’s the position they seemed to be taking this week.

I want to caution readers not to commit the Fundamental Attribution Error. That is, do not attribute the current political strife and apparent short-termism to the personalities of politicians. Instead, these characteristics are structural defects of a system without a hard constitutional brake against deficit spending. Absent an effective constitutional brake, deficit spending is like smoking. In theory, the politicians can quit at any time. In practice, in many cases we end up with cancer.

That is the import of Lenders and Spenders, an essay that I expect I will be linking to regularly. The point of that essay is that debt crises are easy to slide into and very difficult to get out of.

At the end of the second World War, the United States was fortunate in that (a) running deficits in peacetime was still taboo and (b) Social Security was running surpluses that the politicians had not yet put their hands on, because it was considered a separate account. Unfortunately, both of those taboos went away in the 1960s, when Keynesianism became orthodox and President Lyndon Johnson got his hands on the Social Security surpluses by changing to a “unified budget”.

Eventually, some smokers get cancer. And some deficit-spending countries succumb to the fiscal equivalent. I used to think that Europe was going to get there before the United States, because I thought that in this country we had a stronger political will to restrain deficit spending.

I am starting to change my position. The mainstream views in the United States on deficit spending now lie somewhere in between, “We can quit at any time, but now is not the time” and “We never have to quit.”

Have a nice day.