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Monday, February 15, 2010

Beware The Narrative

For the narrative is often fatal.

As a case in point, let us consider Krugman's latest conscience thingie in the NY Times. I pick on Krugman, because he can take it, what with the Nobel prize, the professorship, and the NY Times as a platform. Krugman is capable of doing truly excellent economic work, which makes some of his performances all the more dazzlingly idiotic. This is one of his best efforts along that line ever. I assume that his desire to stick to his narrative causes this, because otherwise it must be meth and the last time I saw a photo his teeth looked okay.

So here goes (as a fair use, I am going to reprint and discuss the whole darned thing):
Lately, financial news has been dominated by reports from Greece and other nations on the European periphery. And rightly so. (No argument so far.)
But I’ve been troubled by reporting that focuses almost exclusively on European debts and deficits, conveying the impression that it’s all about government profligacy — and feeding into the narrative of our own deficit hawks, who want to slash spending even in the face of mass unemployment, and hold Greece up as an object lesson of what will happen if we don’t. (All right, right there he says it is about the narrative. He's worried about the message we'll get, and that it will be the wrong one. I think this is what caused this abject display of incompetence.)

For the truth is that lack of fiscal discipline isn’t the whole, or even the main, source of Europe’s troubles — not even in Greece, whose government was indeed irresponsible (and hid its irresponsibility with creative accounting). (All right, here we go. Greece's government employs more than 1/5th of all workers in Greece. Well more. Officially the labor force is under 5 million; at least 700,000 workers are employed by the government directly, but far more are actually paid through government programs. Government is commonly quoted as being 40% of GDP. The pensions for all those workers are a problem, as is the government share of total GDP. The other problem is that private sector worker compensation is somewhat pegged to public sector compensation. In December the Greek public debt was estimated at 430 billion with a labor force of 4.9 million? Needless to say, when you have a recession as bad as the one we've had globally, the private sector is going to shrink - especially when tourism, etc is a large part of it. So lack of fiscal discipline is absolutely the problem with Greece; the recession brought the problem to the fore, but Greek sovereign debt would have been in trouble in a few short years regardless, as retirements escalated and the funds to pay them collapsed.)

No, the real story behind the euromess lies not in the profligacy of politicians but in the arrogance of elites — specifically, the policy elites who pushed Europe into adopting a single currency well before the continent was ready for such an experiment. (Now really, why and how would a country like Greece be in less trouble if it were not on the Euro? Yes, being on the Euro now does limit its options, but what the heck is going to save a country that gets itself in this fix - certainly not currency manipulation!)

Consider the case of Spain, which on the eve of the crisis appeared to be a model fiscal citizen. Its debts were low — 43 percent of G.D.P. in 2007, compared with 66 percent in Germany. It was running budget surpluses. And it had exemplary bank regulation.

But with its warm weather and beaches, Spain was also the Florida of Europe — and like Florida, it experienced a huge housing boom. The financing for this boom came largely from outside the country: there were giant inflows of capital from the rest of Europe, Germany in particular. (The above is all true.)

The result was rapid growth combined with significant inflation: between 2000 and 2008, the prices of goods and services produced in Spain rose by 35 percent, compared with a rise of only 10 percent in Germany. Thanks to rising costs, Spanish exports became increasingly uncompetitive, but job growth stayed strong thanks to the housing boom. (Professor, Spain imports pretty much all its fossil fuels. Does that give a clue as to how some of those costs occurred? Huh, professor?)

Then the bubble burst. Spanish unemployment soared, and the budget went into deep deficit. But the flood of red ink — which was caused partly by the way the slump depressed revenues and partly by emergency spending to limit the slump’s human costs — was a result, not a cause, of Spain’s problems. (Here we run into an interpretative difficulty. Housing costs escalated sharply, in due part to very loose lending standards, and in part due to Europeans buying housing in Spain - a trend which is very long-term. Another problem for Spain was its green energy program, which has boosted its energy costs sharply. Let's just go to Gabriel Calzada Alvarez's report (he is a Spanish economics professor). Start at page 25 where it is noted that Spain's green energy program probably destroyed more than two jobs for each job it produced. Continue to page 31 and 32, where Calzada looks at the ongoing cost of subsidizing electricity rates in order not to drive industry out: "For example, the average annuity payable to renewables is equivalent to 4.35% of all VAT collected, 3.45% of the household income tax, or 5.6% of the corporate income tax for 2007.60 Regardless of whether the increase impacts consumption or investment more, the most affected sectors of the economy will be those with a greater pro-cyclical productions (such as automotive)." Continue on to page 33 and follow citations of specific industry costs that have exported industry from Spain. It should not be surprising that increases of 50% in electric rates in a decade exported jobs. I guarantee you that the same will happen anywhere. But since the investments were made elsewhere during this time, there is an additional cost due to the lost investment.)

And there’s not much that Spain’s government can do to make things better. The nation’s core economic problem is that costs and prices have gotten out of line with those in the rest of Europe. If Spain still had its old currency, the peseta, it could remedy that problem quickly through devaluation — by, say, reducing the value of a peseta by 20 percent against other European currencies. But Spain no longer has its own money, which means that it can regain competitiveness only through a slow, grinding process of deflation. (Arggh. Only economics professors make every day talk like a doo-rag surfer pirate day. Sigh. Where to begin. Okay, the housing bubble is like, gone, man, which means that the deflation in housing prices is like, inevitable, dude, because when median household debt to income ratios went over 125% in 2005, the words "Mene, Mene, Tekel, Upharsin" appeared in fiery letters above Barcelona. I mean, dude, even WikiNerds know that construction had peaked at 16% of GDP and 12% of employment, which, dude, means that when the building stopped the economy stopped. Deflation is a corrective in and of its own, and deflation makes investment in a country cheaper - but only if countries can afford to produce goods there - and when you have to import just about all of your fossil fuels, deflating your currency inflates your import costs and base costs like crazy. So, like, dude, maybe one thing Spain should consider changing is its energy costs. Want some good weed? Further, deflating your currency causes import costs to rise, which would place further pressure on Spanish consumers, thus making debt less payable.)

Now, if Spain were an American state rather than a European country, things wouldn’t be so bad. For one thing, costs and prices wouldn’t have gotten so far out of line: Florida, which among other things was freely able to attract workers from other states and keep labor costs down, never experienced anything like Spain’s relative inflation. For another, Spain would be receiving a lot of automatic support in the crisis: Florida’s housing boom has gone bust, but Washington keeps sending the Social Security and Medicare checks. (OMG. This was where ZZ Top's "Sharp Dressed Man" started playing in my mind. Dude! Dude! Stop the peyote and try Wiki! If Wiki offends your pride, here is the official Spanish statistics office, dude. 1/1/2000, pop 40.5 million; 1/1/2009, pop 46.745 million. Dude, that's more than a 15 percent increase in a country with one of the lowest fertility rates in Europe! Way more than half of that was immigration. It is also true that Florida, up until the average worker couldn't even afford to rent an apartment, had an influx of workers. Many of them were illegals. But there was absolutely no bar to emigration from the rest of Europe for Spain, and Spain also experienced a large influx of illegal workers from other countries. The lack of workers wasn't a problem. And dude, if you really believe that one of Florida's problems isn't those measly Medicare checks, I advise you to go seek care in a Florida hospital and try paying it without insurance. This paragraph alone would qualify most high school papers for a D, dude. Students spend far more effort on hair brushes than you did on the economy of a nation with 46.7 million people, Prof. )

But Spain isn’t an American state, and as a result it’s in deep trouble. (Oh, my fanny. The difference between Spain's economy and Florida's is that Florida's was never nearly as dependent on construction as Spain's. Try this.As of 2008, FL GDP construction share was under 6%, whereas Spain's was still around 10% as of 2009. See also this backgrounder from 2007.) Greece, of course, is in even deeper trouble, because the Greeks, unlike the Spaniards, actually were fiscally irresponsible. Greece, however, has a small economy, whose troubles matter mainly because they’re spilling over to much bigger economies, like Spain’s. (The Greek workers do not think so.) So the inflexibility of the euro, not deficit spending, lies at the heart of the crisis. (Bubbles and high government spending have NOTHING to do with it? You let your construction peak well over 17% of GDP, and expect there's no problem to come?)

None of this should come as a big surprise. Long before the euro came into being, economists warned that Europe wasn’t ready for a single currency. But these warnings were ignored, and the crisis came. (This has nothing to do with debt, nothing to do with economic growth associated with rapidly escalating household debt levels and unsustainable lending ratios? Nothing? It's all about the inability of countries to play with their currencies? Trade means nothing? It seems to me that the Euro has held up well through this global seizure.)

Now what? A breakup of the euro is very nearly unthinkable, as a sheer matter of practicality. As Berkeley’s Barry Eichengreen puts it, an attempt to reintroduce a national currency would trigger “the mother of all financial crises.” So the only way out is forward: to make the euro work, Europe needs to move much further toward political union, so that European nations start to function more like American states. (You know, this is the strangest, most unsupported claim. It's not as if a state like Michigan or Illinois or California or Florida doesn't experience exceptional difficulties during these downturns, or that states like the Dakotas do. It's all in the mix. And really there is not a lot that the federal government does aside from blend it all together. It's not as if these states can play with their currencies, and it's not as if they can't go bankrupt. And just as you are not going to find the Dakotas willing to pay for Florida's bad taste in condos by paying its taxes, you are not going to get Germany's savers to pay for Greece's government sector. CA is going to have to come to grips with its problems, and so will NJ, and so will Greece. The IMF has already extended large amounts of money to some countries to bail them out (like Hungary), but there is only so much functional countries can do for non-functional countries just as there is only so much functional states can do for non-functional states. To the extent that a state or a country purchases present prosperity through unsustainable spending, their future spending is impaired. Moving it around doesn't change things much.)

But that’s not going to happen anytime soon. What we’ll probably see over the next few years is a painful process of muddling through: bailouts accompanied by demands for savage austerity, all against a background of very high unemployment, perpetuated by the grinding deflation I already mentioned.

It’s an ugly picture. But it’s important to understand the nature of Europe’s fatal flaw. Yes, some governments were irresponsible; but the fundamental problem was hubris, the arrogant belief that Europe could make a single currency work despite strong reasons to believe that it wasn’t ready. (The US achieved a political union and a trade union before it achieved a common currency. But a strong European "national government" wouldn't change the overall European structure; growth in the past decade has been associated mostly with countries which escalated debt to achieve growth; growth over the next decade will have to come from the countries that are less debt-laden. Is this truly that much different from the US? Hasn't the story of US state prosperity been one of changes, the dreaded "grinding deflation", and then rises to a new prosperity, etc, based on competitiveness?)
Krugman wants to believe that playing with currencies can fix structural economic problems, but where is the economic evidence of that? And anyone who thinks Spanish bank regulation was exemplary is way out of touch with reality or does not understand bank regulation. You can't regulate risk if you don't know about risk, and risk in banking is related to collateral quality (assessments and adjustments based on economic background) and borrower financial status.

For a little more in-depth and less narrated discussion of the Euro situation, may I suggest this paper by Sebastian Dullien and Daniela Schwarzer of Eurozone Watch? The paper both discusses the impact of the uniform currency and the impact of different public policies. It is a much more balanced discussion of the EU's current situation and possible future.

The choices the EU must make do have implications for the future of the US, because the choices European countries are making and have made are the choices we are discussing. If we do not change course, we will have public debt of 80% of GDP within a decade, and historically that is a major marker of trouble. We want to halt at no more than 65% or 70%, and thereafter hold debt increases to those which can be financed from internal savings until, at least, we can bring debt down to the 60% level. That leaves us room to address crises.

Such a goal limits future spending plans on defense and entitlements, but it should preserve enough room for growth. We are currently publicly capitalizing private debt at an astonishing rate to bail out our to-big-to-fail banks plus our dysfunctional auto companies, and we will have to end that policy very soon.

Excellent job, M_O_M; it raises the question of how Krugman can continue to write what he does when it is so devoid of data. I suspect when one becomes a member in good standing of the elect, such trivialities as research recede in importance.
And just as you are not going to find the Dakotas willing to pay for Florida's bad taste in condos by paying its taxes, you are not going to get Germany's savers to pay for Greece's government sector. CA is going to have to come to grips with its problems, and so will NJ, and so will Greece.

I both think that you are right and I hope that you are right.

I think the Greece story is a very important wake-up call for the world. Like you, I just can't imagine German taxpayers continually bailing out Greece's taxpayers. It might happen once. It might even happen twice. Something is bound to break at some point though. Big time.

Rhetoric alone is not going to save Greece or California, yet rhetoric is the support that is most often offered.

The following was probably the most vulgar thing I have ever posted on my blog and so was my response.


"This represents a down payment on what California is owed," Department of Finance spokesman H.D. Palmer said after the Obama budget was released.

I have nothing against California. I don't owe California so much as a penny though. If California wants a handout from me then they better ask a heck of a lot nicer.
IMHO; Greece would not be in the shape they are in had they not been allowed to join the single currency. The access to capital, and ability to borrow at absurdly low interest rates makes me feel like they're the subprime borrower of the EU. I had traveled to Athens in 1995 and Invested a great deal of money in their Gov't bonds as their rates seemed high compared to their risk (over 15% at one point). The city was a dump, everyone drove old cars. Fast forward 15 years and the city was cleaned up with new roads and not an old car in sight. The Gov't had repurchased all the old ones. Where were the interest rates then? I dunno, 3% maybe. No Euro, No Problem. Or at least less of one.
It's all Greek to me. If Greece and Spain find themselves unable to redeem their paper, would this necessarily impact on the value of the euro relative to the dollar?
MOM, nice piece. I was trying to picture you doing the surfer dude rebuttal to Kruger....comedic gold. Nice piece and as a European from one of the more stable northern states we aint happy bout bailing out nobody. But we'll gladly go there on vacation and spend our kronors...thats a nice gesture aint it....as opposed to going to Thailand.
And just as you are not going to find the Dakotas willing to pay for Florida's bad taste in condos by paying its taxes, you are not going to get Germany's savers to pay for Greece's government sector. CA is going to have to come to grips with its problems, and so will NJ, and so will Greece.

This is the main reason Krugman wrote what he wrote. He wants bailouts of select US States (read: the ones he'd consider living in, meaning the ones with prestigious universities). His NYT gig may not last and he wants to make sure his academic options remain open and his academic salary doesn't get slashed. Essentially he's begging for his welfare not to get cut because he's a welfare queen. If the California university system starts slashing salaries, other universities public and private will do the same - supply and demand.
SW - One begins to wonder if a Nobel prize doesn't hurt more than it helps. Is it a golden mental manacle of sorts?
Charles - I am old enough to remember the 80s. The austerity hit everywhere; state, local and education spending was all impacted.

Given that the state budget shortfall for this next fiscal year is estimated at 180 billion, which is about 10% of nominal state and local spending according to BEA, I'd say that we have a long way to go to get to something sustainable.

It should be obvious to everyone that it can't come from property taxes, because in most areas the housing bubble boosted property taxes substantially over the last 8 years. And we have an older population - taxing them out of their homes is not going to help our fiscal situation.
But CF, that is why this is so interesting.

Given that Euro membership has never carried any formal governmental guarantee, as Greece's spending got ever more out of control creditors should have been concerned about risk and should have been requiring higher interest rates.

Now I grant you that they didn't, but what was the reason behind this? First, the news that Greece misrepresented its fiscal situation on initiation is old news, so I don't think that the last bit of fiscal shell Greek games really came as much of a surprise to creditors.

Further, it is true that a Euro country cannot simply destroy debt by inflation, a la various South American paradises. Nonetheless, there is no bar to them simply repudiating the debt and leaving their creditors with a weak bargaining position.

If you mean to imply by use of the word "subprime" that this appears to have been a mutual financial agreement to underprice risk for profit, I agree.
Anon - one of the oddest things about this situation is that the northern countries, including Germany, have a very strong public tradition of honesty in business and in government. Why such peoples would agree to fund the lying of a state like Greece is a question indeed.

Further, the public tradition of honesty has forced the citizens of these countries to live with a certain degree of austerity. Why they would increase that austerity to fund larger benefits and earlier retirements for Greek citizens is another burning question.

The only entities which have an interest in this are either countries that have built up significant debt loads, or larger banks which own the debt, and thus might try to get their governments to ameliorate the situation. Also apparently American professors, but we can leave them thankfully aside. Europe will settle its own issues.

All that I have read in the European press tells me that the average European will not stand for it, and if their governments try to go that route, the response of their electorates will make the American tea parties look like a church social. Not that the American tea parties are at all frightening - they look more like PTA meetings than anything else. But the northern Europeans were furious about bailing out their OWN banks due to the corruption and irresponsibility they perceived. I cannot believe they'll be able to swallow funding a government that won't even keep its books straight.
I guess these public sector Greeks don't see why they aren't entitled to the same retirement benefits as Uncle Georgios of the NYPD.
MOM- You need to verify this as I'm not 100% sure, but I believe the ECB was required to take GGB's (AKA Greek Gov't Bonds) with a maturity less than 3 years in as collateral for their open market operations- Ergo; Guarantee.
But the northern Europeans were furious about bailing out their OWN banks due to the corruption and irresponsibility they perceived. I cannot believe they'll be able to swallow funding a government that won't even keep its books straight.

Is there a chance that if Greece is bailed out that some Northern European countries simply leave the EU?

All the market opinions I've read over the last year, until last week, stated flat-out that they assumed there was an implied EU guarantee of Greece's debt. All of a sudden, when the used comestibles meet the HVAC, it turns out that's not true.

It's the same situation as Fannie and Freddie--all the "informed opinion" was that Congress stood ready to guarantee the agency CDO's, right up until it was time to step up to the plate.
CF - unless I have slipped a mental cog, which is very possible because I have spent yet another day chipping ice and shoveling snow, the rules were changed in 2008 so that the ECB could take sovereign bonds BBB and up as collateral. It cannot buy them by law. Before I think it was A-. That was supposed to end in a year, but was extended through to 2010. I have no doubt that banks cheerfully dumped them on ECB, but ECB also has the right to downgrade its percentage, etc. In my view ECB should have taken action when Greece sold the 3-mo bonds in January. There is a a larger issue here.

I want to blog on that paper I linked, which I think takes a better look at the problem. It is more total debt (public and private) than anything else.

What's more an issue is why Greece's bonds have the rating they have, but that's not an EU problem.

I'll search for the information.

Neil - without an explicit legal guarantee, there is no guarantee. Even with a guarantee, it only means a backing to the quality of the guarantor.

Charles - no, but remember, not every EU country is on the Euro. For example, Sweden is still on the kronor, UK on the pound, Switzerland on Swiss dollars, Poland on the zloty, and the Czech Republic on the koruna.
M_O_M, I agree that the "guarantees", in retrospect, were no good. However, in both cases the people who were claiming the debt was, in fact, guaranteed were very well-connected folks in a position to know what the elites of the U.S. and EU were planning. Which is to say, the elites expected to bail out the debt all along. Right up until the day it became necessary. That's how all this debt piled up--the lenders planned to get paid back out of tax revenue.

They just didn't realize that when Judgment Day came, the politicians would value their constituents' opinions more than their well-connected buddies. Which surprised the heck out of me, too.
Neil, see the paper. As these things go, it is not bad reading.

The paper is dated July 2009, and I quote:
Apparently in order to calm the markets, German Finance Minister Peer Steinbrueck publicly suggested in February, that in the case of a crisis, EMU partners would step in to bail out any euro-zone member threatened by a payment crisis. This is a reversal of the previous interpretation of the so-called "no-bailout" clause in Article 103 of the EC Treaty; up to the year 2008, it was repeatedly emphasized that in the European Monetary Union, every country bears sole responsibility for its own debts.
A good read and analysis MOM. Though I think the hole Greece dug for itself was made primarily made possible by the rules operating within the Eurozone. What the UK's excuse is I cannot say!
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