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.


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