You are neither dumb, nor stupid, Paul…

Definitely competitive in 2006, but what about the future? World Cup celebrations in an Italian street, by angelocesare

…, obviously not. But lots of people take an important assumption of your argument for granted.

That, admittedly, was not clear from what I wrote. I was a little sloppy in phrasing my arguments and made it seem like Paul is confusing liquidity with solvency, which of course he is not. So let me try to be clearer this time.

The „illiquid but solvent / self-fulfilling“ (SF) argument says that when solvency concerns lead to rising yields, this in turn undermines the sustainability of the debt, leading to yet another increase in yields, etc. Solvency concerns (or speculation in this direction) become self-fulfilling in this case. This argument is intuitive and under certain assumptions correct. Karl Smith actually applied for the title of „most detached econblogger“ because he found it to be too obvious to write much about it.

However, the key assumption for multiple equilibria is that the true probability of default is in a certain range in which both equilibria are possible. It doesn’t say that every default is the result of a self-fulfilling dynamic. Contrary to many proponents in the German press, Paul is of course aware of that (emphasis mine):

The point, however, is that Italy and Spain arguably are at risk of suffering from self-fulfilling panics. And you need open-ended credit to avert that fate.

And in an earlier post on the subject, he writes:

In the case of Greece and probably also Ireland and Portugal, I’d argue that we’re looking at fundamental insolvency. The debts are just too big, the required fiscal adjustment just too large even if interest rates were low, to make full payment plausible.

The problem is how to distinguish a multiple-equilibria situation from cases of genuine one-equilibrium insolvency – especially for countries as the future capacity to repay is not based on assets in a narrow sense but on the expectation of future economic growth. Some people made the SF argument in 2010 for Greece – a politically and institutionally weak country with ridiculous recent inflation dynamics trapped in a currency union with macroeconomically prudish countries like Germany and a stubbornly suicidal ECB. That was obviously wrong, and in my view not only in retrospect. For Portugal, the verdict is not in yet, but as my guest blogger Henry Kaspar pointed out, it doesn’t look good; for Ireland it looks much better now.

For Italy and Spain, there is a reasonable chance that it is in fact a self-fulfilling liquidity problem, but – and that was my main point – it is by no means certain. A backward-looking remark about Italy having a primary surplus is just not enough to make your case and Henry’s analysis is not encouraging. If a country is credibly committed to re-gaining competitiveness, and it has the political institutions to succeed, there is every reason to start unlimited liquidity support to prevent a self-fulfilling panic. If it can’t (like Greece) or is reluctant to (like Italy?!), then what looks at first like a self-fulfilling liquidity-turned-solvency problem is in fact a garden variety solvency problem, and should be treated as such: support, yes, but with heavy conditionality to turn it into a liquidity problem.

As Henry Kaspar writes:

[L]iquidity support should be conditional – conditional on credible assurances, or even better: demonstrated behavior to do what it takes to improve competitiveness and remain solvent. Any liquidity provider – be it the ECB, or the EFSF, or Germany – is perfectly right to insist on this. Unconditional liquidity support provokes unsustainable behavior, and therefore risks undermining the sustainability of the euro area instead of promoting it.

Exactly. So don’t blame Germany alone (unless you are talking about monetary policy) for a political mess that is founded to an underappreciated extent on other countries’ unwillingness to aggressively restore competitiveness.

PS: I should also point out that my presentation of Germany and its internal devaluation between 1998 and 2006 was not meant as a „look how good we are“ example, but more as a „damn that was hard“ example for why I am sceptical that Italy and Spain are solvent, let alone Portugal or even Greece.

PPS: See also Ryan Avent’s response to Henry’s post.

Kommentare

  1. DreF schreibt:

    The problem is how to distinguish a multiple-equilibria situation from cases of genuine one-equilibrium insolvency.

    Let’s try Krugman: „In the case of Greece and probably also Ireland and Portugal, I’d argue that we’re looking at fundamental insolvency“. The term „probably“ is always a great measure. In the future just ask Krugman and you probably get an answer that is „probably“ correct.

    Also: The S of doom looks like a fallacy to me. You got like three possible scenarios and then you draw a graph that „explains“ exactly does scenarios. Because of the sketchiness of the graph you can always say: Look now we are here, now there and so on. But actually there’s no proof that this graph has something to do with reality at all.

    And you need open-ended credit to avert that fate.

    A real Krugman. He’s serious about this, right?
    Opend end credit – the answer of a true Keynesian to all questions.

  2. redbeetle schreibt:

    I am firmly in the camp of those believing that the European debt crisis is a self-fullfilling panic which should be stopped by joint guarantees of Eurozone governments or the ECB. Here is a response to the various posts of Kantoos and Henry Kaspar over the last couple of days (I post it here even though it refers to various posts):
    • What I see from Henry Kaspar’s second picture (showing the CDSs for Spain and Italy as well as their unit labour-cost based real exchange rates) is this. CDS spread for both Spain and Italy are increasing. Also Spain is paying too high interest on its debt. The fact that the internal devaluation is underway in Spain does not seem to make investors sufficiently willing to lend to Spain at rates implying sustainable debt dynamics. In this sense (and this is the only sense that matters) there is not difference in the way the markets are treating Spain and Italy. Hence the graph does not support Henry’s claim that the behavior of lenders can somehow justified by fundamentals (other than the level of the interest rate the crisis countries have to pay itself) and is thus no argument against a self-fulfilling prophecy.
    • Kantoos argues that the crisis countries have to go through a similar internal devaluation as Germany did in the previous decade and this will be associated with weak growth, since it was in Germany. He thinks that this possibly bleak outlook raises legitimate doubts regarding the solvency of Spain and the other crisis countries, thus warranting the wariness of financial markets. But as the German example also shows, such bleak growth prospects do NOT necessarily lead to doubts regarding solvency. At NO TIME during the 2001-2006 period, when Germany was perceived as the sick man of Europe and the mood in Germany was really bad, did any investor EVER doubt the German government solvency (and that in spite of the fact that it was actually quite fashionable among German Journalists to do so). So pointing out Germanys experience only serves to underline that current market behavior is not rooted in fundamentals.
    • Both Spain and Italy have in the past been able to reduce their debt-to-GDP ratio substantial magnitudes. For instance, Spain managed to reduce it from 67% to 36% in 2007 (and then came the financial crisis). Italy managed to reduce it from 122% in 1994 to 104% in 2004, after which it stayed roughly constant until 2007. The supposedly “functional” political process in Germany praised by Kantoos has only ever managed to produce rising debt ratios over the last 30 years – which is, by the way, why the debt brake was put into the German constitution in the first place. Yes, Spain had a long economic boom to help it, but the German debt ratio does typically not even decline in good times, for instance because cyclical surpluses have often been used for tax cuts, like in 2001. Yet bondholders do not seem to attach importance to these factors. Why?
    • Finally, there is no consensus in the literature regarding criteria determining when a government should be declared insolvent, beyond the triviality that an upward trend in the debt-ratio is possibly dangerous. There appears to be hard limit to the debt-ratio still associated with solvency (as the case of Japan shows). The fact that the US debt-ratio is (under current policy) on a secular upward path does not spook investors. If there are no clear benchmarks, this boosts the scope for self-fulfilling prophecies – absent a central bank which backs government debt. Given the lack of objective criteria, I don’t think the burden of proof should be on Spain and Italy to show that they are solvent. The burden of proof should be on those who believe that there are objective criteria for government solvency, and that they can explain why Spain is in trouble and Germany (and the UK, and the US…) is not.

    • Rien Huizer schreibt:

      @ redbeetle

      You wrote

      „I am firmly in the camp of those believing that the European debt crisis is a self-fullfilling panic “

      So am I, but it is a self-fulfilling panic with real roots. Just communalizing all the present (and especially future) debts is against most lessons from history. Besides, it would mean political suicide in the countries that are currently on top. And it would play in the hands of the Anglo Eurosceptics.

      The real problem that this discussion (very entertainingly) highlights is that solutions for the liquidity crisis risk future solvency of a larger area than now exposed to the positive feedback mechanism.

      There is no shortage of economics based solutions for this (although no solutions would enable the EUR area to grow faster than it did during the run up to the crisis, so whatever happens, there will be discomfort) but whereas the Anglo recipies focus on growing the pie, the Continentals have a habit of focusing on distribution. And given an institutional/power vacuum at the top, distribution considerations will slow down the „solution“ (in essence hoping for times to get better whilst maybe doing too little too late) and distort any initially reasonable design into another EU monster (how long have we complained about the EU solutions for „Regions“ and „Agriculture“). But, at least this acts as a giant damper on the financial markets and helps the EUR from behaving like the JPY (or prevents the USD to usurp the EU’s export space).

      The funny thing is that the policies (or lack thereof) of the stronger EU countries – based on the political imperative to be nationalistic within a community based on communautarian ideals- cause the EU’s critics at least as much pain as the countries at the core of the „self-fulfilling panic.

      As a joke: make the souvereign CDS market and the souvereign bond market completely transparent by requiring all market participants to list their trade in a pubic register (if not, the deals are unenforcible)
      That would show whether this is a self fulfilling spiral (with the CDS market as the tail wagging the dog) or not. But, as a joke only..

  3. LH schreibt:

    In the end it’s of course about competitiveness. But competitiveness is something relative, you need to say competitive against whom? The important thing is that competitiveness against -say- China doesn’t matter here because there is a flexible exchange rate taking care of imbalances. If Europe as a whole is not competitive enough, just let let the euro decline against its trading partners. What matters for the euro-crisis is relative competitiveness within the euro.
    1. The first thing to acknowledge now is, there will always be a weakest country having troubles. The euro needs a mechanism to strengthen that countries fiscal position, not destroying it by austerity.
    2. If you look at labor costs in the euro countries on the way to the crisis, you will see it was Germany and only Germany which stuck out of the bunch with too low increases in wages. So the troubles have their origin in Germany doing the internal devaluation without caring for the others. The easiest (and fairest) solution would be to decrease German competitiveness by higher increases in German wages.
    Because of the flexible exchange rate mechanism, it wouldn’t help the overall competitiveness of the euro-area if all euro-countries would do the internal devaluation Germany did, because this would only lead to a strengthening euro (like the swiss franc now), which then destroys the competitiveness of all euro countries again.
    Right now it looks like German internal devaluation was a success, but that is not true. The currently strong position of Germany is based on the weakness of the other euro-members. There is not only the relative advantage against the other euro-members (where the export-surplus didn’t increase much), it’s especially the lack of competitiveness of the others keeping the euro low and giving Germany an advantage against it’s non-euro trading partners (where the surplus increased greatly). This will not work for the others.

  4. kantoos schreibt:

    Competitiveness for companies is a relative term, but NOT for countries. Krugman made this point himself a long time ago. One of the basics of „competitiveness“ is that wages are at market-clearing levels. Every coountry in the world can be competitive in that respect. And there will be no race to the bottom in case of full employment.

    Have a look at this post here, if you are interested in more: http://kantooseconomics.com/2011/05/03/competitiveness-dani-rodrik-edition/

  5. LH schreibt:

    Thanks for the link and explanation. But aren’t countries in the euro-zone, where there is no flexible exchange rate between them, more like companies? Isn’t that the whole point of constructing the euro-zone as it is?

  6. matt_us schreibt:

    Look, basically, all countries in problems are insolvent, if we believe the markets. And all countries are solvent if the EU/ECB does two things:

    (1) finances itself the weaker countries at low interest rates (even negative ones); or forces banks to do so (pooled bond sales/forced negative interest rates)

    (2) advocates taxing the wealthy and rich and stops legalizing tax heavens (Switzerland. Luxemburg) which might undermine these efforts

    So solvency is not related to competitiveness, but to the ability to finance your debt. Nothing to do with competitiveness. Greece could become solvent overnight if it expropriated all the wealth Greeks citizens have squirrelled away in Switzerland. All 280 bn Euro of it. It would reduce its government debt to 30% of GDP. There woud hardly be a more solvent country in Europe!

    • Blissex schreibt:

      «all the wealth Greeks citizens have squirrelled away in Switzerland. All 280 bn Euro of it. It would reduce its government debt to 30% of GDP.»

      But that’s true of Italy too and many other countries before that are kleptocracies.

      Kleptocracies get into trouble because the elites award themselves and their supporters a lot of easy money, borrowing from abroad to finance imports, and then export capital to put it beyond the reach of recovery.

      This *always* happens. The question then is why the French and German banks subject to obviously stringent regulation decided obviously entirely on their own to lend unsustainably so much to kleptocracies that are sure to be poor credit risks.

  7. Dietmar Tischer schreibt:

    Krugman writes:

    >In the case of Greece and probably also Ireland and Portugal, I’d argue that we’re looking at fundamental insolvency. The debts are just too big, the required fiscal adjustment just too large even if interest rates were low, to make full payment plausible.>

    If one agrees with the reasons he gives for the assumption of fundamental insolvency, then one has to acknowledge that at least in the case of Greece the presupposition for initiating a liquidity problem is fulfilled, i.e. that there is no plausibility for full payment. Further down the road this may lead to a self-fulfilling crisis.

    What about Italy?

    Krugman again:

    >In the Italian case, you have big debt but also a primary budget surplus. So if interest rates stayed low, as they would if no default were expected, it wouldn’t be hard to service the debt with only modest further fiscal adjustment.>

    What is the reason here to initiate a liquidity problem or even to expect default?

    The presuppositions mentioned in the case of Greece are not fulfilled and therefore there must be others, if one has to acknowledge a liquidity problem or expectancy of default.

    Italy’s debt is big, but not too big according to Krugman. And tough big, there is a primary budget surplus which may be considered to compensate for big debt because it allows financing debt. Interest rates stayed low for a long time, but are not low anymore which means that the probability for default is regarded higher than it was before.

    In the case of Italy, the only reason left for initiating a self-fulfilling crisis is a lack of “modest further fiscal adjustment” to enhance the maneuvering potential of a primary budget surplus in order to convince the lenders of the plausibility of continuous debt servicing.

    It is exactly this lack of adjustment that the markets are confronted with day after day.

    And, clearly, it is the political inability to subdue distribution to adjustment.

    So, I fully agree with Rien Huizer who said:

    >Continentals have a habit of focusing on distribution. And given an institutional/power vacuum at the top, distribution considerations will slow down the „solution“ (in essence hoping for times to get better whilst maybe doing too little too late) and distort any initially reasonable design into another EU monster (how long have we complained about the EU solutions for „Regions“ and „Agriculture“).

    I also agree with Kantoos that Germany has no reason to praise herself as “look how good we are”. But I like to mention that the adjustments he points to have their price: The social democrat led government introducing these adjustments lost the support of the unions and consequently had to give up power. Besides minor modifications, the adjustments were not changed by the governments following the “loser”.

  8. matt_us schreibt:

    @Blissex
    Here is the whole problem – kleptocracies. The rich, powerful and and wealthy taking the money, shifting it into Swiss Bank account and investing it into CDS and then shout „Country A, B or C is insolvent“

    I think the kleptocratic Greek government (if it is one) should be investigated. And a European tax imposed which would end the robbing and pilfering of economies by the elites at the top.

    There should be a law against robbing countries blind by its elites, and one against declaring countries insolvent when they clearly are not. A country is not insolvent until it does not pay its debts, but of course investors loose confidence with every utterance of „insolvency“.

    @ Dietmar Tischer
    „Krugman writes: >In the case of Greece and probably also Ireland and Portugal, I’d argue that we’re looking at fundamental insolvency. The debts are just too big, the required fiscal adjustment just too large even if interest rates were low, to make full payment plausible.>“

    I completely disagree with that and, of course, with kantoos heading!

    Mr Krugman should give us a nice spreadsheet which shows that with a 1,5% or 0% interest rate and a 30 year amortizing loan, that Greece is insolvent. Of course, Greece would be highly solvent with a helpful financing programme such as this. The markets would not allow it? 0% interest not very attractive for them? Even 1,5% a bit low? Well, stuff the markets – in Europe we can make laws which could tell the markets what to do. They should be implemented at the next EU summit tomorrow.

    We in Europe, we have enough of market driven economies which fail at every turn. Hence we have a far superior social model than in the Us where 1/6th of the population is now on food stamps because the US government is too stupid to raise taxes.

    If we want to keep it, we tell the markets what to do. If we want to end up like the US, waiting for food hand outs from the governmetnt and no health insuracne, we listen to US economists!

    • Blissex schreibt:

      «There should be a law against robbing countries blind by its elites»

      Good luck with that, even if the USA have a law against the enforceability of „odious debt“. Which would not apply to Greece, because it is s democracy, and democracy is meant to make voters accountable for the leaders they choose.

      But there is also the counterpart to the kleptocratic issue: it was always pretty clear that the loans to Greece etc. were liar loans, and most likely the French and German banks who signed off on the liar loans were endorsed if not pressured to do so by their governments.

      Part of the current problem is that the German elites don’t want to confess to German voters that they were aware that German banks were making liar loans to Greece, and arguably (very arguably) it was the least bad option, even knowing that they would have to be bailed out later.

  9. Dietmar Tischer schreibt:

    @ matt_us

    What does Krugman mean when he says „In the case of Greece … I’d argue that we’re looking at fundamental insolvency…”?

    He means

    i) that the CONVICTION regarding fundamental insolvency is JUSTIFIABLE in the case of Greece, if one looks at debts, required fiscal adjustment and interest rates.

    ii) that it is JUSTIFIED, i.e. one can hold the conviction of fundamental insolvency, if one looks at the AMOUNT of debt, … , …, i.e. at DATA.

    He does not mean

    iii) that the convictions regarding fundamental insolvency are “OBJECTIVELY JUSTIFIED”, i.e. that the debts are too big with respect to a criterion which allows claims of “objective truth” about insolvency. For the basis of his argument is that there is no such a criterion, at least not an applicable one, and therefore the case must rest on justifiability and justification. If this was not the basis of his argument, his thesis of a self-fulfilling crisis would be nonsense.

    This said the question is what it is you disagree with Krugman.

    You say:

    >Mr Krugman should give us a nice spreadsheet which shows that with a 1,5% or 0% interest rate and a 30 year amortizing loan, that Greece IS insolvent. Of course, Greece WOULD BE highly solvent with a helpful financing programme such as this.>

    I don’t want to consider whether such a financing program is realistic or not, nor what the consequences besides and beyond Greece would be. To do so would be speculation. However, it is no speculation that you don’t argue against Krugman. You don’t hit him, because – as I have shown under iii) above – he is not at all concerned with what IS or WOULD be the case under what conditions.

    This does not mean that Krugman cannot be criticized.

    With regard to what Krugman claimed about convictions concerning Italy, I concluded in my former posting:

    >In the case of Italy, the only reason left for initiating a self-fulfilling crisis is a lack of “modest further fiscal adjustment” to enhance the maneuvering potential of a primary budget surplus in order to convince the lenders of the plausibility of continuous debt servicing.>

    Following his analysis Krugman proposes the following with respect to Italy:

    >So there is a reasonable case that what we’re seeing in Italy is a self-fulfilling crisis trying to happen, in which fear of default is precisely what leads to default. And that’s exactly the kind of case in which intervention could short-circuit the crisis. Let the ECB buy lots of Italian bonds, in effect guaranteeing a low interest rate, and the possibility of default fades – which in turn means that further intervention isn’t needed. It’s certainly worth a try.>

    Clearly, this means in effect that we should not insist for the “modest (!!) further fiscal adjustments” in order to eliminate the presupposition for a self-fulfilling crisis. Instead of this the ECB should buy lots of Italian bonds in order to compensate for the Italian deficit of taking appropriate measures.

    To be sure, there could be situations where the ECB should buy Italian bonds and those of other countries.

    But Krugman’s proposal is wrong in the context he makes it. It is wrong, because it avoids dealing with the CAUSE of the assumed self-fulling crisis.

    I don’t want to judge about the smartness or stupidity of other people. I just like to give an example of what you, I or anybody else does when common sense is applied:

    If one detects that the bathroom is to be flooded, one does not start to wipe off the water and continues to wipe off and wipe off and wipe off … One starts by closing the tap.

Trackbacks

  1. [...] You are neither dumb, nor stupid, Paul… – Kantoos [...]

  2. [...] links: You are neither dumb, nor stupid, Paul… – Kantoos Economics You shall not default, the ECB commands it – FT Alphaville Pressure [...]

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