Lessons from the euro crisis, part II

Resilience and robustness, resilience and robustness, repeat three times after me.

Less than two years ago, it was a common meme that “Italy can handle all this debt, so can we.”  And now suddenly they can’t.  It is correct to point out that currency mismatch is a serious issue for Italy (though massive debt, inefficiency, and twelve years of no growth don’t help either!), but there are two points here.

First, it would be odd to argue that the importance of currency mismatch was misunderstood.  Everyone has known about this factor for many years.  The more plausible explanation is that the speed of fiscal collapse, and bond market adjustment, was underrated.

Second, let’s say the importance of currency mismatch had been underrated.  Is it so convincing to proclaim “don’t worry, we won’t make that mistake again”?  When currency mismatch is gone, is everything really OK?

What if we are misunderstanding something else about the current U.S. situation, just as previously the Italian situation had been misunderstood?  Ever look at those Obama administration growth projections?  Are they factoring in a partial collapse of the eurozone?  The possibility of another “lost decade”?  I don’t think so.  Would a new Republican administration respect the need for medium-term fiscal balance?  What if some “black swan” event hits?

And so on.

It remains the case that:

1. Short-term fiscal cuts usually hurt your gdp in the short-term and that can be disastrous.  (It also may hurt social goals, since the cuts are not usually well targeted, for public choice reasons; has EU ag. spending gone down much?)  It hasn’t worked for Greece for instance.  The Keynesians have an absolutely essential point here and we ignore it at our peril.  Still,

2. At some point, for most Western countries, those cuts will have to come,

3. Politicians don’t seem very willing to make those cuts in advance so you can’t count on technocratic fine-tuning, and

4. No individual should have such a firm or confident sense about the appropriate timing of such cuts.  If nothing else, we don’t know when future cuts will be possible.  And we don’t know when the bond market vigilantes will appear, just as we did not know for Italy.

The “pretense of knowledge” I have seen in these discussions is staggering.  Roubini forecast the Italian crisis in 2006 (bravo to him), but overall how many people on the left were so wise to be calling for such Italian spending cuts in 2005, when the country had relatively low bond yields?  How many, say in 2009, even ran the line of “It’s too late now, because of the Keynesian downward spiral problem, but they should have cut spending in 2006”?  For that matter, are there 2011 left-leaning Keynesians insisting Italy should have cut spending radically in 2006, if only for reasons of resiliency and robustness?  (Or is the preference to criticize German views on central banking and remain rather silent on Italian fiscal reforms?)

James Hamilton makes an essential point:

A year ago, the Italian government was able to issue 10-year bonds with an interest cost below 3.8%. Some might have argued that those low rates were a signal from the market that there was not much chance of Italy following Greece down the drain. At a visit to UCSD a few weeks ago, University of Maryland Professor Carmen Reinhart was asked whether that’s a correct inference to draw from a low government borrowing cost. Emphatically not, she said: “Yes, yields are low– until they’re not.” Historically, the changes can come pretty quickly, as the Italians discovered last week.

The correct response to the Italian situation is: “We didn’t think it could get so bad so quickly.  We will take this as a sobering lesson more generally.”

That is not the response I have been seeing.  There is too much at stake for us to take comfort in our own supposed abilities to foresee the future.


As Minsky understood and ecologists and biologists have found out in many instances, an extended period of stability by itself itself leads to a loss of resilience. The real problem isn’t so much that spreads have blown out but that they have blown out after a prolonged period of stability - a stability that was artificially enforced by the perverse structural nature of the Euro project - http://www.macroresilience.com/2011/11/14/the-euro-and-the-resilience-stability-tradeoff/ .

Any economists in the US still remember the "Great Moderation?" I really felt for the job market PhD candidates who showed up at my work in the winter of 2008 and (even worse) 2009 to present dissertation papers related to this "phenomena." Didn't see a single one in this year's crop of candidates.

Yes, the Great Moderation lasted from approximately 1983, when OPEC threw in the towel on trying to sustain oil prices, until 2005, when excess oil production capacity was consumed and oil supply growth stalled.

In 1983, four years of high oil prices had created spare oil production capacity equal to 25% of total consumption. It took nearly a generation of low oil prices to work this off. At present, it's highly questionable whether there's really any spare capacity at all. So six years of high oil prices have led to, well, pretty much no spare capacity. Maybe the Saudis have 1-2 mbpd (1-3% of global consumption), but even that's not a certainty.

So much for EMH.

EMH requires a free market.
There is no free market in currency. Its completely controlled by the government.

It amuses me when people point to government monopoly failures and say, "well obviously this means capitalism/EMH/free_market doesn't work." Its an incredibly common nonsequitor.

I thought the problem with the euro was that there is a free market: people are free to sell off their euro denominated assets and the bank run causes it to collapse.

I think the criticism of the EMH here is that the right price for Italian euro denominated debt could suddenly change by a large amount very quickly: the market price is not necessarily anywhere near the right price because even the wisdom of crowds can't predict the future very well (per Cowen's statement about predictions) and is subject to large corrections.

I think a similar thing can be seen in prediction markets. A price shows the chance candidate X will win, but the prices seem to randomly fluctuate and then only at the end of the market rapidly converge to reality (even if that reality is the opposite of what that prediction market was saying all along). Effectively it seems like there is zero information in a market while it is being traded.

Political prediction markets, like point spreads in football, reflect the conventional wisdom and nothing more.

Is not the same thing true for bond markets? Isn't conventional wisdom fairly critical for price discovery?

Markets tend to be extrapolations (looking from the present forward) rather than forecasts (looking from the future backward). They don't tend so see turning points.

EMH is just says that the market is the most right wrong answer. Consider - even favorites don't win all the races, but over time you will expect favorites to win most races (otherwise the bookmakers would be out of business). Another example - the market value of a quoted business includes very low chance of their main factory being struck by a meteor, so the discount applied to the business's expected cash flow is small. The factory is then struck by a meteor and the value of the business falls to zero. Was the market or EMH wrong in applying a small discount prior to the impact? You have to be very careful in analyzing predictions posterior and anterior.

In the particular case of European debt, in the past the market was clearly ascribing a high probability of German bail out, as shown by convergence of debt prices after monetary union. It seems that the current probability is a lot lower than this.

Or rather: the bond markets didn't know any better than the economists this time.

Dr. Cowen, you have been pretty hard on the Tea Party in the past. Does this mean that you now think that they have been right? Or at least more right than you used to think?

I'm not sure how you got there from the statement that "short term fiscal cuts ... can be disastrous."

I'm not sure what Tyler is saying. He says it's disastrous to cut now - but it's disastrous to wait because nobody's smart enough to know when it's not too late... which to me is an argument for cutting now.

Has there ever been a case of a government introducing significant austerity measures in good times? Isn't that basically the whole problem with applying Keynesian stimulus?

Its only one of the myriad of problems.

Weren't there some large tax cuts put in place during a "recent" period of balanced budgets (even surpluses)? I don't recalled those cuts being promoted by Keynesians...there is always more than enough blame to go around.

Yes to the second point, no to the first. There's plenty of blame, but the tax cuts in 2001 and 2003 came during a recession and then a weak recovery. Surely Keynesians weren't promoting budget surpluses during a recession.

I do recall reading at the time (I think it was Keynesians I was reading) that tax cuts are an inefficient stimulus, and that you get more bang for your government-borrowed dollar from traditional spending, either extending unemployment benefits, or the sort of spending that hires people to work on "stuff".

Back in 2001 surpluses were going to be used to pay down the deficit, but the Bush administration used Greenspan's testimony against doing that as an argument for tax cuts.

Sorry, I meant debt, not deficit.

Thomas, there was an acceleration of tax cuts in both 2001 and 2003 that was marketed as stimulus...however, the overall tax cuts were primarily non cyclical policies. Ten-year tax cuts are generally not used to fight recessions.

Tax cuts, unless accompanied by more-than-offsetting base broadening reforms, don't strike me as an austerity measure. Rather the opposite. Out of curiousity, why therefore are you mentioning this case in response to my question?

The GOP and moderate Dems combined to do so in the 1990s, in the wake of the fall of Communism. They both cut defense and reined in spending increases.

But it's a good point, responsible spending is a hard sell even in relatively good times. I doubt many remember today just how contentious that fight was even in the boom times of the 1990s. The GOP was constantly accused of throwing poor women and children into the streets to die (as you can see, some things haven't changed much!) and a lot of Dems felt betrayed by Clinton's finally accepting welfare reform after some initial vetoes.

They also raised taxes, or rather the Democrats did, over predictions of disaster by the right. Turned out OK, as I recall.

In fact, I'm rather surprised to see a post on fiscal isues that contains neither the word "taxes" nor "revenues."

We don't have a revenue problem, we have a spending problem.


Primarily, we have an incentive problem.

Good point, thanks. I'm not American, so that didn't naturally spring to mind. Maybe an outcome of the US's checks-and-balances system.

+1, The budget cuts of the early 90's were my first thought also.

A good point: perhaps it should be called Semikeynesian economics because half is the most that's ever attempted.

Correct. For Keynesianism to work on a sustainable basis, there need to be large surpluses in the good years to support the large deficits in the bad years. Instead, we have had small surpluses or deficits in the good years, which were a pale shadow of the deficits incurred in the bad years. (The only significant exception in the past 50 years was from 1998-2001, but that was a happy accident rather than Keynesian economics.) In real life we have achieved "Asymmterical Keynesianism" which has resulted in vast public debts that may lead to an unimaginably difficult crisis.


I wonder how the fact that the US has its own currnecy factors into this. Countries in which the Central bank declares its intention to be a LOLR, something that I believe the Fed is willing to do, should make a fairly significant difference. At least it should mitigate the problems presented by 'vigilantes'.

“The correct response to the Italian situation is: “We didn’t think it could get so bad so quickly.  We will take this as a sobering lesson more generally.””

But, Tyler, isn’t the implied point of the book by Reinhart and Rogoff (This Time Is Different) to show the micro lessons do not get learnt... ever? As you suggest, currency mismatch may have nothing to do with *that* in the final analysis. The too little too late levers don’t ever get pulled. All the more reason in my view to escape the engineering perspective of Keynesian theory and return to classical ‘system analysis’ of capitalism in which debt sustainability is just one part of a larger package of logics about the realistic scope of governance in modern economies. Funnily enough, some simple commonsense logics on the left-right continuum (tea party adjustment style) happily coincide with the more complex ones about resilience and robustness to risk.

As for Krugman, he is floundering in the flood water, just ignore him.

Dr.Cowen, your post is great and honest. My answer is yes, you (americans) are misunderstanding something. i am not an economist but my economics 101 says that a country with 10 pct deficit and a total debt that will be too high in a couple of years is not sustanable expecially if you consider that after an important devaluation against some major economic partners (europe, japan, Canada just to mention) the Us current account is still deeply in red (by the way, european current account is basically positive). It is just a matter of when, not if, the financial markets will aggressely move to Usa.

It hurts to see so much cut down in irrational complexity, that could be saved. But how often are people able to save what is good when the bad overwhelms it?

I would say that the big warning sign for the US should be that policy paralysis can have terrible consequences. Any number of solutions could be made to work if somebody was truely in charge at the EU level. Instead decisions must be made unanimously, and this results in no decision.

Simiilarly, both Republicans and Democrats could "fix the budget" if they were in a position to impose their policy preference (as, say, the prime minister of Canada is able to). But neither can because the opposition has simply too much power in the American system. Get rid of the filibuster before it's too late!

Policy paralysis does not seem to play well with the American people or firms...the economy could use less not more uncertainty right now. Europe is not helping, but we don't need to look overseas to find problems.

How appropriate a comment on the weekend the supercommittee is deadlocked because of taxes.

The Democrats had 60 Senate votes, the WH, and the House. Remind me what happened again?

Oh, wait, I remember -- they passed a new trillion-dollar entitlement that made the problems even worse.

Only one side of the political aisle is actually going to fix the problem.

Here's a fact checker comment to your claim. http://www.washingtonpost.com/blogs/fact-checker/post/obamacare-and-the-myth-of-rising-cost-estimates/2011/03/24/ABn6JmRB_blog.html

Unlike Part D, there is revenue associated with this, and, unless you do not have a sense of double entry bookkeeping, to the extent my private insurance costs go down because freeriders are not showing up at the emergency room, I am probably better off on net with people paying for some of their care and being managed, unless you can show me that, contrary to Ron Paul, we let people die in the street rather than treat them in the hospital.

I hope you aren't actually stupid enough to believe that drivel. Everyone who followed the debate knows the numbers were gamed for the ten-year window.

And no, there are no savings from emergency room visits. This is perhaps the most asinine of all the terrible arguments for Obamacare -- those people don't have any money. They are going to get free health care one way or another, and subsidizing them is only going to increase their costs.

Also, your link is basically irrelevant to my point anyway, since it only deals with changes in the estimates since Obamacare was passed, and not the long-term fiscal picture, which was terrible even when Obamacare was passed.

The entire Obamacare will be fiscally neutral argument has fallen apart. The PPACA bill was gamed to appear fiscally neutral for the 10 year window scored by the CBO. Now that we are 18 months past that window the cracks are showing.

Most recently:
"10/14/2011 - The Obama administration Friday pulled the plug on a major program in the president’s signature health overhaul law — a long-term care insurance plan dogged from the beginning by doubts over its financial solvency.

The demise of CLASS immediately touched off speculation about its impact on the federal budget. Although no premiums are likely to be collected, the program still counts as reducing the federal deficit by about $80 billion over the next ten years. That’s because of a rule that would have required workers to pay in for at least five years before they could collect any benefits.

The whole point of the 'CLASS' was to be able to credit an extra $80 billion to Obamacare's bottom line for the 10 year window. The program was structured in such a way that it would show up as a positive in that time span, even though the program itself was bound to be a huge expense in the long run. The Obama administration set up the CLASS program to start collecting premiums in 5 years, but not pay out any expenses until 10 years out. It's a clear cut example of gaming the CBO scoring system.

Also, budgets can't be filibustered anyway.

If anything, we need an even more powerful filibuster, something that would require a 2/3 majority for new spending.

TallDave, as you surely know, unified government in the US is in fact quite rare, and even when that happens there are many, many people who are able to block things from happening (think joe lieberman). the filibuster is only one of the ways this can happen.

in the current situation, the people who would need to agree for something to happen are locked in a zero-sum battle for power. So, nothing happens.

of course, admitting that this is a problem would imply admitting that perhaps the american system of governement is not perfectly designed, and i suspect this sounds like blasphemy to you.

The flaw is your assumption that the ability to block things more of an impediment to solvng our fiscal problems than an impediment to making them worse. The one time we had filibuster-proof gov't in the last few decades, the party in power immediately made things much worse. Somewhat weaker Republican control from 2000-2006 also saw spending rise irresponsibly.

Note that we DID achieve fiscal responsibility in the 1990s -- with divided gov't.

The problem with the U.S. system of government is that it is too easy to get things done, not that it is too hard.

Simiilarly, both Republicans and Democrats could “fix the budget” if they were in a position to impose their policy preference (as, say, the prime minister of Canada is able to). But neither can because the opposition has simply too much power in the American system. Get rid of the filibuster before it’s too late!

Neither party wants to. They both know they'd be severely punished by the voters for doing the responsible thing. Not worth it to them.

I think some credit should go to those who thought currency union without fiscal union was flawed from inception. No one who has their debts denominated in their own currency is in anywhere near as much trouble as Italy or Greece. The opinions there primarily centered around the idea that fiscal union would be forced, but the human ability to ride the warhead to the ground is astounding. That is the real surprise.

However I think the root of these problems is a complete failure for people to admit they were wrong, which shouldn't have been a surprise.

This is why you see the guys who profited during the crisis, the hedge fund managers such as Bass and Hendry; the out-of-the-mainstream economists, from right-wing/libertarian Austrian school followers over to Steve Keen on the left, have not really changed their tune. And yet, these guys are still sitting on the outside, occasionally brought in to be harangued (such as the latest BBC interview with Bass) because this is a much bigger story about institutions, cycles of history, failed theories and assumptions taught to every student. Guys who are putting their money on the line in financial markets are spending a lot of energy trying to figure out if gold is going to 5000, 10000, or 40000 an ounce, but government/keynesian economists laugh at it. These investors don't see any improvement and they see far more landmines, with Japan the mother of them all. The U.S. will be the last to go, but who can predict the speed of the crisis?

And how about puppet governments in Italy and Greece? I just throw up my hands and laugh.

Hummm...... The guys who profited? Pls look @ the performances of that guys. And, as an italian, I Hope Mr. Monti will be a "puppet" like Mr. Ciampi, the other technocrat governament that we had 17een years ago. Don't underestimate people like Monti in italy

Tyler's bringing out his inner Russ Roberts.

The correct response to the Italian situation is: “We didn’t think it could get so bad so quickly. We will take this as a sobering lesson more generally.” That is not the response I have been seeing. There is too much at stake for us to take comfort in our own supposed abilities to foresee the future.

That reminds me of Megan, the other day: When things blew up, we didn't say to ourselves, "maybe it's not possible to engineer a low-risk 6% annual return on assets" or "maybe it's not possible for everyone a demographically mature population to expect to spend as much time out of the workforce as in it."* Instead, we search for the fault in the system: were pension fund managers too incompetent? Bankers too greedy and clever about searching for loopholes? Regulators too lax? Did we write the rules governing bank risk capital wrong?

And, of course, for the most part we still aren't asking those questions, because they're painful to contemplate.

This post is just an exercise in hind-sight punditry--pulling a long face cluck-clucking, trying to look wise *after the fact*.

"James Hamilton makes an essential point: . . . 'Historically, the changes [in interest rates, and market predictions in general)] can come pretty quickly, as the Italians discovered last week'." Changes can happen quickly--what an insight!

High-profile economists on the Left such as deLong and Krugman have been arguing that the US should add aggressively to its debt in the short term in order to alleviate unemploymen, based on the fact that current bond yields are low. This view is premised on the idea that changes in the bond market do not happen quickly. So, unfortunately, it is important to make the contrary point that bond markets are unpredictable for countries with substantial and growing debt-gdp ratios, even though you rightly identify it as a truism.

@matt: thanks a lot for explaining the context. it may be a little dumb to repeat ideas, but sometimes it is mandatory. =)

Without alien space bats to enforce discipline, ANY sort of government will be prone to these sorts of issues - because anything real depends on keeping some set of people happy.

You could impose rules that required people to vote on what level of taxes they would PAY, and then severely constrain government to abide by that - but then other things would explode on a regular basis.

And by the way Philo - I've seen some lines of commentary like this going on for years, and Rogoff and Reinhart's book was first published *before* the 2008 debacle. So it's not all "hind-sight" punditry. Some of it is a dialog like this:

Q:"Can't our society be more disciplined and realistic in its behavoir?"
A:"No, it is not the nature of humans to do that."

So I predict right now that in the US total disaster will be narrowly averted, with avoidable partial disaster an ongoing essential feature of what happens. I predict this to continue into the indefinite future.

Carmen's exactly right. But I don't get the comment about currency mismatch.

Another reason much of the discussion of this matter is incoherent in the extreme is a fact not mentioned by anybody on this thread so far, including Tyler. Italy is one of only four eurozone countries running a primary surplus, the others being Luxembourg, Belgium, and Germany. While it and Belgium have high debt/GDP ratios, it also has the highest percent of its debt domestically held, the famous high Italian savings rate that was supposed to prove Ricardian equivalence correct.

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