Irreverent Economics

It is clear that a key reason for the 2008 crisis was the failure of financial regulations. Therefore we should redesign the regulatory structure. Indeed, this is underway in Basel III and other initiatives.

I do however question the qualifications of those calling for and making new regulations. After all, the latest crisis is wholly created by governments themselves and even worse, they keep on making the crisis worse by inability to make decisions. This does not show a good example for how to make financial decisions.

How can the very same governments and their financial experts be qualified to design effective future financial regulations if they display such incompetence in managing their own financial affairs?

I think all of this suggests what asset class one should be investing in.

Written with Casper G. de Vries

European politicians will make decisions in the next few weeks that are likely to determine the future prosperity of Europe. The leaders have two choices. Feed the crisis by ignorance, political disagreement, forbearance, muddling through and inaction, or recognize reality, face the upfront cost of restructuring, remove the information uncertainty and create conditions for future prosperity. By our analysis the relative benefit of opting a properly managed default is a gain of 22% of the European GDP over the coming two decades.

In order to estimate the cost of the ostrich attitude it is useful to look at what has happened in other large economies facing similar choices, with no better example but Japan, as the EU approach to crisis management does have a strong parallel with how Japan handled its crisis in the early 1990s. The slow crisis management approach of the Japanese state to its crisis is eerily similar to what we see now from the EU authorities: Hoping for the best, doling out partial bailouts, ever greening loans, and trying to maintain the status quo ex ante. This created zombie banks, triggering years of debt deflation and economic stagnation. The cost to Japan has been an economic growth of 0.67% a year for the past two decades, a reasonable estimate if the EU opts for inaction.

In the case of the Euro, the main reason for slow growth would be the continuing political risk and the ongoing uncertainty regarding the strength and exposures of commercial banks. There is even a real fear we have started to see the emergence of zombie banks Japanese style, as the ECB is becoming the lender of first resort for many banks, entire banking systems and even national governments. This leads to a vicious feedback loop between the dry-up of liquidity, reduced lending and diminished economic growth.

The alternative for the EU authorities is to recognize reality and allowing restructuring ofGreek and possibly Portuguese debt.

We suspect the benefits of a default would be substantial for the entire European economy, including those defaulting. A default will break the vicious cycle between a lack of confidence, banking crisis, increasing borrowing costs and fall in liquidity has been created.

A reasonable estimate of the cost of recognizing realty is the average growth in the Eurozone over the past 20 years or 1.67%. In this case the euro area GDP would be 22% higher after 20 years, or €3.5 trillion, while muddling only yields €1.3 trillion in GDP.

It would be preferable if the default were orderly instead of being the chaotic endgame it would likely be in the ostrich approach. The authorities would need to be prepared for possible liquidity and balance of payments problems for countries like Italy and Spain. The IMF, the institution set up for that purpose, should stand ready to provide the necessary support.

The government’s task of effectively provide being bailouts is complicated by several factors, both the close connections between governments and industry and lack of experience and knowledge on behalf of senior government advisers.

The financial system in many countries is in effect an oligopoly of very large powerful and well—connected financial institutions. In some countries, the industry might have very close connections with the government, such as France, while in other countries the relationship is more arms length. Indeed, one could say the more banks a country has, the less political power they have. The revolving door between the industry and government in some countries, like the US, can exasperate this problem.

Government institutions are also at a disadvantage when it comes to the industry. Not only can banks vastly outbid the government when it comes to human capital, they also have orders of magnitudes more people working for them. This can be particularly problematic when it comes to addressing highly complex issues by relatively junior staff members.

In addition, the governments problem in understanding the complexity of the financial system is made worse by the fact that it is task is more difficult the task of any bank. The bank has only to worry about its own risk, the government has to worry about the risk of each and every bank, individually and in aggregate — an impossible task.

All of this suggests that when it comes to regulating the financial industry and providing bailouts when it fails, the interests of the taxpayers are at a serious disadvantage. Not only can the banks exert targeted lobbying at the government, the technical ability of the government to respond effectively unlimited.

In a crisis, this becomes especially difficult. Senior government ministers and their advisers are unlikely to understand the underlying problem in detail. How is the government to know when a banker comes to it saying “if you do not bail me out the financial system will  collapse” whether that is true or not? If the government then brings in expertise from the industry, perhaps even putting them in charge of government ministries, it is unclear whom they actually represent. The interests of industry or the interests of the taxpayer.

Noam Chomsky visited Iceland last weekend, give a public talk and got the star treatment – which he does deserve. That included an interview on the premier news analysis program on Icelandic TV. The 3 parts of the interview  can be seen on the program website linking to YouTube.

Chomsky is one of the most perceptive public intellectuals around and listening to him is always a delight. However, in this interview he strayed into the areas of my expertise — economics and Iceland and either told things that are not true, misrepresented facts or did not provide the necessary connection to understand what he was advocating. There were several such things in his discourse, here are the three worst:

1. He said Iceland had found a unique solution, including not paying back the money. He was not clear on who paid the money back, but we do know that the government of Iceland has paid back every penny it owes and been rewarded with lower credit spreads than for example Spain. There is a myth of Iceland not paying back debt — sparked by Icesave — which is simply not true. His fact here is wrong.
2. He talked about the idea of efficient markets as something like a religious orthodoxy that people still clung to, even though it is  supposedly false and to blame for the excesses of the crisis.  He does not know what the efficient market hypothesis is. All it says is that one cannot systematically make money forecasting the markets. So he used it in a completely incorrect sense and then criticized people who still think it is  correct as being like religious fanatics. This is populism at its worst.
3. Finally, he talked about the end of the Bretton Woods system and the start of floating currencies as some sort of a capitalist plot decided on by evil bankers and implemented by corrupt politicians. Yikes. Talking about not knowing your facts. The Bretton Woods system collapsed because it was unsustainable, the bankers very much would’ve liked for it to continue. The sad truth is we have tried every arrangement for currency management and they all fail. Not because of evil plans by bankers and corrupt politicians but because they ignore economic fundamentals.

This makes me worried about everything else he says. It sounds very convincing and I am not an expert in those areas so cannot assess the veracity of his analysis. However, for someone who is as liberal with the truth, everything else he says becomes suspect. And that is sad. He is one of the sharpest public intellectuals there are and we need such people.

Paul Krugman likes to write about Iceland. I don’t know where he gets his facts from but his analysis is amusing. He’s a great economist, I teach his models, but his Iceland analysis does leave something to be desired.

It’s a short piece but with important inaccuracies.

And it has done all that with very heterodox policies — debt repudiation, capital controls, and currency depreciation. It was as close as you can get to the polar opposite of the gold standard. And it has worked.

Iceland has not repudiated any debt, at least the government hasn’t. On the contrary, the government has paid back every penny owed and signaled willingness to do so in the future. The government has been rewarded by open access to international capital markets at fairly low rates — for example borrowing more cheaply than Spain. Perhaps Krugman got his facts from the fact that Iceland has refused to honor Icesave. That however is a special case. It is a relatively small amount of the overall debt created by Icelanders — private and public — perhaps hundred million euros, and the legal obligation to honor it does not exist. So it’s not debt repudiation in any sense.

The currency depreciation has been very successful to get the economy back on its feet but is a orthodox type of policy. Besides, with so many Icelanders having their dept foreign exchange linked or inflation linked, the collapse of the currency has wreaked havoc on Icelandic families and firms. It may have helped the economy, but the collateral damage is enormous.

Iceland did implement capital controls. Such tools used to be heterodox — even if they were popular in the 1950s and 60s — Iceland finally abolished capital controls in 1993. Capital controls have come back into the mainstream, and  have the full support of the IMF. How is an economic policy that is out of the IMF rulebook anything but orthodox?

The implication of the capital controls — and other measures taken by the government — has been the Iceland has just about the lowest private investment in Europe and close to the world’s highest taxes — adjusting for peculiarities of the pension system.

I don’t see this as working.