Monday, 28 November 2011

my Spanish elections review...

on Bavarian radio [in German].

optimism out of nowhere

Markets today were "upbeat" about the prospects of an eventual Eurozone rescue... the basis? Some vague reports that the Germans are pushing for....? You guessed it, tougher fiscal rules. Exactly what Europe needs. Sigh. Just like Germany definitely needed another wage-and-price-cutting package in 1931. How is that going to help? Let's see... more austerity will be a tit-for-tat. In exchange, the ECB will buy everyone's bonds in a bid to make that nasty PSI aftertaste go away (that grand idea of scr**ing Greek bondholders so as to reassure the others). That is what some people think. It's part of that true-and-tested model that says - if things are really bad, they will get better, because now people need to do something. Except that they haven't. For about 18 months. My take? Never underestimate human stupidity. I will believe it when I see it. The German government has decided that, after pretending that Greece had a liquidity problem (when it actually had a solvency one), everyone now has a solvency problem (even if the issue is liquidity and self-fulfilling prophecy scambles for the exit). I am waiting for the market counterreaction when people realize that there is only tit, and no tat...

more war, better states...

Good things come to those who wait... and Nicola's and my paper on state capacity and war has certainly taken a bit of time. The idea? In many historical accounts of the rise of states in Europe, war does the heavy lifting: You fight more, hence you invest more in centralization, bureaucratization, tax raising, etc. There are two problems with this: First, warfare is not exactly an early modern European exclusive. Hunter-gatherer societies have lots of violent death; there are no strong hunter-gatherer states. Second, war means that you can disappear as an independent power, as did Poland, Burgundy, and a long string of independent states and statelets in early modern Europe.

Nicola and I decided to put things together in a single model that can explain 1. divergence between powers 2. a rise in state capacity as the cost of warfare escalates. The abstract is:
In 1500, Europe was composed of hundreds of statelets and principalities, with weak central authority, no monopoly over the legitimate use of violence, and multiple, overlapping levels of jurisdiction. By 1800, Europe had consolidated into a handful of powerful, centralized nation states. We build a model that simultaneously explains both the emergence of capable states and growing divergence between European powers. In our model, the impact of war on the European state system depends on: i) the importance of money for determining the war outcome (which stands for the cost of war), and ii) a country's initial level of domestic political fragmentation. We emphasize the role of the "Military Revolution", which raised the cost of war. Initially, this caused more internally cohesive states to invest more in state capacity, while other (more divided) states rationally dropped out of the competition. This mechanism leads to both increasing divergence between European states, and greater average investments in state building on the continent overall.

Friday, 18 November 2011

The arithmetic gets better and better

Over at WSJ marketbeat, they report on Goldman Sachs' latest thinking re the Greek restructuring. They seem to have concluded that the proposed 50% haircut is not enough to return Greece to debt sustainability:
In our view the key problem lies with the structure of the PSI itself, namely the insistence on a 50% reduction in face value for bond holders. From an investor’s perspective, a 50% haircut reduces both the final payment but also the coupon payment. Thus the impact on the NPV of the bond is much larger than 50%. The voluntary nature of the deal assumes some incentive for investors. Thus, the IIF have suggested an increase in coupons for the new bonds in order for investors to be compensated in terms of cash flows at least.
 The problem, of course, would be that this by itself undermines sustainability -- higher coupon payments mean bigger deficits. As GS points out, what Greece needs is the exact opposite: lower coupon payments right now, so that the worst of austerity can be undone. Once growth resumes, and interest rates fall a bit, sustainability will look a lot better quite quickly. I guess there is something not altogether great about thinking up restructuring rules as a fly-by-night operation between a handful of overwrought, half-numerate politicos... 

Thursday, 17 November 2011

Productivity in Process - this week in the Economist - Economics Focus

The Economist this week discusses research by my old college friend Tim Leunig (LSE) and myself on process innovations - that's two Econ Focus highlights in three weeks... Here is the abstract of the paper (available on SSRN):

Fifty years ago economic historians found surprisingly small gains from 19th century US railroads, while more recently economists have found relatively large gains from electricity, computers and cell phones. In each case the implicit or explicit assumption is that researchers were measuring the value of a new good to society. In this paper we use the same techniques to find the value to society of making existing goods cheaper. Henry Ford did not invent the car, and the inventors of mechanised cotton spinning in the industrial revolution invented no new product. But both made existing products dramatically cheaper, bringing them into the reach of many more consumers. That in turn has potentially large welfare effects. We find that the consumer surplus of Henry Ford’s production line was around 2% by 1923, 15 years after Ford began to implement the moving assembly line, while the mechanisation of cotton spinning was worth around 6% by 1820, 34 years after its initial invention. Both are large: of the same order of magnitude as consumer expenditure on these items, and as large or larger than the value of the internet to consumers. On the social savings measure traditionally used by economic historians, these process innovations  were worth 15% and 18% respectively, making them more important than railroads. Our results remind us that process innovations can be at least as important for welfare and productivity as the invention of new products. 

decision time

In August, I gave an interview to Der Spiegel, saying that the Euro can't last another 5 years in its current form. At the time, many people thought I was nuts. Now, some 3 months later, it looks as if the beginning of the end is near. Yields on AAA-countries like Austria are moving up. Bloomberg reports that Spanish 10-year yields are now above 7%. That's not a catastrophe just yet - Spain can pay a bit more interest, and the debt profile isn't that short-term. But if it lasts any length of time, this is going to be very painful: Higher interest rates mean that the country will need more austerity measures to keep the future debt path under control; output will fall yet further; yields may increase even more. It's now abundantly clear that the last rescue package was a disaster on a monumental scale - forcing a 50% haircut on the private creditors felt good, but now everyone is asking who will be next. If all the promises over Greece were worthless, is the same true for Spain and Italy? Of course; they are too big to rescue outright. The only solution is to convince the markets to keep buying. It's a confidence trick that makes the markets work; once confidence goes, the spreads explode. The more people worry, the higher the yields, the higher the collateral requirements, the weaker the banks.

As the ECB tried to tell politicians for the last year - sovereign bonds are too important as a risk-free asset in the financial system to mess with them. The only solution now, to avoid defaults of Spain and Italy in the near future, is to offer a blanket guarantee of all existing EU debt, incl. Greece; undo the haircut on Greek bondholders; and introduce unlimited bond-buying by the ECB. I won't like it any more than the average German, but there is really no alternative short of a wholesale implosion of the weaker Eurozone economies.  

Wednesday, 16 November 2011

at last...

someone is thinking about the mountain of unrecognized losses in Spanish banks due to bad real estate deals, and the need to recapitalize. Bloomberg runs a story that the PP - poised to take power in Sunday's election - is preparing either a bad bank solution or will force capital injections. The latter (especially if done right - break up some of the bigger banks) would be a sensible step in the right direction... but my money is that there will be a half-botched bad bank instead, with taxpayer money dropped on the banks in exchange for some vague hope of starting lending again.

Friday, 4 November 2011

A new paper

Europe's spectacular own-goal

The latest Euro summit was meant to build a firewall around Greece, and to isolate it from the other weaker members of the Eurozone. One week later, it is clear that this has failed spectacularly. Yields on Italian bonds are rising; the IMF has now been called in to monitor the budget. What is going on? Why does even the extended bailout fund not do more to stabilize investor confidence? The truth is actually very simple. The 50% "haircut" imposed on the private sector lenders to Greece is a gross violation of everything that European politicians promised until a few months ago. That's a bad way of reassuring investors.

Remember all the claims that no member of the Euro zone would ever default? That speculators betting on this would go bankrupt? That there would be no touching the creditors before 2013? All of this has gone out of the window, as a result of an ugly display of political strong-arming. Just as Germany's first post-war Chancellor Adenauer once said - "what do I care about the rubbish I talked yesterday". True, the politicians had the banks over a barrel; Ackermann could not say no to Mrs Merkel when she insisted on this voluntary write-down. But the obvious implication is that all other promises and declarations are equally empty - that bondholders of Spain and Italy might find themselves in exactly the same spot as the ones who hold Greek paper. Guess what? If you know you can lose up to 50% (up from 21% just 3 months ago -- latest update in November - Greece would now like to default/"voluntarily restructure" 75% of its debt in NPV terms), you don't feel that confident. About anything. How this was meant to solve the deeper crisis is anyone's guess.

With the benefit of hindsight, it's pretty clear that Europe should have just written an XXL-sized cheque for Greece a year ago. The Financial Times Germany is citing a few economists - Aghion, Alesina, me - saying precisely that. Austerity isn't working, and won't work. A single bad day on the exchanges destroys more value than all of Greece's external debt. Yes, Greece don't "deserve" another penny, but that's not the point. Europe has to do what is right for itself, without worrying about moral hazard (let's be honest - how many countries would want to follow the Greek route even if they get a big cheque?) It's time to switch from moralizing and punishing to actual crisis prevention.

Thursday, 3 November 2011

CNN reflections

CNN has an op-ed by yours sincerely on the Greek crisis, and analogies with the case of Argentina in 2001. As they say - history doesn't repeat itself, but it certainly rhymes.