Home > Uncategorized > Mad Scientist Blogging #1

Mad Scientist Blogging #1

Via Thoma, I see that Simon Wren-Lewis is arguing that European austerity may not be self-defeating. Granted I’m just a dumb microeconomist (and a grad-student at that!), but I’m pretty sure this is wrong. Seems to me like a great topic for an inaugural post of mad-scientist theorizing. Warning: in what follows I may be completely-off-my-rocker insane–you’ve been warned!

It turns out that I may know as much about the economics of international defaults as the majority of macroeconomists. This is not because I am so smart, sadly, but rather it turns out this is a badly neglected topic in the field. When and why nations sometimes default is a surprisingly sparse literature (given its importance), and what papers there are seem to make wildly ludicrous assumptions (such as “imagine all debt is in the form of TIPS“). Or, another group of economists who think a lot about national default are the MMTers–I don’t want to draw their wrath by saying exactly what I think–so let me just say that they have little support in the field. I don’t want to be too critical, these researchers are doing the best they can, but clearly this is an open problem.

Anyway… on to the theorizing!

As I said, I’m pretty sure that Wren-Lewis is wrong here, but to be fair let me just quote the offending passage.

For any government not having to pay a large risk premium on their debt, and not likely to encounter such a premium, this is an important argument. If true, it does indeed suggest that the rapid austerity being undertaken by countries such as the UK will eventually make their fiscal position worse. In addition, arguments that we have to follow the austerity path because the stimulus path is not credible are beside the point…. Nor does the argument that we cannot change course now make much sense. In the UK and US fiscal policy does not have to be credible, it just needs to be sensible.
In the case of Ireland and other Eurozone countries the immediate motivation for austerity is a high risk premium on government debt. What potential investors in Irish government debt are worried about is not where debt is likely to end up, but the likelihood of default before we get there. Here the credibility argument does apply.

One reason why government might default is a political inability to cut spending or raise taxes enough to get the primary budget balance into surplus. Governments can demonstrate that they do have that ability by cutting the deficit rapidly now. Promises to cut it in the future carry much less weight, and so as a result have less impact on the chance of default. Even when the primary balance is in surplus, a government may decide it is in the country’s best interest to default, because any damage to its reputation will be offset by the advantages of not having to cut spending or raise taxes still further to pay the interest on its debt. Once again, a government can demonstrate that it is not minded to do this by reducing its debt as quickly as possible.
In either case, default is less likely if debt follows the black line (austerity) rather than the red line (stimulus). The markets are, quite rightly, not very interested in what happens into the medium term, because by that time default risk under either policy has all but disappeared. So if the overwhelming priority is to reduce the risk premium on government debt, austerity makes sense. In addition, as I have said often before, a long period of economic stagnation is required in many Eurozone countries to reverse the competitive disadvantage they accumulated relative to Germany in the early years of this century.

Let me go through this step-by-step.  Governments may default because;

  1. There is a high risk premium on debt.
  2. There may be a (political) inability to cut spending or raise taxes.
  3. Defaulting may be in the national best interest at some point.

OK.  Call these A1, A2 and A3, respectively.  To which I add an A4, which doesn’t quite fit with the other three: “Financial markets do not care about the medium/long term”.But, countries like the US and UK need not worry because,

  1. Stimulus improves the long run fiscal outlook).
  2. Austerity is no more credible than stimulus.
  3. We should ignore the temptation of status quo bias and be willing to change course.

Call these B1, B2 and B3.

First, notice that A1-3 all apply to the US. The US nearly (voluntarily) defaulted last summer (A3)! The default risk implied by CDS spreads on US debt are not zero (A1). And who actually thinks the current congress (or the republican party, for that matter) would ever let taxes rise (A2)? That’s three for three. So is the US really just like Greece after all? Of course not!

Second, what exactly among B1-3 doesn’t apply to, say, Spain? Certainly, to the extent that bond purchasers care only about a nation’s ability to pay back debt at or before its maturity date it is tempting to think that short-term debt dynamics might be a binding constraint on policy. This is almost certainly wrong, though. Rather, the current default risk premia on peripheral Euro debt are almost certainly the result of a self-fulfilling prophecy of doom.

Here’s how I see it. The ECB is not printing enough Euros. Since the ECB is seen as not being willing to print Euros, bond investors in the Eurozone cannot be sure that enough Euros in the future will be printed to cover all debts, not just sovereign debts. The risk premium on all debts across the Eurozone rises, which hits peripheral countries hardest since these were the countries with the largest housing bubbles. With asset prices crashing in these countries, safe collateral becomes more difficult to obtain and the banking systems in these countries contracts. These are the main purchasers of debt. So, the savings rate in these countries explodes as agents attempt to deleverage–which implies that aggregate demand collapses. Which implies that tax revenue falls which, assuming constant policy from the ECB, implies a rising risk premium and debt burden. The ECB observes this last consequence and decides to avoid “moral hazard” by refusing to print money that may be used to fund these “profligate” governments (rinse and repeat).

It’s important here to stop, though, and ask what role austerity is playing here. Well, there are fewer bonds that need to be printed for a given level of taxes/spending. This does nothing to relieve the shortage of collateral, though. Almost certainly, the collateral crunch is marginally worse, in fact, as at least some transactions would accept even the “risky” government debt. How is that supposed to improve “confidence”? Remember B2, that “credibility” of policy goes both ways–austerity does not imply more reserved policy later.

OTOH, it seems to me that the “moral hazard” that the ECB is so worried about is what the rest of us would call “standard 1940-1970’s vintage business-cycle-stabilizing fiscal policy”. Maybe you think fiscal policy isn’t ideal… fine. It’s not the end of the world, either. Some of the money that the ECB could have printed would have been spent by these governments, which would raise AD and provide collateral at the same time. And since these countries (from DeLong-Summers) will also be making their long-run fiscal position better in the process the default risk premium should fall–a virtuous cycle. Why in the name of Zeus’s skinny jeans are we worrying about moral hazard?

So here’s my “crazy” idea. Forget austerity, it’s never a good idea. Forget moral hazard, seriously just forget about it… leave it to the micro people like me. The real problem in the Eurozone is the current account deficit between members. The ECB should print money and buy German assets–say real estate–until the internal imbalances disappear. As property values rise in Germany, not only would Germans spend more (from the wealth effect) on more German and Greek goods (and so raising AD in both places) but capital would flow into Germany, shrinking the CA deficit with the periphery (i.e. Greece). If you’re concerned about property bubbles, then just make sure to buy a balanced portfolio of German assets (instead of real estate) and, ideally, sell Greek assets.

Problem solved. Now to sit back and wait for my Nobel Prize… just waiting… anytime now…

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Categories: Uncategorized
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  1. June 15, 2012 at 1:32 pm

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