Category: Uncategorized

Here is Willem Buiter, trying to make a case that the euro will survive.  It’s an interesting piece, but in contrast I have focused my attention on two issues:

1. In my view, the survival of the eurozone is not simply a matter of adding up the current solvency deficits and comparing them to the available quantity of aid.  Rather I see the aid recipients as leaky vessels.  Pumping more money into those countries won’t recapitalize their banking systems.  In fact, once leaving the euro is seen as an option, those banking systems will systematically lose both deposits and capital.  Depositors are afraid to wake up one morning and have lost their euros.  The banks in those countries can’t ever be sound, at least not until something gives.

Imagine if the FDIC weakened or eliminated its deposit guarantees to regional banks, once those regions started experiencing some economic troubles.  That’s the parallel situation in Europe.  If sovereign debt isn’t secure, how can the guarantees of those sovereign states to their banking systems be secure?  And then why should non-guaranteed banking systems recover?

2. The best shot at patchwork regulation is to introduce a common resolution authority and a common bank deposit guarantee mechanism for the eurozone; Buiter discusses a related option.  But ultimately that leads to full fiscal union or at least a eurobond.  If you guarantee all of a country’s banking deposits, you are creating/guaranteeing a riskless security for that country.  In the limiting case, imagine the government itself opening a bank and suddenly having guaranteed liabilities.  You may or may not favor eurobonds and fiscal union, but I feel on safe ground predicting that they won’t happen.  Nothing in the partial bailouts up until now has led me to change or weaken that opinion.

I do not so much see people denying #1 or #2, but I also do not see them starting with these as the main problems to solve.  And thus I am more pessimistic than they are.  But I am pessimistic about the survival of the full eurozone, which is not the same as being pessimistic about Europe.  By the way, the latest news update is here and it isn’t good.

Paul Krugman has an intemperate polemic against Alan Greenspan, for instance:

It’s terrible on all counts; but the most offensive thing intellectually is the incredible fallacy of claiming that higher capital requirements for banks amount to keeping resources idle…the man once revered as a demigod of finance doesn’t understand basic economics — or, more likely, that he chooses not to understand what he, amazingly, is still being paid to not understand.

There is no mention of the actual literature on this topic.  Here is one summary of some common views:

Hall (1993) presents evidence that from 1990 to 1992 American banks have reduced their loans by approximately $150 billion, and argues that it was largely due to the introduction of the new risk-based capital guidelines. He goes even so far as to say that “To the extent that a “credit crunch” has weakened economic activity since 1990, Basle-induced declines in lending may have been a major cause of this credit crunch.” Hence, it is not an overstatement to say that Basel I did have an impact on bank behavior as it forced them to hold higher capital ratios than it otherwise would have been the case.

It is a common belief, though by no means universally held, that the implementation of Basel meant a slower U.S. recovery from the recession of the early 1990s.  Here is a summary of some of the international evidence, plus there is a general literature survey in the first few pages at that link; see for instance Peek and Rosengren (the term “capital crunch” will help in Google searches).  Perhaps the literature on the early 1990s may not apply today, but Greenspan’s claim is not incoherent a priori.  Furthermore the Greenspan piece links to an FT piece which a) is consistent with his general account, and b) shows various Europeans, not all of whom are bankers, sharing the same worry for today, and c) makes it clear Greenspan is not committing the “Junker fallacy” of confusing paper holdings with real resource destructions.  The negative effects come through a tax on financial intermediation.  Maybe just maybe one could criticize Greenspan for not being clear enough on the mechanism, but he is still right on the comparative statics and certainly not spouting nonsense.

At the theoretical level, papers on Modigliani-Miller deviations, and the interrelation between production and finance, also make Greenspan’s argument acceptable, if not necessarily correct; one can even look to Joe Stiglitz here.  Krugman admits that capital requirements lower bank risk-taking but of course that can lead to less lending and, in many future world-states, lower output.  That may well be a good thing, since it lowers systemic risk and thus helps output in some world states, but it’s wrong to deny the significant possibility of a real opportunity cost.

Also, bank capital requirements are not well understood in terms of a pure Modigliani-Miller debt-equity swap.  For one thing, the capital requirements favor some asset classes over others, and arguably in a way which limits expected growth.  The capital requirements also involve a commitment to particular accounting standards.

On matters of policy, I do in principle favor significant increases in capital requirements for banks.  But should we push to impose those tougher requirements today in such a weak economy?  Perhaps Krugman would be eager but I’m not so sure.  For all his worries about repeating the mistakes of 1937-8, Krugman doesn’t seem to recognize this may well be another step down that path.

How should we revise structural interpretations of unemployment in light of the new gdp revisions?  (For summaries, here are a few economists’ reactions to the report.)  Just to review briefly, I find the most plausible structural interpretations of the recent downturn to be based in the “we thought we were wealthier than we were” mechanism, leading to excess enthusiasm, excess leverage, and an eventual series of painful contractions, both AS and AD-driven, to correct the previous mistakes.  I view this hypothesis as the intersection of Fischer Black, Hyman Minsky, and Michael Mandel.

A key result of the new numbers is that we had been overestimating productivity growth during a period when it actually was feeble.  That is not only consistent with this structural view but it plays right into it:  the high productivity growth of 2007-2009 now turns out to be an illusion and indeed the structural story all along was suggesting we all had illusions about the ongoing rate of productivity growth.  As of even a mere few days ago, some of those illusions were still up and running (are they all gone now?  I doubt it.)

On one specific, it is quite possible that the new numbers diminish the relevance of the zero marginal product (ZMP) worker story.  The ZMP worker story tries to match the old data, which showed a lot of layoffs and skyrocketing per hour labor productivity in the very same or immediately succeeding quarters.  Those numbers, taken literally, imply that the laid off workers were either producing very little to begin with or they were producing for the more distant future, a’la the Garett Jones hypothesis.  The new gdp numbers will imply less of a boom in per hour labor productivity in the period when people are fired in great numbers, though I would be surprised if the final adjustments made this initially stark effect go away.  BLS estimates from June 2011 still show quite a strong ZMP effect, although you can argue the final numbers for that series are not yet in.  (I don’t see the relevant quarterly adjustments for per hour labor productivity in the new report, which comes from Commerce, not the BLS.)  Furthermore there is plenty of evidence that the unemployed face “discrimination” when trying to find a new job.  Finally, the strange and indeed relatively new countercyclicality of labor productivity also occurred in the last two recessions and it survived various rounds of data revisions.  It would be premature — in the extreme — to conclude we’ve simply had normal labor market behavior in this last recession.  That’s unlikely to prove the result.

Most generally, the ZMP hypothesis tries to rationalize an otherwise embarrassing fact for the structural hypothesis, namely high measured per hour labor productivity in recent crunch periods.  If somehow that measure were diminished, that helps the structural story, though it would make ZMP less necessary as an auxiliary hypothesis, some would say fudge.

Other parts of the structural story find ready support in the revisions.  Real wealth has fallen and so consumers have much less interest in wealth-elastic goods and services.  This shows up most visibly in state and local government employment, which has fallen sharply since the beginning of the recession.  Rightly or wrongly, consumers/voters view paying for these jobs as a luxury and so their number has been shrinking.  Construction employment is another structural issue, and given the negative wealth effect, and the disruption of previously secure plans, there is no reason to expect excess labor demand in many sectors.

In the new report “profits before tax” are revised upward for each year.  That further supports the idea of a whammy falling disproportionately on labor and the elimination of some very low product laborers.

Measured real rates of return remain negative, which is very much consistent with a structural story.  Multi-factor productivity remains miserably low.  In my view, a slow recovery was in the cards all along.  Finally, you shouldn’t take any of this to deny the joint significance of AD problems; AS and AD problems have very much compounded each other.

There is a mother and a daughter, and the mother wants the daughter to clean her room.  Cleaning the room doesn’t take long, but it does involve the daughter getting out of bed at some positive cost.

The mother can come and threaten to beat the daughter with a broomstick.  That will induce a rapid-enough cleaning (or a good enough start), but the mother would prefer to achieve the end of a clean room without such drastic measures.  That said, the mother will wield the broomstick if that is the only means of getting the room cleaned.  The daughter has a slight preference not to be threatened with the broomstick, ceteris paribus.

Time passes and for a while nothing happens.  What is the equilibrium?

By construction of the example, I’ve ruled out “the mother comes with the broomstick right away” and “the daughter cleans up the room right away.”  So it cannot be common knowledge who will yield first; if it were common knowledge, the cleaning with or without broomstick threat already would have occurred.

The daughter is Congress.  The mother is an anthromorphized set of bond and equity markets.

Under EMH, the next move of “the mother: is generally unpredictable, including by the daughter.  And if the daughter cannot predict her mother’s behavior, what should the mother infer about the daughter’s future behavior?

Does common knowledge arrive?  Does a trembling hand eventually force an outcome?  Which variable is affected by the mere passage of time?  Does it depend on differential discount rates?

There are other ways to think about this.