Unfair, But Hilarious

The First Step Toward a Euro Treasury?

So the Eurozone is getting its $ 1 trillion "shock and awe" rescue package and markets are responding with enthusiasm. There has been a lot of discussion about this package, but one potential implication of this plan that has received little attention is that it may put in motion the beginnings of a Euro treasury market. Among other things, the plan calls for the creation of special purpose vehicle that will be able to raise up to $440 billion by issuing debt backed by the Eurozone countries. This description sounds to me a lot like a centralized fiscal authority for the Eurozone. Yes, it has been given only a three-year life, but once folks see that this entity is essentially a Eurozone Treasury it could morph into something more permanent--especially if it plays a key role in preserving the monetary union. And if that happens, a Euro treasury market will emerge that could provide stiff competition to the U.S. treasury market. Moreover, should there arise a Euro Treasury then the Eurozone will have eliminated a key barrier that prevents it from being an optimal currency area.

Update: Ambrose Evans-Pritchard sees the same implications:

[T]he accord profoundly alters the character of the European Union. The walls of fiscal and economic sovereignty are being breached. The creation of an EU rescue mechanism with powers to issue bonds with Europe's AAA rating to help eurozone states in trouble -- apparently €60bn, with a separate facility that may be able to lever up to €500bn -- is to go far beyond the Lisbon Treaty. This new agency is an EU Treasury in all but name, managing an EU fiscal union where liabilities become shared. A European state is being created before our eyes.

Krugman, Mankiw, and the U.S. as an OCA

Paul Krugman has an interesting column today where explains the Greece and Eurozone crisis from the optimal currency area (OCA) framework. Greg Mankiw also likes the OCA framework, but takes issue with Krugman's emphasis on the lack of a centralized fiscal authority as the key reason why the Eurozone is a mess:

A large part of [Krugman's] argument is that Europe is not an optimal currency area because it lacks a large central government enacting transfer payments among the various regions... Is that right? I am not so sure. The United States in the 19th century had a common currency, but it did not have a large, centralized fiscal authority. The federal government was much smaller than it is today. In some ways, the U.S. then looks like Europe today. Yet the common currency among the states worked out fine.

Mankiw attributes the success of the U.S. currency union in the 19th century to wage flexibility and labor mobility. He notes, though, that Greece and much of the Eurozone lack these and thus the Euro experiment may be doomed. I agree with Mankiw that the Eurozone problems are more than just the lack of a centralized fiscal authority. As I have shown before, members of a currency union should (1) share similar business cycles or (2) have in place some combination of economic shock absorbers including flexible wages and prices, factor mobility, fiscal transfers, and diversified economies. Having similar business cycles among the members of a currency union means a common monetary policy, which targets the aggregate business cycle, will be stabilizing for all regions. If, however, there are dissimilar business cycles among the regions then a common monetary policy will be destabilizing—it will be either too stimulative or too tight—for regions unless they have in place some of the economic shock absorbers. Here is how I represented this understanding graphically:

Using this framework I showed that Greece lies inside the OCA boundary. That is, there is not enough of either business cycle similarity or shock absorbers in Greece to justify the cost of its membership in the Eurozone. This is the point Mankiw is making--a number of factors not just lack of meaningful fiscal transfers is why Greece and other countries in the Eurozone may abandon the Euro.

Mankiw's claim, however, that the U.S. currency was an optimal currency area in the 19th century is less convincing. In terms of labor mobility, Gavin Wright has shown that South was an almost entirely separate labor market up until the 1930s-1940s. There was very little labor movement going into and out of the South up until New Deal programs and World War II spending opened up the region. Thus, the cost of the South's membership in the U.S. currency union may have exceeded the benefit up until the latter half of the 20th century. Interestingly, Hugh Rockoff makes the case the U.S. economy did not become an OCA until the 1930s!

I will go one further in this debate. It is not clear to me even now that all of the United States is an OCA. Do we really think Michigan and Texas over the past decade or so benefited from the same monetary policy? And do we think both states had an adequate amount of economic shock absorbers? Given the vast differences between these two states in their business cycles, diversification of industry, union influence, and wage stickiness it easy to wonder whether these states should belong to the same currency union. Yes, they have access to fiscal transfers, labor mobility is great (I myself left a job in Michigan for this one in Texas), culturally they are similar, and politically there is will for the dollar union. Still, given the disparate impact of U.S. monetary policy on different regions of the country one does wonder whether all the United States is truly an OCA.

Update: See Ryan Avent, Paul Krugman, JJ Rosa, and Urbanomics for replies to this post.

The Latest Fed Smackdowns

Here are the latest critiques of Fed policy in the early-to-mid 2000s. First up is Roger Lowenstein:

[A]s it still does today, the Fed continued to concentrate on inflation in consumer goods such as cars and computers while all but ignoring speculation in investment assets.

By focusing so zealously on inflation, the Federal Reserve is essentially fighting the last war. The United States' most recent bout of serious inflation occurred in the 1970s and early '80s; in response, then-Fed Chairman Paul Volcker moved aggressively to raise rates in order to curb prices. Since then, asset bubbles have been inflating and popping ever more often.

Excesses that in the past would have produced inflation now cycle back into the economy through the financial markets.

It sounds like Lowenstein has been reading some of William White's work, maybe even his classic "Is Price Stability Enough?" My own answer to White's question is no, price stability is not enough. As I have said before, the Fed's focus should not be on stabilizing inflation but on stabilizing aggregate demand. Given current institutional arrangements, I would also like to see some form of macroprudential policies implemented as well. After all, the period of the Great Moderation was one with relatively stable aggregate demand growth but still experienced unsustainable expansions of credit and debt.

Next up is Barry Ritholtz. I am not sure what motivated this outburst today at the Big Picture, but I liked it:

I Direct Your Attention, Mr. Fed Chairman, to Exhibits 1 through 10:

1. Ultra low interest rates led to a scramble for yield by fund managers;

2. Not coincidentally, there was a massive push into subprime lending by unregulated NONBANKS who existed solely to sell these mortgages to securitizers;

3. Since they were writing mortgages for resale (and held them only briefly) these non-bank lenders collapsed their lending standards; this allowed them to write many more mortgages;

4. These poorly underwritten loans — essentially junk paper — was sold to Wall Street for securitization in huge numbers.

5. Massive ratings fraud of these securities by Fitch, Moody’s and S&P led to a rating of this junk as TripleAAA.

6. That investment grade rating of junk paper allowed those scrambling bond managers (see #1) to purchase higher yield paper that they would not otherwise have been able to.

7. Increased leverage of investment houses allowed a huge securitization manufacturing process; Some iBanks also purchased this paper in enormous numbers;

8. More leverage took place in the shadow derivatives market. That allowed firms like AIG to write $3 trillion in derivative exposure, much of it in mortgage and credit related areas.

9. Compensation packages in the financial sector were asymmetrical, where employees had huge upside but shareholders (and eventually taxpayers) had huge downside. This (logically) led to increasingly aggressive and risky activity.

10. Once home prices began to fall, all of the above fell apart.

I hate having to repeat myself, but it is apparently, necessary.

Well said Barry!

The Threat of Euro Contagion

Nelson D. Schwartz had a great piece in the New York Times a few days ago that showed how susceptible the entire Eurozone would be to a Greek default. Here are the key paragraphs:

The first domino is Greece. It owes nearly $10 billion to Portuguese banks, and with Portugal already falling two notches in S. & P.’s ratings and facing higher borrowing costs, a default by Greece would be a staggering blow. Portugal, in turn, owes $86 billion to banks in Spain; Spain’s debt was downgraded one notch last week.

The numbers quickly mount. Ireland is heavily indebted to Germany and Britain. The exposure of German banks to Spanish debt totals $238 billion, according to the Bank for International Settlements, while French banks hold another $220 billion. And Italy, whose finances are perennially shaky, is owed $31 billion by Spain and owes France $511 billion, or nearly 20 percent of the French gross domestic product.

“This is not a bailout of Greece,” said Eric Fine, who manages Van Eck G-175 Strategies, a hedge fund specializing in currencies and emerging market debt. “This is a bailout of the euro system.”

Read the rest of the article here and check out the cool graphic showing the debt linkages here.

Is the Fed's Long-Run Inflation Target 2.5%?

Karl Smith is thinking about inflation forecasts and directs us to the figure below. Here the daily nominal interest rate on 10 year treasury securities is graphed along with the daily real interest rate on 10-year Treasury inflation-protected securities (TIPS) :


Karl notes the difference between the two series is the bond market's 10-year forecast of inflation and currently it is about 2.5%. Interestingly, outside the financial crisis the forecast value is on average close to this 2.5% value. This can be seen more easily by plotting the difference between the two series as is done in this figure:


This caught my attention because if one goes and looks at the quarterly forecast for the average annual CPI inflation rate over the next 10 years in the Philadelphia Fed's Survey of Professional Forecasters the value is also around 2.5%. Here is the forecast data:

The similarity of inflation forecasts from the bond market and the survey is remarkable.* Even more remarkable is that this long-run value of 2.5% has persisted since the late 1990s and has not been seriously affected by the crisis. It suggests that this value is the Fed's long-run inflation target. As I have said before, the stability of this value attests to the Fed's inflation-fighting credibility. Bond markets, apparently, see no unanchoring of inflation in the future. Of course, this stability of the long-run inflation target also lends support to the view that the Fed was been too tight with monetary policy over the last year and half or so. And on the flip side such a rigid long-run inflation target may also present problems when there are sustained productivity gains.

Update: Peter N. Ireland sheds some light on the Fed's target inflation rate.

*Yes, there is a big difference between the two series during the financial crisis, but much of that may be due to the sharp rise in the liquidity premium on TIPS during this time. Also, the bond market data is daily while the survey is quarterly so some of the day-to-day variation is lost in averaging for the survey.

Greece: Deja Vu Argentia 2001-2002?

The $146 billion rescue package for Greece over the weekend has given some folks hope that Greece and the Eurozone more broadly will survive in their current form. For these folks, this is the needed "shock and awe" package that will save the day. But is it? Peter Boone and Simon Johnson argue that to save the Eurozone not only are funds needed for Greece but also for Italy, Portugal and Spain over a three-year period. They estimate that such a package at a minimum would be around $1 trillion. Other observers are concerned about whether Greece can truly impose the savage austerity on the Greek people that is required by the bailout package. Here is Charles Wyplosz at Vox:

The plan will not work. Greece is supposed to reduce its deficit by 11% of GDP in three years. This would have been a tall order of requirement if the recovery was going to be strong. The drop in public spending, along with the psychological impact of the crisis, will provoke a profound recession that will deepen the deficit. This, along with the social and political impact of the crisis, will undoubtedly prevent the Greek government from delivering on its commitments.

This is beginning to sound a lot like Argentina in late 2001. It too had a sovereign debt problem, an overvalued real exchange rate, and was effectively part of a currency union (via a currency board) that did not meet the optimal currency area criteria. It also tried to cut wages and prices but found the deflationary price too high. Argentina ultimately defaulted on its debt in December 2001 which was just a few months after receiving a second IMF rescue package in August! In retrospect this second bailout from the IMF looks misguided--it only pushed back the inevitable default a few months but added more debt to the country. After defaulting in December 2001, the government of Argentina broke the the peso-dollar link in January 2002. It seems like, then, the Greek crisis is playing out just as it did in Argentina in 2001-2002. Of course, the implications are far bigger here: the crack up of the Eurozone versus the ending of the peso-dollar link for Argentina.

P.S. One of the best reads of the Argentinian crisis is Paul Blustein's "And the Money Kept Rolling In (And Out)." Blustein also had an enjoyable book on the emerging market crises of the late 1990s titled "The Chastening:Inside the Crisis the Rocked the Global Financial System and Humbled the IMF." Both of these books are informed but accessible to a wide audience. I hope he can find time to write a book on this current crisis. It would be a great public service.

Update: Martin Feldstein says Greece will default.

Update II: Maybe Paul Krugman is reading this blog.