I hate to sound like a libertarian, but there seems to be a problem with democracy and the problem is government. Unfortunately, the debt crisis afflicting much of the industrialized world has focused the debate on whether government is too big or two small. I am a firm believer that there is no such thing as big or small government: a government can be too big in all the wrong places, but also too small in areas where society would benefit hugely from its presence. Indeed it seems to me that Western democracy (particularly its Anglo-Saxon variety) has swayed too far into this inefficient equilibrium, one which – to use a domestic example – appears scarily like the father who leaves their kids out on the street all day, and then abuses them when they are at home. It doesn’t take a genius to see what kind of children/citizens this noxious type of paternity creates in the long run.
Big brother is blinding you
Leviathan is alive and kicking
The US and Britain are undoubtedly the poster boys for this new kind of two-headed government: one which is a true leviathan in the ways that its all-powerful security apparatus puts a stranglehold on society, but at the same time retreats from its socio-economic responsibilities. It justifies the former attitude by the claim that they are at war with “terror”, however laughably ambiguous this concept is. To be fair, that these countries are in the cross-hairs of terrorist groups is unquestionable; according to the NSA, the data captured through its PRISM program managed to thwart 50 terrorist attacks. Perhaps this is true, perhaps it’s an exaggeration. But this has left some serious questions on the legal and constitutional mandates that such espionage programs rest upon, and most importantly, whether a democratically elected government has effectively been given a blank check to spy on its own citizens. The West, including the US and UK, has criticized Turkey’s prime minister, Tayyip Erdogan, for his wild claim that “winning three elections” gives him the mandate to rule as he wishes. But how is justifying domestic and global espionage in the name of the war on terror any different? How to justify even more blatant abuses such as spying on diplomatic missions, even from military allies? Considering the filth that just two whistle-blowers (Bradley Manning and Edward Snowden), have uncovered about these programs, one can only wonder what appalling and outright criminal acts these two self-described standard-bearers for democracy and freedom have done or are capable of doing. Continue reading
Holy stagnation, Batman!
For the better part of the past four years, I’ve been tracking the way the world’s leading industrialized economies have performed since the 2008-09 global crisis through a chart which shows real GDP relative to their pre-crisis level. The beauty of this chart is that it shows the post-crisis recovery as a sort of race between the various economies as they struggle to regain the lost output from the crash. For those who find reading Excel charts to be akin to reading a manuscript in Aramaic or Swahili, allow me to explain. The chart takes the peak pre-crisis level of real GDP as “100” and tracks quarter-on-quarter growth from there. So the first data point (“100”) for each country is the quarter before the crisis when real GDP peaked, this being Q1 2008 for most (Q4 2007 for the US where the crisis began, and Q2 2008 for Spain whose crisis began later). As you can see, the paths of these countries have diverged considerably since bottoming out during the 2008-09 crash. Some of the hardest-hit countries at the beginning like Germany and Japan are doing better, while some of the lesser affected ones, like Spain, now appear to be on a death spiral with no end in sight.
It doesn’t pay to be frugal
Perhaps the first obvious conclusion from this chart is just how bad the Eurozone is doing, and how the continent’s on-going crisis is dragging down even its star performer, Germany. Germany, until quite recently (Q2 2012), had been the best performing among the “trillion-dollar” economies and along with the US, the only to have managed to exceed its pre-crisis output. But it just goes to show how even a hyper-productive economy like Germany’s will feel the pinch if its trading partners get mired in recession which is what has been happening over the past year. This further makes the case that even if bailing out the continent’s basket cases may not be “morally” right from the frugal Germanic perspective, it makes perfect economic sense in order to keep your own economy from sinking in the same ship. Continue reading
The future is looking increasingly blurry
I have long believed that the only real solution to the Euro crisis, barring a fiscal union which Germany so staunchly opposes, is to publically announce a mechanism whereby countries can leave the Euro in an orderly and negotiated fashion. This would diffuse the crisis’ most volatile element: the market uncertainty arising from the potential domino effect of defaults and Euro exits. As I’ve argued on more than one occasion, a Greek collapse matters little in the grander scheme of things. It’s the uncertainty over how European institutions would handle a Euro exit that generates the potential for contagion to other countries that indeed matter, like Spain or Italy which by virtue of their size are capable of breaking the union should they end up in Greece’s sandals.
Blasphemy say the Eurocrats! Such a mechanism is an implicit acknowledgement that the union has failed and there’s no legal basis for it anyway. Plus, you don’t just walk out of your family do you? Well, actually you do if your family is completely dysfunctional and the house is burning down in front of your very eyes. This is the unfortunate position that Europe once again finds itself in, barely a few months after a series of measures had led many to believe that the crisis had been “solved”. The first was the ECB’s bond buying programme in late 2011 and early 2012 which brought Italian yields back to stable levels (they had hit 7% for a while). The second was the fiscal compact agreed by 25 out of 27 countries in which they agreed to abide by certain fiscal rules or else face an empowered EC now able to dish out punishment. The third was the second Greek bailout, accomplished only negotiating a bond swap with private bondholders. Problem solved? Not. Continue reading
“Gentlemen prefer bonds” – Andrew Mellon (1855-1937)
They rock your markets
Ever since the global financial crisis exploded a few years back, the bond market has been at the forefront of the media’s attention after decades of always playing second fiddle to the stock market. Be it sub-prime mortgage bonds which were tearing holes out of investment banks’ balance sheets in 2007 and 2008, or Greek sovereign bonds on the verge of default, people are finally waking up to the importance of the bond market within the global economy. But besides being the largest and most important financial market in modern capitalism, the bond market can tell us a lot about the current and future state of the economy in ways that the Dow Jones or Nasdaq could not. And despite the jargon, they are not so difficult to understand. So, without further ado, here’s all you wanted to know about the bond market, in a language you can read (which is English, a language seemingly lost to many economists).
What is a bond?
In the simplest sense, a bond is basically debt. What makes a bond different from other types of debt (say, a loan) is that a bond is tradable, just like any other security such as a stock. So for example, a company can go to a bank and get a $1 million dollar loan, or he can issue $1 million dollars’ worth of bonds (say, 1,000 bonds worth $1,000 apiece) to a potentially limitless range of investors. Bonds are generally preferred over loans as a form of debt because you can issue more of it at one go (no bank is ever going to give anyone a $10 billion loan!), and because it is generally cheaper than a loan. This is because there is less risk attached to it from the lender’s perspective. Whereas the risk of a loan defaulting is borne entirely by the bank that issued it, the risk of a bond defaulting is spread across dozens of bondholders, none of which owns the full amount of the issuance (i.e. no-one bought all those bonds). As a result, a bond will likely fetch a lower interest rate than an equivalent loan, which is clearly better for the issuer. The flip side is that bond issuance is only feasible for government and medium/large firms: a small and relatively unknown firm needs to convince dozens of investors who probably know nothing about the company to buy its bonds. Continue reading
It is said that a picture is worth a thousand words and an economist would probably agree that a chart has similar value. And if one chart can make the claim that Germany has been the single country in the Eurozone to most benefit from the common currency, then this is it: the current account balances of all Eurozone states over the past two decades. The implications of this chart are staggering. Since the Euro was adopted in the year 1999, Germany’s current account balance (which basically sums up the balances of trade in goods and services, as well as income and transfers) has ballooned from a mild deficit into a colossal surplus – in absolute terms it is now the second largest surplus in the world, only behind China’s. German policymakers will not stop boasting that the country’s surplus is actually a reflection of its competitiveness, itself a consequence of the efficiency of its export-based manufacturing base, as well as in the self-sacrifice of the German labor force who accepted a decade of stagnant real wages and consumption in order to stay competitive. This is partly true. Yet in the last decade before adopting the Euro, Germany was actually running a deficit. Looking at the other side of the line is equally interesting, for those countries now running massive deficits were actually doing quite well during the 1990s: Italy and France all had surpluses and Spain’s deficits were negligible. Is this all just one giant coincidence or did the Euro have a fundamental role in widening the imbalances of the Eurozone to critical proportions?
The Eurozone’s imbalances
To answer that question, it’s important to recall the ways in which unproductive economies (mainly the southern European periphery), stayed competitive in the bygone days of national currencies: by devaluation. The constant debasement of their currencies would offset the productivity differences with their more efficient trading partners (such as Germany), and also offset the differentials in inflation rates which worked against them (a country with higher inflation sees its currency strengthen in real terms to its partners). By keeping their currencies weak, they kept their exports strong, the flip side being that little effort was made to address the structural issues behind their lack of competitiveness since there was such an easy way out of the trap. But the Euro changed all this. By having the same currency as their main trading partners, the easy route of instant competitiveness disappeared. This was exactly what the Germans wanted, for according to Germanic logic such limits would naturally push these countries into “turning German”, i.e. becoming competitive the right way, through increased productivity. The Eurozone would therefore turn into a hyper-competitive economic giant to rival, if not surpass, the United States which since the 1980s had widened the productivity gap with its trans-Atlantic rivals. Continue reading
When the Euro was launched in 1999, I was but a wee lad, barely over one year into an undergraduate degree in the dismal science. The common currency was something of a curiosity at the time as its ambition was unprecedented even for our globalized age. After all, it certainly seemed to be one giant step ahead of my country’s own feeble attempt (in comparison) at economic union: NAFTA, which had barely half a decade of existence at the time. For those who were worried about US hegemony, the launch of the Euro was a subtle reminder that a new and powerful economic force was being born, one which would hopefully shape the global economy into the more socially progressive image of Europe, rather than the rapacious gung-ho capitalism which Washington and Wall Street had shoved down our throats. More symbolically, it represented – at least in my eyes – a watershed event in history, whereby for the first time Europe was united not by Napoleon’s guns, or Hitler’s panzers, but by a common and voluntary belief that the path to future prosperity was one that no European country should have to travel alone.
It’s time to question its existence
How the times have changed. I’m not going to dwell on the implications or even the possibility of a Euro breakdown (there’s plenty of that around), but it has come to a point where a economists we should really question whether the Euro was that great leap forward promised a decade ago by Europe’s leaders, or a colossal mistake whose benefits were overhyped and its potential drawbacks blissfully (or conveniently) ignored. For this I found a nice little PDF from the European Commission, probably written around 2007, right before the financial crisis exploded in everyone’s faces. With the benefits of hindsight let’s see whether the Euro has lived up to its lofty promises. Continue reading
Before I begin my third and last post on the Euro crisis (read the other two here and here), let’s recap on the two main points I’ve made so far. The first point is that a Greek collapse, as catastrophic as it would be for the Greeks themselves, should not in itself endanger the integrity of the Eurozone as a whole. The second point is that if a Eurozone meltdown is going to happen, it will be because a bigger country, most likely Italy, will be the one crashing out. But the economic and political fundamentals of Italy are no worse than Japan’s which has not faced anything even remotely like the fury which the markets have unleashed upon the hapless Italians. So now this leads me to the third point. The Euro crisis is not a crisis of macroeconomic and debt fundamentals but a market crisis of political confidence displaying all the characteristics of a self-fulfilling prophecy.
“If men define situations as real, they are real in their consequences.” – William Isaac Thomas (sociologist)
We might be seeing a lot more of this soon
The self-fulfilling prophecy is without a doubt the most pernicious of all economic phenomena. It is where rationality gets trampled by the animal spirits which more often than not guide the behavior of economic agents, that is, human beings (you are more likely to find the yeti before you find homo economicus). In financial markets, this is all the more evident and all but the most fervent apostles of the efficient-markets hypothesis (which assumes that markets always perfectly factor in all available information) cannot deny that the behaviour of markets often seems to be guided more by euphoria and paranoia than cool, calculating logic. Self-fulfilling prophecies are the catalysts of bank runs, of stock market collapses, and of turning a small country default into an economic Armaggeddon the likes of which capitalism has not yet experienced in its two centuries of existence. In the latter case, it is because no other economic force has the power to turn a problem of illiquidity into a much more dangerous one of insolvency. Ultimately, this is what markets have created out of Greece and nearly done the same for the smaller troubled peripheral countries, mainly Portugal and Ireland. If they do it to Spain or (especially) Italy, we’re screwed. Continue reading
One is on the cross-hairs. The other not quite.
In my previous post, I tried to explain why a Greek collapse (be this in the form of a default or a Euro exit) should not be such a catastrophe to anyone except for the Greeks themselves. The cost of recapitalizing exposed banks would be a fraction of the money spent rescuing the banking system in 2008, and the financial and trade linkages with Greece and the rest of the Eurozone are so meagre that the common currency area should be strong enough to resist one of its weakest members going bust. But of course, that is not the scenario that keeps European politicians awake at night these days. That is Because although a Greek default may appear to be a disaster, a default among one of the Eurozone’s bigger economies – mainly Spain and France – would be economic Armageddon. A scenario like this would dwarf even Lehman’s bankruptcy in the scale of devastation it would unleash upon the global economy, particularly now that governments in the West are too weak to undertake bank bailouts and fiscal stimulus packages like they did back in 2008-09.
But this leads me to the second part of my argument: even the doomsday scenario of an Italian collapse doesn’t hold up to the reality of its economic fundamentals. I’m not saying this means it could never happen. Quite the contrary: if markets believe it will happen, it will happen, all that is needed is to get enough market aversion to Italian debt that Italy’s bond yields are pushed to unsustainable levels. But why should markets believe it? And more importantly, why didn’t markets believe this during the first year of the Euro crisis, when Italian bond yields had been left practically untouched? What has changed during this time?
The answer, quite simply, is nothing. Continue reading
Setting Europe ablaze
As an economist, it’s hard to look at the financial news coming out of Europe recently and not get a sense of déjà vu. In the last few weeks we have witnessed the most severe stock market crashes since the post-Lehman meltdown, a major European bank has needed to be bailed out, the recovery appears to have petered out (on both sides of the Atlantic no less) and frantic discussions are taking place in the upper echelons of power in order to starve off what many believe is another imminent disaster. I don’t want to sound nostalgic but it sure is feeling like the summer of 2008, this time with Europe rather than Wall Street at the center of the gathering storm.
But it’s time to stop and think for a minute. How did we get from a debt crisis in a peripheral member of the Eurozone, to openly contemplate the breakdown of the world’s biggest and most solid economic union? To answer this question, it is necessary to see the current European crisis from two separate angles. The first is through the simple logic of economic fundamentals of debt and growth. As I will try to prove in this post (and its follow ups), the fundamentals are actually not as dire as most people think. However, the second angle is indeed quite frightening. It is that of a market crisis, triggered by a loss of confidence in European policymakers’ ability to effectively address a series of worst case scenarios related to the integrity and future of the Eurozone. Will any of these scenarios actually play out? Only if markets believe they will, thus becoming a textbook case of a self-fulfilling prophecy of apocalyptic proportions. Because if there’s anything to be learned from economic history, it is that when reason and panic collide, panic will always win out.
What follows is my humble attempt at trying to put reason back into the spotlight. So put down the latest newspaper or magazine cover story on the Euro breaking apart, turn off that video with the ranting analyst preaching doom and gloom. Let’s look at the cold hard facts. Continue reading