Lessons from the Dutch Republic

I have an op-ed which ran on the CNN website this weekend, comparing recent events in Catalonia with the Dutch fight for independence in the 16th century:

• • Catalonia's fight for independence: Are there lessons from the Dutch revolt?
  • 
    
  • A small, wealthy region feels at odds with Spanish rule. Taxes are too high; political representation is limited; the elite feels unheard and ill-treated; unrest and popular opposition spread. Hardliners in Madrid advocate repression and have the ear of a new ruler. Turmoil ensues and escalates until a major confrontation is inevitable.
    http://www.cnn.com/2012/11/21/business/catalonia-dutch-revolt-lessons/index.html
    
    
    
    

Reading about punishment

fodder for our next reading group session (Hermann, Thöni, Gächtner, Science 2008):

We document the widespread existence of antisocial punishment, that is, the sanctioning of people who behave prosocially. Our evidence comes from public goods experiments that we conducted in 16 comparable participant pools around the world. However, there is a huge cross-societal variation. Some participant pools punished the high contributors as much as they punished the low contributors, whereas in others people only punished low contributors. In some participant pools, antisocial punishment was strong enough to remove the cooperation-enhancing effect of punishment. We also show that weak norms of civic cooperation and the weakness of the rule of law in a country are significant predictors of antisocial punishment. Our results show that punishment opportunities are socially beneficial only if complemented by strong social norms of cooperation.

Greeks vs Germans

Guiso, Herrera and Morelli have a new version of their working paper on "A CULTURE BASED THEORY OF FISCAL UNION DESIRABILITY". They first show just how big cultural differences are between Germans and Greeks; they then move on to build a model of when a fiscal union can work. Interestingly, and contrary to what I expected, they find that diversity is actually good for a  the sustainability of a fiscal union.

Economic history pays

at least in the UC system... Keefe and Wang have a new paper on faculty salaries in economics departments of the UC system, and find that there is a 13-17% premium for economic history, after accounting for campus, seniority, gender, and publications. My guess is that economic history is a tougher field to get hired in (more of a "luxury" item); the scholars that do get in are way better than the marginal candidate in more mainstream fields. Eventually, quality shows and a good university system rewards them accordingly.

Amongst other interesting findings is how much higher pay at UCLA is than at Berkeley... the authors also have a hugely misspecified regression where they claim that they can back out the value of extra publications in different journals... after controlling for rank. This is a classic "controlling for an intermediate outcome" mistake, where an important outcome influenced by what you are interested in - publications - goes on the right hand side, and gives you completely the wrong results. For an interesting example, see the discussion by Andrew Gelman of "Engineers have more sons". 

Readings

Felipe Valencia and I are organizing a reading group in long-term persistence this term. Today, we'll be discussing "Poor Institutions, Rich Mines: Resource Curse and the Origins of the Sicilian Mafia" by Buonanno, Durante, Prarolo, and Vanin. Here is the abstract:

This study explains the emergence of the Sicilian mafi a in the XIX century as the
product of the interaction between natural resource abundance and weak institutions. We
advance the hypothesis that the ma a emerged after the collapse of the Bourbon Kingdom
in a context characterized by a severe lack of state property-right enforcement in response
to the rising demand for the protection of sulfur - Sicily's most valuable export commodity
- whose demand in the international markets was soaring at the time. We test this
hypothesis combining data on the early presence of the ma a and on the distribution of
sulfur reserves across Sicilian municipalities and nd evidence of a positive and signi cant
e ect of sulphur availability on ma a's di usion. These results remain unchanged when
including department xed-e ects and various geographical and historical controls, when
controlling for spatial correlation, and when comparing pairs of neighboring municipalities
with and without sulfur.

Fewer Guns...

More Violence. The NRA will love this piece of research! MIT's Laura Ralston has a paper that looks at a disarmament campaign in Uganda, and finds that there is more violence afterwards. Remarkably, it's not cross-border raids from Kenya that increased, but Ugandan-on-Ugandan violence:

This paper studies the effect of Uganda’s 2006 disarmament policy in the Karamoja region in East Africa, a traditional tribal area that is one of the most violent places in the world. This policy greatly reduced the guns of tribes in the Ugandan districts of the region but not in the Kenyan districts. Theoretically, the impact of the disarmament is ambiguous, since guns can be used for deterrence as well as helping aggressors carry out crimes, such as livestock raiding. For example, disarmament could reduce the advantage of heavily armed tribes over weakly armed tribes and lower the number of tribes willing to carry out raids. At the same time, it will also lower the expected cost of confrontations for all tribes, which may lead to more tribes initiating raids, particularly if the weakly armed tribes begin to raid. Empirically, I find that the disarmament campaign had the unintended effect of increasing the frequency of raids in Uganda by about 40%, while, consistent with the idea that disarmament reduced the costs of raiding, I find no impact on the monthly death rate. Moreover, this increase in raids in Uganda was driven by an increase in Ugandan initiated raids on other Ugandans, not an increase in Kenyan initiated raids on Ugandans, suggesting that in this context the deterrent effect of guns outweighs their impact as a tool of aggression.

Waiting for Woody

It seems that there is a serious failure in marketing the case for Catalan independence. As I peruse the news sections of the gazettes, printed and online, I find many commentators who seem to say that the Catalans are simply a group of rich Spaniards who are tired of paying for the rest of the country. A currency strategist (!) at a London bank was quoted (via WSJ marketwatch) as saying

In view of the movements towards fiscal union within the euro zone it is perhaps ironic that Catalonia is calling for more autonomy from Spain. The region currently transfers EUR15 bln [about 19 billion] of its economic output to the rest of Spain each year, a situation that over a million protesters in Barcelona last week clearly view as undesirable. One question that inevitably arises from Catalonia’s protests is that if richer Spaniards are becoming more reluctant to support their less economically well off countrymen, who else do they expect will rise to the challenge?

This is, of course, breathtaking in its ignorance. The 11-S demonstrations were about much more than the injustice of current transfers. There was a very good case for Kosovo to separate from Serbia, and for Southern Sudan to break free. Nobody framed the issue of the dissolution of Czechoslovakia or Yugoslavia in terms of solidarity. And that's where the failure of the Catalan political elites lies. They have completely failed to market their case -- a country that is linguistically, culturally, economically distinct and largely ruled as a conquered province since 1714 by its bigger neighbor. If Catalonia was in another continent, everyone would agree that this is colonialism; within Europe, it is somehow ok. Everywhere else in Europe, smaller regions with a sense of independence are effectively paid to stay ... see Scotland, or Southern Tirol. Not so in Spain; the fiscal transfers from Catalonia to the rest of Spain are huge, and most "autonomy" until now has been a sham.

What's missing? In two words: George Clooney. The handsome actor lent his voice to the case for independence in Southern Sudan, and quite effectively. Before you can hope for the world to recognize you as a separate entity, you need someone to communicate what makes you distinct. Perhaps the Generalitat should ask Woody Allen to act as ambassador for the Catalan case.

Prometheus Shackled

my book with Peter Temin on banking and the Industrial Revolution will be out later this year. We are just finalizing the cover and waiting for the index. In the meantime, our friends who generously read (and criticized) the  manuscript have sent in their testimonials, and they have been very kind. Here is what their testimonials say:

“A major contribution to economic history, business history, social history, and economics, Prometheus Shackled resolves a great enigma about the Industrial Revolution by explaining why economic growth was so slow despite massive technical change."—Philip T. Hoffman, California Institute of Technology "Based on newly opened archival material, two economists have written a sparkling and provocative book on how banking worked in the past, that will force all scholars working in the area to re-examine their notions about the economics of the British Industrial Revolution, the importance of banking and finance in economic development, and the role that government regulation has played in the process of capital accumulation and industrialization."—Joel Mokyr, Northwestern University; author of The Enlightened Economy “Peter Temin and Joachim Voth have written a marvelous blend of business history and economic analysis.  Their careful study of Hoare’s Bank documents the origins of modern banking and relates the story to the state’s insatiable demand for credit to finance war.  Prometheus Shackled is a pleasure to read and calls into question many grand narratives that seek to explain the rise of the West.”--Bob Allen, University of Oxford; author of The British Industrial Revolution in Global Perspective “In a world still hobbled by the unchecked excesses of modern finance, this timely study of Industrial Revolution banking reminds us that bankers are as important for growth as engineers.  Indeed, the authors argue, too few bankers in eighteenth century Londonlimited economic growth much more than too many in the untrammeled City of today.” -- Greg Clark, University of California, Davis; author of A Farewell to Alms.

“This is an important work, and it is written in an engaging style. The authors integrate goldsmith banking operations with the history of the rise of the nation state’s finances and military aspirations, the broader economic trends that gave rise to industrialization, the rise of the middle class and the changing distribution of wealth, and evolving societal attitudes that accompanied industrialization. The central thesis of the book – that England’s constrained banking system served sovereign interests at the expense of private interests during the early industrial revolution (1760-1830) – is argued persuasively.” -- Charles Calomiris, Columbia University

“Prometheus Shackled solves a major puzzle:  Why during the first Industrial Revolution was Britain's economic growth anemic?  The authors show that financial and other policies diverted credit from the private economy to the government, making it easier for the British state to finance its numerous wars.  With implications for both history and our own financially and economically troubled times, this is an important book.” -- Richard Sylla, New YorkUniversity

a mostly stimulating and important black hole...

in the space + time continuum: I have just spent a few days writing tenure letters. It's hugely interesting... you get to read pretty interesting stuff that you wouldn't normally read, and you have to think about where the profession/subfield is headed. One can even live with the pleasant thought that one can influence (in a small way) where one's own field is going. Of course, the time cost is staggering. I hit "word count" on the last letter I wrote, and it weighs in at ~2,000 words. An average academic article is ~ 8,000 words, and much of the work that goes into it - except for the data analysis - isn't so different either ... the sifting of evidence and the ferreting out of research trends, plus the polishing of the text to make sure it conveys finer nuances. Good thing one only gets to do this with tenure under the belt!

Small nuggets at the Fed

I am visiting the Fed in Minneapolis, giving talks there and at the university. A lot of fun, especially since they don't really "do" economic history here. Next week, our strength doubles - Peter Koudijs is coming over from Stanford for some joint work.

Two priceless nuggets that I spotted on the information screens: one is for a free massage you can request on certain days to deal with stress; the other is for an IT-seminar entitled "What's new in Windows 7?". Judging from the atmosphere at the Minn Fed, the world is not coming to an end just yet...

Economists are useless

at predicting anything... so here is a bank that uses this often-lamented fact for advertising purposes (featuring Tom Sargent, really!):

Radio days

It's normally not a good sign for the politics/economics of the Eurozone + stability of financial markets when I start to get interview requests... this leading indicator is currently flashing orange. Here is an interview with Deutsche Welle on Glass-Steagall from August, and another, more recent one regional finances in Spain...  and here is one on the prospects for ECB intervention in bond markets (Swiss radio -- all of them in German). 

Finally...

Sometimes, I wonder about the disconnect between the time-scale of human life on the one hand, and of academia on the other. I have one paper that's been with a journal for 14 months now; some 3 months ago, I asked the editor about the state of play, and heard that he will make a decision "soon" [economists can probably guess which journal I am talking about - I hear a lot of really awful moaning and groaning about the very same journal from a lot of other people]. And there are papers that spent more years under submission and r+r [admittedly, at more than one journal] than it took to fight World War II...

Of course, many a paper improves immeasurably during the refereeing process. Now, Nico and I finally got our article about the Three Horsemen of Riches into the Review of Economic Studies:

How did Europe escape the "Iron Law of Wages?" We construct a simple Malthusian model with two sectors and multiple steady states, and use it to explain why European per capita incomes and urbanization rates increased during the period 1350-1700. Productivity growth can only explain a small fraction of the rise in output per capita. Population dynamics -- changes of the birth and death schedules -- were far more important determinants of steady states. We show how a major shock to population can trigger a transition to a new steady state with higher per-capita income. The Black Death was such a shock, raising wages substantially. Because of Engel's Law, demand for urban products increased, and urban centers grew in size. European cities were unhealthy, and rising urbanization pushed up aggregate death rates. This effect was reinforced by diseases spread through war, financed by higher tax revenues. In addition, rising trade also spread diseases. In this way higher wages themselves reduced population pressure. We show in a calibration exercise that our model can account for the sustained rise in European urbanization as well as permanently higher per capita incomes in 1700, without technological change. Wars contributed importantly to the 'Rise of Europe,' even if they had negative short-run effects. We thus trace Europe's precocious rise to economic riches to interactions of the plague shock with the belligerent political environment and the nature of cities.

Now out in the QJE

Persecution Perpetuated: The Medieval Origins of Anti-Semitic Violence in Nazi Germany:

How persistent are cultural traits? Using data on anti-Semitism in Germany, we find local continuity over 600 years. Jews were often blamed when the Black Death killed at least a third of Europe’s population during 1348–50. We use plague-era pogroms as an indicator for medieval anti-Semitism. They reliably predict violence against Jews in the 1920s, votes for the Nazi Party, deportations after 1933, attacks on synagogues, and letters to Der Stürmer. We also identify areas where persistence was lower: cities with high levels of trade or immigration. Finally, we show that our results are not driven by political extremism or by different attitudes toward violence.

[and for the time being, it's top of the pops in terms of downloads at the journal website]  

economics productivity

One of the hardest things to explain to non-academics (or non-economists) is the length of time it takes to publish a paper in economics. Quality control? There is a well-known paper by Glenn Ellison (2002) arguing that there is nothing in that. Economists, high-priests of efficiency, actually run a remarkably inefficient system overall (yes, I am waiting for a first-round decision on a submission I made in the summer of 2011). What is the aggregate effect? James Choi reports that economists today are markedly LESS productive than earlier generations:

Negative productivity consequences of long economics journal review times

Ellison (2002) documents that the time an economics paper spends at one journal between submission and publication has more than doubled over the last thirty or so years. ... Intuitively, one would expect that, ceteris paribus, increased publication lags would make it more difficult for members of recent cohorts to produce as long a curriculum vitae in six years as earlier cohorts. ...

[W]hen we look at the number of AER equivalent papers instead of pages published at the end of six years... we find large and statistically significant drop-offs in productivity over time for graduates of both the top and non-top thirty departments. By this measure for graduates of the top thirty programs, the oldest cohort [1986-88 Ph.D. graduates] is 51% more productive than the middle cohorts [1989-94 graduates] and 72% more productive than then youngest [1995-2000 graduates]. The middle cohorts in turn, are 14% more productive than youngest cohorts.
Thus, unless we believe that recent graduates are fundamentally of poorer quality, the same quality of tenure candidate is significantly less productive today than 10 or 15 years ago.

How to rescue the Euro?

I am on the Inet Council on the Eurozone Crisis. Yesterday, we published a statement on what to fix if one wanted to get serious about resolving the current mess... it's a tall order, with possible debt mutualization and changes to the remit of the ECB on the table. The change in what counts as alarmist and excessively negative over the last 9 months or so is really quite striking. Even half a year ago, one could not say "end of the Euro" without the majority of listeners shaking their heads and saying "surely it won't come to that." Personally, I am sceptical that Europe has the political will (and economic acumen) to sign up for such the monumental effort that we wrote into INET program to save this failing project, but we'll see.

How will the end come, if it does come? One can speculate endlessly, but I think we have a likely scenario now: Spain will lose market access in a matter of weeks, meaning that bond yields hit 8%+, and the Spanish government gets a full-blown bailout. A Greek exit, extremely likely now, will hardly matter. But Italy will starts to wobble once Spain goes, and there is no chance in hell that Northern European countries have the stomach for the bailout required in the case of Italy. Then, it is either monetization of debt issues by the ECB, or game over. The hard-money countries are now in a minority on the ECB council... and once they push for vote for the home team, the Germans may decide to bail out. Probability? ~50%, if you ask me. 

Capital

is now leaving Spain at a rate of ~50% of GDP, annualized, according to CreditSuisse. The details are over at creditwritedowns.com

Last week also brought a massive new austerity program from the Spanish government, worth ~65 bn €, or 6.5% of Spanish GDP. Up goes VAT, down the pay for civil servants, etc. While retail sales are falling at 10% p.a., that is a really smart move. As I predicted in January, after the last austerity program, growth will slump, fiscal revenue will dry up, and nothing gets better. That turned out to be exactly right, and this new program will make matters worse. Of course, if you have to make a mistake, make it at least twice... in six months. The bond market is not impressed - it worries more about growth than about the deficit.

Student Guest Post: Monetary Folly Edition

As part of our series of ITFD student project summaries as guest posts, here is the latest thinking (by Alex Ballantyne, Julian Ebner, Thomas Jones, and Sam Chapman) on the potential benefits of QE in the Eurozone:

Last week the ECB cut their main policy rate by 25 basis points in response to decreased inflationary pressure stemming from weak growth outlooks in the Eurozone. Policy rate adjustment is unsurprising given the evolution of financial and economic indicators in the second quarter; however, in light of the severity and persistence of the current crisis it appears trivial. Indicators show that the relief provided by large injections of liquidity from the ECB’s Longer Term Refinancing Operations (LTROs) in December 2011 and February 2012 was only temporary. Once again rising sovereign bond yields and uncertainty over banks’ solvency (particularly within Spain) dominate the headlines of the financial, and mainstream, press. Alleviating Europe’s woes requires addressing three inter-related trouble spots: sovereign default risk, bank solvency, and weak growth prospects. It is unrealistic to believe that small adjustments in the ECB’s policy rate will have a substantial impact in all these areas.

There is mounting evidence that large monetary interventions from the ECB are not only desirable, but necessary. The LTROs were a much publicised attempt at providing such an intervention; however, evidence suggests that their impact has been confined to the banking sector alone and left the other two trouble spots largely unaffected. An impaired bank lending channel has failed to improve lending conditions for non-financial firms, thus preventing the transmission of liquidity to the real economy (left graph). The LTROs’ effect on sovereign yields appears to have been confined to Italy and Spain and even there it has been mostly temporary (right graph).

In place of liquidity provision to banks, monetary policy should address all three trouble spots in a more direct fashion. Evidence from the recent Bank of England and Federal Reserve interventions suggests that purchases of sovereign bonds on secondary markets, commonly referred to as quantitative easing, have been effective in lowering sovereign yields. In turn, this provides banks with the opportunity to improve liquidity while reducing their exposure to sovereign risk. Stimulating growth through improvements in non-financial firms’ borrowing conditions is a less tractable objective. Lending to banks conditional on loan expansion, or even direct lending to non-financial firms, by the ECB are attractive policy options. Recently, the UK Treasury and Bank of England have embarked on a joint initiative to ensure liquidity provided to banks is transmitted to non-financial firms. The ECB should follow suit with similar policies.

Objections to such unconventional policies are often raised, usually stressing the costs of inflation and moral hazard. Exactly how high these costs would need to be to outweigh the benefits of the policies proposed above is nearly impossible to pinpoint; however, a slightly higher, yet stable, level of inflation is quite unlikely to tip the scales. In any case, the costs of non-intervention are starkly evident and only increase with further hesitation, potentially endangering the prosperity of an entire generation. An obsession with one-dimensional monetary policy targets has proven destructive in past crises, most prominently the Great Depression. If the ECB continues down its current path, one would be tempted to cast it in the role of Nero, fiddling as Rome burns. 

Email from a failing state

It's over a year ago that the Greek education ministry asked me to act as an evaluator for their research projects. One gets many requests like this... over the years, I have evaluated proposals for the Israeli Science Foundation, the NSF, ERC, and the UK's ESRC, inter alia. I thought it might be interesting... and so it proved. First, the program is really generous. As in - I cannot believe they are spending so much money generous. The research project funding is allocated 120 million; maximum for each grant, 600,000. That in a country of 11 million people -- that's more than 10 euros for every man, woman, and child, on average. I don't know what the aggregate number for Spain is, but I can tell you that research funding here is now really pretty miserable - even worthy projects get piddling amounts of funding, if any.

The project I was assigned was GOD AWFUL. I mean, truly, truly awful, as in "i don't know who let these people into a university, let alone teach there". Fine, this happens. I said what I thought, and figured it was the last of it... and then the emails started. One, two, three. Would I not wish to reconsider? Here is how to change your feedback! Do I really want to say that? Amazing. As if I had somehow had a bad day, and giving a low mark to a project was somehow insulting. The emails never quite said it, but they were telling me to give a better mark, indirectly. I didn't. Now, that was last year September. Now (July), I get an email saying they would like to pay me for my services (!). First, this is a bad sign; you don't get paid for this, you do it to further scholarship. Second, it is amazing that it takes so long... a year? Really? For an email? Third, there was no promise of payment initially. The original emails all came from minedu.gr. This request comes from thalis_payments@epeaek.gr, asks for a lot of details about my bank account, and looks about as official as your average Nigerian scam. I think I will give this one a pass...

Spanish bond yields surge

Spain's ten year bond yield hit 7% today. At levels such as these, the other PIGS got support through European bailouts. Nobody can be surprised by the fact that the 100€ bn of extra debt that Spanish taxpayers will have to carry due to the banking rescue has not calmed markets - more European multilateral debt means less debt capacity for everyone else, like the ordinary Joe Bloe's who lost a shirt or two in Greek bonds. The debt dynamics are now getting seriously interesting, in a very Greek kind of way -- at borrowing costs such as these, the primary surplus needs to rise a lot. Taxes have hit the Laffer point, where raising rates won't give you much more yield, and may damage growth so much that revenue actually falls. True, there is a lot of untaxed income, but getting at it takes a long time and plenty of state-building. So spending cuts are logical, but they will also produce a deeper recession. So with a primary surplus too small, it looks as if the debt service is not sustainable; interest rates rise further. In no time, only the European partners will be able to offer funds, and even they may give up given the size of the package necessary. When the Euro dies, remember June 14, 2012, when the first European country that is too big to bail out saw its interest rates rise to unsustainable levels. Of course I hope I am wrong, but it is hard to be optimistic at this stage...

Just hand over the cash

Spain has just announced it will be asking for €100 bn in European aid to recapitalize its banks. This was coming for some time now. The only problem was that the dithering and incompetent Madrid team felt it would hurt national pride too much if, in exchange for aid, there were conditions attached. So now we get aid to Spanish banks, not to Spain. Note that this follows the familiar European pattern of announcing great-sounding initiatives, without much of the nitty-gritty clear at all. Neither the EFSF nor the ESM can actually recapitalize banks at the moment. So instead of clarifying things, this will actually cause more anxiety and uncertainty. Second, the aid will be in the form of loans to Spain, via FROB, the Spanish government's recapitalization vehicle. The success of the Paulson plan (beautifully analysed by Veronesi and Zingales) seems to suggest that one should instead go for direct equity injections, with European shareholders having real oversight.

The Spanish regulators - mainly the Bank of Spain - will remain in charge, and therein lies the problem: The idea that the same clown show that gave us Bankia, Catalunya Caixa and CAM is now receive a cool €100 bn in European money without real oversight is sickening. What's worse is the absence of any discussion WHY these banks should be rescued at all. If Bankia, for example, was wound up, the depositors would still be paid. Would the country suffer? The only reason to do bank rescues is to protect "intermediation capital", a mythical property said to reside in the heads of certain bankers - the ability to say, yes, this is a good borrower and I will lend to him, based on past experience, intimate knowledge of an area, clientele, or industry. The fact that Bankia and CAM are now effectively bankrupt tells you that there was no intermediation capital there in the first place, just a lot of venal rent-seeking. Surely the best thing would be to put the financial institutions that are below a sensible equity threshold into bankruptcy, with depositors paid out and the financial firm shut down. That way, the better banks like BBVA and Santander would pick up the slack, win customers and make money; the incompetent bankers could go and join the long queues of unemployed. Ideally, this should have been done with all the small, bust cajas, instead of merging them into things like Bankia - in the US, small banks fail all the time, and nobody panics.

Ode to the missing envelopes...

If you look at income statistics, things are not so bleak in Spain. Wages are falling only a bit; GDP will contract by, maybe, 2-3% this year. And then you come across statistics like this one (hat tip to marketwatch). Retail sales in Spain are falling at a rate of 10% yoy. What is going on? Partly, precautionary savings. Partly, incomes are falling much faster than measured - in the boom, the black economy grew much more than the official one, and it is all those extra payments (in little envelopes) that companies used to make that are disappearing at a fast rate. In boom times, countries love to add the black economy to their GDP statistics. If we captured how quickly it is shrivelling now, GDP growth in Spain for this year would look a lot bleaker...

a good headline

is like a great paper title... worth its weight in gold. Remember the famous "Ford to City: Drop Dead" one by the Daily News, during the NYC budget crisis in the 1970s? Here is another contender for greatest headline (via downtownjoshbrown)

Maybe Mauricio Drelichman and I should have tried to write a paper called "Meet the Fuggers" (about the German banking family's dealings with Philip II...)

everything you need to know

about Spanish banks, lucidly explained, over at fist full of euros. The conclusions are cheerful:

Naturally the whole BFA/Bankia edifice is the first good example I will point to of the use of chewing gum and chicken wire in Spain, since it is hard to imagine a more complicated way of doing something that is almost guaranteed not to work. Basically BFA, the parent bank, was created as a bad bank, where the toxic property assets (largely land) of the seven participating savings banks were to be warehoused, supported by a mixture of preference shares, subordinated debt and own resources in terms of company shares, equity etc, plus a 4.5 billion euro “hybrid capital” loan from the government restructuring fund (FROB), which was to be paid 8% a year. Naturally the value of the toxic assets was bound to drop as time past, and I suppose the hope must have been to tranfer earnings from new (“better” – not “good”) bank Bankia to both offset losses and service the FROB loan. But things weren’t to work out that way (as could have been anticipated), since Bankia itself was created with its own property exposure (especially in the form of developer loans, many of which were on the point of “souring”) as there simply were not enough resources available to wharehouse everything. And when the new government introduced a law requiring more provisioning, well it was all over, bar the large injection of public money now needed to clean up the mess. Others were given the opportunity to kick the can a little further down the road by entering a merger, and thus offseting the write-downs against capital rather than having to charge them directly to profit and loss. But Bankia was already too big, and too about to fall over, to be able to find a “dancing partner”.

Going back to gum and chicken wire, I remember reading in the report on the Three Mile Island nuclear accident, that in the run-in to the problem maintenance had either been neglected or was completely ad hoc. The archetypal example for this was the discovery that a hole in a cooling pipe had been plugged using a basketball. There you go Mr de Guindos... go find a basketball!

fun paper of the week - snow and liquidity

finally, a fun finance paper with some really cool (!) identifying variation:

Based on a sample of highly leveraged Austrian ski hotels undergoing debt restructurings, we show that reducing a debt overhang leads to a significant improvement in operating performance. Changes in leverage in the debt restructurings are instrumented with Unexpected Snow, which captures the extent to which a ski hotel experienced unusually good or bad snow conditions prior to the debt restructuring. Unexpected Snow provides lending banks with the counterfactual of what would have been the ski hotel's operating performance in the absence of strategic default, allowing them to distinguish between ski hotels that are in distress due to negative demand shocks (“liquidity defaulters”) and those that are in distress due to debt overhang (“strategic defaulters”).

who said

that economists aren't working on real-world problems? Here is the abstract of a paper by Diamond and Rajan (QJE 2011):

Is there any need to clean up a banking system by closing some banks and forcing others to sell assets if the risk of a crisis becomes high? Impaired banks that may be forced to sell illiquid assets in the future have private incentives to hold, rather than sell, those assets. Anticipating a potential fire sale, liquid buyers expect high returns, reducing their incentive to lend. Privately optimal trading decisions therefore lead to a worse fire sale and a larger drop in lending than is necessary. We discuss alternative ways of cleaning up the system and the associated costs and benefits.

While one can't apply it 1:1 to the situation in Spain,  it's definitely food for thought...

ECB smoke signals

First came the news that Jens Weidmann is openly arguing for collateralizing TARGET balances in the Eurozone. If you don't breathe and live Eurobabble - in simple words: The head of the Bundesbank now thinks that the risk of a Euro breakup is so high that it wants more than just the word of the Banco de Espana, Bank of Italy, etc. that they will repay all the money they have stuffed into their banking systems. Hand over the assets; this only makes sense if the risk of exit for the Club Med is getting high, in the Bundesbank's view. Ouch.

Now it emerges that the ECB has drastically curtailed lending to Greek banks, partly as a reaction to the fact that the 25 billion € given to Greece to recapitalize banks has not been used for that purpose. Remember that Greeks withdrew about 700 million € last week, after the elections. Without ECB liquidity, the banks will implode. This, to my mind, means the writing is on the wall. The ECB's long-term liquidity program in December last year bought a bit of time for countries that run big current account deficits, but now that Spanish banks are virtually out of collateral that they can post, and with the ECB getting restrictive, everything is set for a rapid unravelling once another small shock or two occur... 

How culturally isolated are you?

Take Charles Murray's little online quiz and find out how far away you are from American "mainstream culture". Notice that the definition of American culture is singularly narrow... hunting, fishing, cheap beer, pick-up trucks. Miraculously, I managed to score not 0 but 4 out of 20 (where 20 is full engagement with US culture). But no worries - acc. to Murray, I still qualify as "your bubble is so thick you don't even know you are in one". (hat tip to CheapTalk)

Chimps are smarter than humans

Better think twice before you call someone an ape next time... Colin Camerer just wrote what must be the most amazing paper in economics in a long time. Here is the abstract:

Chimpanzee game theory

The capacity of humans and other animal species to think strategically about the likely payoff-relevant actions of conspecifics is not thoroughly understood. Games are mathematical descriptions of canonical ways in which joint choices determine interdependent rewards. Game theory is a collection of ideas about how strategic thinking and learning determine choice. We test predictions of game theory in three simple competitive abstract games with chimpanzee and human participants. Subjects make choices on a dual touchscreen panel and earn food or coin rewards. The chimpanzee and human protocols are closely matched on experimental procedures. The results show that aggregated frequencies of chimpanzee choices are very close to equilibrium points; and choices shift with reward changes almost exactly as predicted by equilibrium theory. Remarkably, chimpanzee choices are closer to the equilibrium prediction than human choices are. Chimpanzee and human choices also exhibit unpredictability on average from trial-to-trial (a
property which is adaptive in competitive games), but individual subject-sessions show substantial predictability of choices from past choices and rewards. The results are generally consistent with the cognitive tradeoff hypothesis, which conjectures that some human cognitive ability inherited from chimpanzee kin may have been displaced by dramatic growth in the human neural capacity for language (and perhaps associated skills). As a result, chimpanzees retained the ability, slightly
superior to humans, to adjust strategy competitively and in unpredictable ways, conforming remarkably closely to equilibrium predictions from game theory.

The paper is here; there are other results pointing in the same direction (hat tip-CheapTalk)

Amazing

To have a bank executive to utter these words in 2012 is truly, truly stunning (via marketwatch):

“... in hindsight, the new strategy was flawed, complex, poorly reviewed, poorly executed, and poorly monitored. The portfolio has proven to be riskier, more volatile, and less effective as an economic hedge than we thought.”

This is Jamie Dimon, explaining why the synthetic credit products that JP Morgan created blew up in their face. This is fully 5 years after the financial crisis broke out. The last time something similar to the financial crisis since 2007 happened - in the Great Depression - the US introduced the SEC; broke up universal banks via Glass-Steagal; and introduced deposit insurance. Politicians did what they are there for. They look; they learn; they regulate the craziest risk-taking out of existence. And today? No more than the mildest of wags with a finger. The fact that anyone thinks this is an excuse for big banks - which, as we now know, only exist in bad times because of the taxpayers' generosity - losing billions is truly staggering. What exactly have we done to restrain risk-taking amongst the banks since 2007? Where are the adult politicians and regulators chaining the financial hounds of hell?

Bad banks in a world of bad choices

CNN is quoting me on the Spanish banking crisis. After Bankia was taken over by the government, there will now be bad banks for every Spanish bank by government fiat. The problem is that if the government ends up shouldering the burden (even if only in part), it will blow whatever little credibility it has in bond markets right out of the water. Most of the Spanish banks and cajas are bankrupt today; it is only because the regulators let them pretend that houses in Spain are worth 3 times what they are worth in Germany (yeah right) that they are still in business. If the banks have to do the recapitalizing themselves, this won't really help, except for the illusion of clean accounting -- the reason why we worry about the banks is that they should lend, instead of nursing their wounds from hundreds of billions of misguided lending. There is no clean solution here, short of the banks defaulting on their debts. This would clearly help -- the new financial institutions stepping forward afterwards would find it a lot easier to lend. Of course, this is the step all governments have been avoiding like the plague since Lehman, and it has to be said that it is really hard to gauge the likely consequences.

What I would like to see is a significant shrinking of the Spanish banking system, with a number of bankrupt lenders not taken over, but wound up. That will give the rest more pricing power and the ability to make money off lending money. 

the no-more austerity consensus

is slowly emerging. I am not talking about having to "evacuate" the university building yesterday because of student protests. Or the asinine expectation that the ECB (one a "fact-finding" mission to Barcelona, where they sipped champagne in the most luxurious hotel in town) would introduce new measures to fight the crisis. No less a grand pundit than Paul Krugman is starting to tell people what I have been saying for two years now - at the rate at which we are going, the Euro won't survive, and it's unclear that it should. When I first said it, people shook their heads and mumbled "other-worldly economic historian". It's becoming clear rapidly that the transfers from the North of Europe won't continue, and that belt-tightening is hitting a limit in the South. Via Paul Krugman's "Conscience of a Liberal":

Austerity AlternativesRyan Avent writes what I’ve been meaning to write about the backlash against the austerity backlash. It’s all about attacking a straw man. Nobody — certainly not me — believes that, say, Spain or even France can simply go back to Keynesian policies unilaterally. Instead, the point is that if European leaders want the euro to survive, they have to recognize that the austerity thing isn’t working, and offer Europe-wide alternatives.....
For in the end, Spain and others do have an alternative to endless austerity, one that may be forced on them by events: exit the euro, with all the financial and political fallout that follows. And on the current course, that’s what’s coming.

Transforming Hatred

Vox just published a new piece by Nico Voigtländer and me on anti-Semitism in Germany:

Hatred Transformed: How Germans Changed Their Minds about Jews, 1890-2006

The persecution of Jews during WWII is one of the darkest and most puzzling chapters of recent history. This column asks how economics can help our understanding, particularly of how people’s attitudes to Jews have changed over time. It argues that ‘cultural economics’ shows that there is more to understanding how people behave than looking at their incentives. How and when do people change their minds? For example, watching a popular television series like AMC’s Mad Men seems to transport us straight to another planet. It shows the lives of advertising executives on Madison Avenue in the 1960s who spend their days drinking heavily (from 9am), chain-smoking, and fornicating. While not necessarily an accurate portrayal of corporate life in the middle of the 20th century, it reminds us how deeply cultures can be transformed in a relatively short space of time. In the Western world today, attitudes towards homosexuals, pre-marital sex, and women working outside the home are radically different from what they were a generation ago (Fernandez-Villaverde et al. 2011). At the same time, culture seems to persist over long periods of time. Italian towns that were self-governing in the middle ages are still more prosperous, citizens give more blood, and are more trusting (Guido et al. 2008). Areas of Africa affected by the slave trade continue to show lower levels of interpersonal trust (Nunn and Watchekon 2011). What accounts for the two-faced nature of culture? Why does it change so radically some of the time, while remaining unaltered over long periods? Anti-Semitism as an indicator In the past, canaries were used in coal mining to detect the presence of toxic fumes. Anti-Semitism serves a similar function in our study. As an attitude, it is arguably puzzling – it is extreme, clearly-defined, and dysfunctional. Germany has not been home to Jews in any significant numbers since 1945 (despite some minor inflows after the 1990s). In recent research, we look at the persistence of Jew-hatred in Germany (see Voigtländer and Voth 2012). In earlier work, we show that towns that saw pogroms in 1350, at the time of the Black Death, were still more anti-Semitic in the 1920s and 1930s (Voigtländer and Voth 2011). In this column, we examine how much of the past still matters for the present. Specifically, we ask how much of the anti-Semitism we see based on data from 1996 and 2006 reflects attitudes in the same location as far back as the late 19th century. We also examine the conditions under which hatred of this kind can be accentuated or reduced. Germans today are on average probably not much more anti-Semitic than other Europeans (Bergmann and Erb 1997). At the regional level, however, there are considerable differences. We use data from the German Social Survey (ALLBUS) to examine attitudes towards Jews. The survey asks a battery of questions, such as “Do you think that Jews partly brought persecution in the 20th century on themselves?” Answers range from 1 (strongly disagree) to 7 (strongly agree). Figure 1 shows regional differences (at the district level) for answers to this question, based on the proportion of the population giving a score of 5, 6, or 7. Figure 1. Distribution of extreme anti-Semitic views you can read the rest here. If you want to read the article on which the VOX piece is based, look here. This research follows on from earlier work we did on the medieval origins of Jew-hatred in the 1920s and 1930s in Germany (now forthcoming in the QJE).

J-Pal hires more ITFD students

Congratulations to Filippo Sebastio, who will work for J-PAL (Abdul Latif Jameel Poverty Action Lab) in Bangladesh, starting this summer. He will help with evaluating policy interventions designed to reduce poverty, using the randomized experiment methodology.

Student Guest Contribution: The EU Proposal for a Tobin Tax

As part of the requirements for the ITFD master, our students write a policy memo. Instead of looking at an issue analytically, we ask them to work in teams, and to come up with a concrete policy proposal, assess, and try to convince people of its merit. The students aren't done yet, but they have had to write a first version. This year, I was particularly taken with a contribution by four ITFD students - Alex Hodbod, Daniel Chorzelski, Hannes Timischl, and Lukas Doerfler. Their team is working on the benefits and problems of the Tobin tax, as proposed by the EU commission. Here is their assessment:

Blogpiece – Financial Transaction Tax:Financiers have a lot to answer for. As the architects of the ‘structured products’ that turned into ‘toxic assets’, as the funders of those subprime mortgages, and as the recipients of hundreds of billions in taxpayer bailouts during the crisis, they are blamed by many for the mess the world economy is in. With anti-banker sentiment reaching fever pitch politicians, commentators are looking for ways to tame financial market excesses. One of the more interesting of such proposals is the Financial Transaction Tax, or Tobin Tax. In our Masters project we will investigate whether the introduction of such a policy is a good idea. Here we give some initial insights on the issues raised. We find that the proposal has some merit as a tool to curb trading that is of dubious social value e.g. some high frequency trading and some derivatives activity, but that more targeted interventions might address problems more efficiently.

This idea was initially proposed by John Maynard Keynes in 1936 as a mechanism to reduce uninformed short-term speculative trading and thereby reduce the excessive volatility that the financial sector caused for to the real economy. James Tobin reinvigorated the idea in 1971 with a stronger focus on taxing international trading and maintaining countries‘ economic independence in a floating exchange rate environment. Since then the idea has attracted the support of latter day economic heavyweights such as Joseph Stiglitz (1989), and most recently Paul Krugman (2011).

With such an illustrious list of advocates it does not come as a surprise that policymakers have become interested in this idea. Gordon Brown began this trend by backing an FTT at international meetings in 2009. Support has gradually grown in the European Commission, which recently published a specific proposal for a cross-EU Tobin Tax. The Commission‘s draft proposes a 0.1% tax on the exchange of shares and bonds and 0.01% across derivative contracts. The tax would be levied when one of the trading partner is located within the European Union. Our work will use this proposal as the basis for analysis. We investigate how effective the tax will be at its stated objectives of generating revenue and reducing volatility, and look at the wider negative impact – most notably on the price of and access to funding:
Generating revenue – the EU’s 57 EUR billion estimate is based on a tax of a very broad range of transactions, and involves contentious assumptions about the elasticity of demand for transactions, and the behavioural response of economic agents (who may relocate transactions in order to avoid the tax). In our view the estimate is on the high side of what could be extracted and we see huge political economy problems generated by the uneven geographical distribution of revenue creation from the tax as proposed (with the majority coming from the UK) which makes it unlikely to be agreed.

Reducing volatility – if short term transactions produce more volatility than long term trades, then the tax should reduce overall volatility, as the burden will fall more heavily on shorter term ‘high frequency’ traders. Unfortunately, both the empirical evidence from FTTs in operation, and economic theory generally tends to suggest that decreasing liquidity through an FTT would if anything increase volatility. However, this evidence is generally based on the impacts of equity and debt securities transaction taxes, whereas the EU proposal would fall hardest on derivative activity - as discussed below.

Cost of finance – to the extent that financial markets are competitive the costs of an FTT will at least in part be passed on to the consumers of financial services – most importantly the entrepreneurs in search of finance for projects that will create wealth and employment. In addition, through increasing the illiquidity premium investors demand for holding less liquid assets, an FTT will tend to reduce asset values. This net worth effect can reduce firms’ access to pledgeable collateral and thereby make financing more costly and less available. Estimates of the increase in the cost of capital differ greatly across the literature – Schwert and Seguin find a range of +10 - +180 basis points, Oxera find a range of +66 - +80 basis points.

What is perhaps most interesting about the EU’s proposed FTT is the questions it poses about the value of the huge increase in the volume of derivative activity over recent years. This opaque and ill understood world has exploded in size and importance in the past two decades, and the economic consequences of this remain uncertain. The graph below (taken from Financial Transaction Tax: Small is Beautiful, Darvas & von Weizsacker, 2010) shows the annual turnover of spot and derivatives market trades as a ratio of world GDP.

Total turnover in 2007 had reached almost 70 times total world GDP, 88 per cent of which was accounted for by derivatives trading. This represents a tripling of activity since 1995. Looking at these numbers it is difficult to avoid the instinctive reaction that this market was (and may still be) completely out of control. It is also noticeable that this revolution in the volume (and complexity) of transactions has not been translated into any obvious improvement by the financial sector in its core functions of intermediating credit between savers and borrowers, and allocating resources efficiently. Perhaps a dosage of Tobin’s ‘sand in the wheels’ of this market wouldn’t be the worst thing in the world. 

There is much work to be done to fully understand the different effects of an FTT, not least its application to the derivative market whose value added to the real economy is itself not well understood. Given this, the policy’s most coherent rationale is possibly just that: ‘something must be done’ to slow down the financial sector’s recent tendency to generate ever more transactions and extract ever larger rents whilst failing to improve its service to the real economy. The Tobin tax is a ‘something’ that could fit into this bracket. It may play a useful role as an interim measure to slow some unhealthy tendencies down prior to the introduction of more targeted interventions to address the market failures manifest in excess trading once these are better understood. Meanwhile it could also help to address the public’s concerns about the financial sector’s excessive remuneration and modest tax contributions. However, the question is whether this is sufficiently convincing to justify the potentially significant increase in the cost of capital it would create. As things stand, with Europe still in the midst of a substantial sovereign debt crisis, political leaders seem to have decided that now is not the time to add further to firms’ difficulties in raising funds, and therefore the EU Tobin proposal remains stalled in the EU machinery. Even if that is where it remains this time round, one thing we can be sure of is that the calls for its implementation will resurface somewhere before too long – as the Tobin tax is the idea that will not die.

My Inet Lecture in Berlin

... due to family reasons, this must have been the shortest trip I ever took, but with 1,600 + hits on youtube on day one, it seems to have hit a nerve:

The whole thing was made more challenging by the (normally highly efficient) INET people not managing to upload my presentation, so that I had to speak without slides or a manuscript. At least, one finds out if one knows one's own stuff...

"What has to be said" - Germany's leading Waffen-SS poet lectures Israel on its right to get nuked - special edition

Günter Grass, German novelist and poet and a Nobel Laureate, is causing a stir with his poem "What has to be said." You can see him read it here. As poetry goes, it is a sad joke; it has no redeeming poetic qualities whatsoever. Instead, it displays every last bit of incoherence and moralistic-condescension-as-politics that makes German left-wing public discourse to sickening to watch, especially for those who (like me) actually can occasionally see some merit in the arguments. This time, however, there are no such redeeming features.


Let's start in the beginning. What is it that Grass feels he has to say? He can no longer remain silent, he says, given that Israel now claims a right for a first strike on Iran. He thinks that this is all wrong. Israel has nuclear weapons, many; and the mean Israelis don't even want those nice Iranians to have a single one! And a pre-emptive strike? How evil. The German involvement, the reason why Grass now has to go public? Selling submarines to Israel. In his book, this is equivalent to collaborating in a crime against world peace. If this all sounds confused and confusing to you, that is because it is. Grass was never very coherent, but old age has not helped. Some of his novels are decent, and form part of German curricula for a reason. 


If you think in abstract categories of "should sovereign states be allowed to decide if they want nuclear weapons", the most you can say is that there a hint of logic here. Almost a century ago, the German economist/lawyer/sociologist Max Weber distinguished two types of ethics - ethics of intent ("Gesinnungsethik") and ethics of responsibility ("Verantwortungsethik"). One cares about feeling superior and good about your own intentions, and consequences be damned; the other thinks through what the results of one's own actions will be, and then decides on a responsible course of action. Tom Lehrer, the American mathematician and comedian, described the left-wing penchant for ethics of responsibility best in his Folk Song Army:

One type of song that has come into increasing prominence in recent months is the folk-song of protest. You have to admire people who sing these songs. It takes a certain amount of courage to get up in a coffee-house or a college auditorium and come out in favor of the things that everybody else in the audience is against like peace and justice and brotherhood and so on. The nicest thing about a protest song is that it makes you feel so good...

We are the Folk Song Army.
Everyone of us cares.
We all hate poverty, war, and injustice,
Unlike the rest of you squares.

If you feel dissatisfaction,
Strum your frustrations away.
Some people may prefer action,
But give me a folk song any old day.

Remember the war against Franco?
That's the kind where each of us belongs.
Though he may have won all the battles,
We had all the good songs.

Grass's so-called poem is ethics of intent at its most maddening. The idea of moral equivalence between Israel and Iran is so troubling that one doesn't really know where to start. Israel is the only more-or-less democratic, open, Western, more-or-less liberal country in the Middle East. Whatever one thinks of occupation policies, the country as a whole has freedom of speech, freedom of assembly, free elections, a free-market economy.  Let's think through where Grass's logic leads. Iraq, accordingly, should have also had a right to build nuclear weapons; Israel was wrong to attack the Osirak reactor in 1981, too. How would a world with an Iraqi nuclear weapon have looked? How much of Tel Aviv would be left after the last Scud missile had rained down on Israel? Not much.

I am not saying that attacking Iran now is a brilliant idea; it may well be very, very stupid, given how advanced the Iranian program is and how hard it will be to degrade Iran's nuclear capability. But the idea that the (not exactly nice) Netanyahu administration should not consider all options, faced with the chance that a madcap regime like the Iranian one might acquire the bomb, is simply bizarre. And it doesn't call for self-absorbed, vacuous and quite frankly bad "poetry" from a former soldier of the Waffen-SS, no less; it calls for considered judgement and hard choices, for responsible pragmatism.

Austerity and Confidence

Brad Delong has written an excellent VOX piece containing some home truths on austerity, together with a review of the latest writings by Corsetti, Alesina, and Giavazzi:

WILL SPENDING CUTS IMPROVE CONFIDENCE? THE ARITHMETIC PROBABLY GOES THE WRONG WAY
VoxEU: This column is a Lead Commentary on VoxEU's debate on Austerity:In their recent ‘Lead Commentary’, Alesina and Giavazzi (2012) attack Corsetti (2012) for missing the point:
The European debate on fiscal austerity has gone astray – focusing exclusively on the size of deficit reductions. What policy makers should really be focusing on is the budget tightening’s composition (tax versus spending) and on the accompanying policies. Indeed, the title of this Vox debate – “Has austerity gone too far?” – reflects this inappropriate emphasis…
But as I read further, I feel that Alberto Alesina and Francesco Giavazzi immediately proceed to miss an even bigger point. They say:
…spending-based consolidations accompanied by the right polices tend to be less recessionary or even have a positive impact on growth. These accompanying policies include easy money policy…
But right now in Europe we are not going to have easier monetary policies to offset the contractionary effect of fiscal policies, are we?
Indeed, it is not even clear what, in today's context, easier monetary policies would mean.
The ECB could induce banks to make more loans, and fund more investment and consumption spending by credibly promising to raise its permanent inflation target – but it will not so promise, and it would not be believed if it did. The ECB cannot induce banks to make more loans and fund more investment and consumption spending by swapping bonds for reserves as long as the value of pure liquidity is zero and reserves are as good as – nay, better than – short-term bonds. The ECB could induce banks to make more loans and fund more investment and consumption spending by taking risk onto its balance sheet and so freeing-up scarce private risk-bearing capacity – but is that monetary policy? No, that is fiscal policy, albeit non-standard fiscal policy.
Fiscal policy is the only game in town. If austerity is to boost recovery, it must do so because it in itself is good for recovery – not because it is accompanied by monetary policies that speed recovery.
It is certainly the case that a Europe with shaky credit could boost its economy by pursuing a spending-based reduction in its deficit that boosted confidence in public credit. As Karl Smith (2011) of UNC Chapel Hill noted, one way of seeing this is to look at a neo-Wicksellian equilibrium flow-of-funds condition in financial markets. On the left-hand side place the net flow of private savings into a country's financial market: its domestic private savings which depends on the level of economic activity (i.e. Savings[Y]), minus net exports (NX). On the right hand side place the change in the desired bond holdings of banks and other investors, a function of the riskiness of bonds ρ and the real opportunity cost of money to banks, the difference between the nominal interest rate i and the expected inflation rate π, i.e. i.e. ΔB[i - π, ρ]. The resulting neo-Wicksellian equilibrium condition is:
Savings[Y] - NX = Δ Bond_holdings[i - π, ρ]
This equation tells us that the warranted level of domestic private savings – and thus, via savings, the short-term equilibrium level of economic activity Y – can be boosted by: 1) a depreciation that raises NX, 2) monetary policy that reduces i, 3) a commitment to higher future inflation that raises expected inflation π, or 4) policies to reduce the riskiness ρ of the bond stock – by policies like loan guarantees, forced recapitalization of the financial sector, or adoption of a budget strategy that reduces the risk of holding private or public bonds that may be subject to default, less-than-fully-voluntary exchange, or unexpected inflation.
The only stimulus possibleIn a situation where an economy is at the zero lower bound so that i cannot be lowered, a central bank that will not raise π, and a common currency that rules out depreciation to raise NX, reducing the riskiness ρ of the bond stock is the only game in town.
Now a credit-worthy government like the US would have no problem reducing the average riskiness ρ of the bond stock. It would simply issue more bonds and spend the money on projects of social utility. Because its credit is good, its bonds are automatically less risky than the average, and so the average riskiness of the bond stock falls.
And a government with shaky credit that adopts a credible fiscal plan also has no problem reducing the average riskiness ρ of its bond stock. It adopts its plan. Its plan is credible. And, voila, the average riskiness of the bond stock declines – and so the warranted flow of private domestic savings rises, and so the equilibrium level of economic activity rises as well.
What makes a fiscal plan credible?But what is a credible fiscal plan? It certainly involves in the long-run balancing the funding requirements of the promised social insurance system with taxes. But what does a credible fiscal plan require in the short run? Does it require austerity now, and spending cuts now?
The point of Lawrence H. Summers's and my contribution to the spring 2012 Brookings Institution Panel on Economic Activity was that, as a matter of basic arithmetic, if there is any short-term Keynesian multiplier at all – even one as low as 1/2 – and if there is any long-run shadow cast on potential output by a deeper economic downturn at all – even one as low as 1/10 – then for a country like those of western Europe with a marginal tax-and-transfer share 0.4 and an expected long-run growth rate of 2% per year, short-term spending cuts worsen the long-run fiscal picture as long as the government's real long-term borrowing cost is under 5%.[1]
Thus, unless we believe that the long-term real borrowing costs for western Europe as a whole will be more than 5% per year – that nominal borrowing costs will be more than 7% year – spending cuts now to reduce the deficit are likely to erode rather than bolster the overall fiscal situation. They damage rather than restore confidence. They raise rather than lower the riskiness of the outstanding bond stock. And so they reduce rather than raise employment and production in the economy.
Credible plans and programs for long-run fiscal balance, yes.
Structural reforms to free-up enterprise and increase opportunity, yes.
Reworking the social-insurance state to make it cheaper and less wasteful, yes.
But spending cuts now to lay sacrifices on the altar of credibility in the hope of improving confidence and reducing the riskiness of the outstanding bond stock? No. The arithmetic simply goes the wrong way – unless you believe that Eurozone nominal bond yields will soon normalize to levels above 7% per year.

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ReferencesAlesina, Alberto and Francesco Giavazzi (2012). "The austerity question: ‘How’ is as important as ‘how much’", VoxEU.org, 3 April.
Corsetti, G (2012), “Has austerity gone too far? A new Vox Debate”, VoxEU.org, 2 April.
DeLong, Bradford and Lawrence H. Summers (2012). “Fiscal Policy in a Depressed Economy”, paper presented at the Spring 2012 Brookings Panel.
Smith, Karl (2011). “More on BL-MP”, blog post on Modeled Behavior, 8 October 2011.

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Greece's money supply is

evaporating at a very high rate. The usually excellent Sober Look blog dissects the paradox of the BOG's growing balance sheet on the one hand, and the country's imploding monetary aggregates on the other:

The ECB has completely lost control over the monetary policy for GreeceThe Bank of Greece balance sheet has expanded sharply this year. This of course is part of the ECB's balance sheet expansion on a consolidated basis. But the Greek central bank's balance sheet by itself is now almost €200 billion. That's an unprecedented amount for Greece and represents over 65% of the nation's annual GDP. It is also close to a 50% increase year-over-year.

Bank of Greece balance sheet ( €mm, source: BoG)

One would expect at least some impact on the monetary aggregates from such a dramatic expansion. Yet the money supply measures, both narrow and broad have collapsed. We've seen this before with other periphery nations such as Italy. But nothing on this magnitude.

Greece contribution to Eurozone's money stock year-over-year growth (source: BOG)

This trend shows a massive drain of liquidity out of the system that will result in a total seizure of credit. How can the ECB claim any control over the monetary policy when a 50% increase in the Greek central bank's balance sheet results in a 16% decline in M1 and nearly a 20% decline in M3 money stock?  Greece is now in a  permanent state of extraordinarily tight monetary conditions no matter what the central bank does. In such an environment there is absolutely no hope for any growth, let alone fiscal consolidation. It seems the only possible solution for Greece may be to take control of its own monetary policy, which would require abandoning the euro. An ugly outcome, but given the ECB's inability to stabilize Greece's rapidly shrinking money supply, there may be little choice.

What's being cut in Spain?

You may have read about budget cuts in Spain. Where do they fall? Over at nada es gratis, a great econ blog (in Spanish), FLORENTINO FELGUEROSO has a great post on "Bread and Circus". R+D is going down; this matters for the hard sciences. In the humanities and social sciences? Not sure. Research grants from the Research/Education/add renaming exercise here Ministry were always so small you needed a microscope to see them... largely independent of the merit-points in the academic evaluation, or the amount one requested. Apparently, the time-honored distribution rule was "cafe para todos" (coffee for all). You see, discrimination based on quality is inappropriate. So, to be honest, this won't make much of a difference to the quality of research that I see going on here; funding was a joke long before. All the serious money comes from the ERC anyway these days, at least in economics. Job training is also being cut, clearly part of a cunning plan in a country where unemployment is pushing towards 25%. And what's going up by 13.6%? Payments to the state's sports agency. No joke. Apparently, they are taking on some new responsibilities, too, so this is not quite comparing like with like, but it is still... pretty depressing.

All of this reminds me of an old joke by American comedian Evan Esar, who said "America believes in education: the average professor earns more money in a year than a professional athlete earns in a whole week." Let's do the numbers for Spain. The country's soccer clubs dominate the international leagues largely by paying what it takes, and buying the best, like Cristiano Ronaldo (Brazil) - current pay $17.06 million -- and Lionel Messi ($ 16 million). Average pay at Barca and Real Madrid is now $ 7 million p.a. Most professors would be hard-pressed to earn €45,000 a year. So the equivalent calculation to Esar's quip is even worse: "Spain believes in education: It pays the average professor more money in a year than a soccer player earns in three days of hard work."