Holding Out for a Euro

In Friday's Paul Krugman column, gloom about Greece:

Greece’s problems are deeper than Europe’s leaders are willing to acknowledge, even now — and they’re shared, to a lesser degree, by other European countries. Many observers now expect the Greek tragedy to end in default; I’m increasingly convinced that they’re too optimistic, that default will be accompanied or followed by departure from the euro.

Barry Eichengreen is a relative optimist, but even his roadmap out of the crisis begins with a debt restructuring:

European leaders and the IMF have badly bungled their efforts to stabilise Europe’s financial markets. They have one last chance, but success will require a radical change in mindset.

First the easy part: Greece will restructure its debt. This point is no longer controversial; the only controversy is why a restructuring was not part of the initial IMF-EU rescue package.

Only the delusional can believe that, when everyone else is taking swingeing cuts, Greece's creditors can continue receiving 100 cents on the euro. It beggars belief that Greek government debt can top out at 150% of GDP, as the IMF envisages. At this point the government will be transferring well more than 10% of national income to the creditors. In a time of severe austerity, this outcome is unsustainable both economically and politically.

The lack of a restructuring seems the most obvious weakness of the current rescue plan; on this The Economist makes an astute point:

EU governments and the IMF refuse to discuss the possibility of an eventual rescheduling of Greek debt for fear that it would spark uncontrolled contagion. In fact, the logic may increasingly be the opposite. By refusing to admit that Greece faces an obvious solvency problem, whereas Spain, Portugal and Ireland do not, Europe’s policymakers have made it harder to draw a clear distinction between Greece and the rest. As a result contagion has intensified.

Why is the Greek government so hesitant to make a move that seems so obviously necessary? In a Vox column, Edwardo Borzenstein and Ugo Panizza offer a political economy insight from their research:

[D]efault episodes seem to have high political costs. We find that, on average, ruling governments in countries that defaulted observed a 16 percentage point decrease in electoral support. We also look at changes in top economic officials and show that in any given tranquil year there is a 19% probability of observing a change in the finance minister, but after a default episode the probability jumps to 26%. The presence of such political costs has two implications. On the positive side, a high political cost would increase the country’s willingness to pay and hence its level of sustainable debt. On the negative side, politically costly defaults might lead to ‘‘gambles for redemption’’ and possibly amplify the eventual economic costs of default if the gamble does not pay off and results in larger economic costs.

Krugman's column also prompted an interesting exchange on optimum currency areas - the crisis shows that Europe isn't one, but how sure are we that the US is? - among Greg Mankiw, David Beckworth, and Krugman.

On Greece, see also Ezra Klein's conversation with Desmond Lachman and this Vox column with advice from Domingo Cavallo (!!*), which includes an interesting idea about how Greece (and Portugal and Spain) could improve competitiveness without devaluation by shifting taxes from labor to consumption.

*Argentina's Finance Minister during its 2001 crisis.

Bad Headline, Better News

It was not pleasant to wake up to the news that the unemployment rate rose to 9.9% in April (from 9.7% in March), but, behind that discouraging headline number, the other figures in the BLS employment situation report are more positive.

The key thing to remember unemployment rate is calculated as the number of people unemployed as a fraction of the labor force, which includes both employed people and those who are looking for work. In April, the labor force surged by 805,000 which suggests that some people who had given up on looking for work were drawn back into the labor market. This is reflected in an increase in the labor force participation rate, to 65.2%.

Labor Force Participation Rate

According to the household survey (from which the unemployment and labor force participation rates are calculated), the number of people employed rose by 550,000, and the employment-population ratio increased to 58.8%.

Employment-Population Ratio

The establishment survey yielded an increase in employment of 290,000. Some of that is government hiring for the census, but private payrolls were up 231,000.

Overall, the April numbers suggest things are moving in the right direction. Because so many people had left the labor force during the downturn, the unemployment rate has been understating how bad things are. The increase serves to remind us - and our policymakers - how deep the hole is.

Also, it may be worth noting seasonal adjustment contributed to the change - the unadjusted unemployment rate was 10.2% in March and 9.5% in April (that is, the BLS tries to remove the 'normal' month-to-month changes that occur within every year, including a significant improvement that occurs every April).

This Recession is Un-'Real'

One way in which the recent recession - particularly the later part of it - has been unusual is that productivity growth has been very strong, as can be seen in the BLS index of output per hour worked:That is in contrast to the usual pro-cyclical pattern, where productivity suffers during recessions: The historical association between productivity and employment declines lends at least superficial plausibility to the "real business cycle" (RBC) story wherein fluctuations result from optimizing agents choosing to work less (and enjoy more leisure) during periods where their marginal products are relatively low. While many find the RBC story dubious for other reasons (see, e.g., Larry Summers), the behavior of labor and productivity over last couple of years would appear to directly contradict it.

The rapid productivity growth has also caused a violation of the "Okun's Law" rule of thumb relating output growth to unemployment, as we have had an even larger increase in unemployment than the path of output would normally imply. This was examined in a recent San Francisco Fed Letter by Mary Daly and Bart Hobijn, which included this figure: Today's BLS numbers suggest the productivity boomlet is tapering off. The AP's Martin Crutsinger writes:

U.S. companies are running out of ways to increase productivity from leaner workforces, a sign that they may need to step up hiring in the months ahead.

That was the takeaway from reports released Thursday by the Labor Department.

Productivity grew at an annual rate of 3.6 percent in the first quarter, better than economists had expected. But it still declined sharply from growth that exceeded 6 percent for each of the previous three quarters....

Now, economists think companies are nearing the limits of how much they can expand output without hiring more workers.

"Companies addressed the post-Lehman collapse in the economy with a massive wave of layoffs. With demand now picking up ... they need to hire again," said Ian Shepherdson, chief U.S. economist at High Frequency Economics.

Normally, I wouldn't be rooting against productivity growth since it is, after all, why the US and much of the world has become rich, but, under the circumstances, I hope he's right.

One Instrument, How Many Objectives?

Some have blamed the Fed's low interest rates for the housing bubble. For example, in a Washington Post op-ed, Roger Lowenstein writes:

Critics of the Fed have long urged it to intervene in bubbles -- an argument that seems even stronger now. Had the Fed raised interest rates more aggressively in the early part of the decade, it is possible that banks would not have made so many questionable loans. We can't know for sure, of course. But we do know what did happen: From 2001 to 2003, the Fed lowered short-term interest rates 13 times, reaching a rock-bottom level of 1 percent. They stayed there another year, and thereafter rose at a painstaking pace. With credit so cheap, people and institutions borrowed as if there were no tomorrow. And when the bust came, it spawned the worst recession in 75 years.

What could the Fed have done about it? By law, the central bank is responsible for promoting maximum economic growth while maintaining stable prices. When bubbles burst, they wreak havoc on the economy, so reining them in should be considered part and parcel of keeping the economy growing.

This line of argument implies that the fed funds rate should have been higher in 2001-03. When one looks at the unemployment rate (red line), which was high, and inflation (blue line), which was low, the Fed's policy (green line) at the time seems pretty understandable.Recent experience provides good reason for reconsidering whether the Fed should pay more attention to possible asset price and credit bubbles. Using the traditional tool of adjusting the federal funds rate target to "pop" bubbles, however, burdens that single policy instrument with a third objective. Simultaneously keeping inflation and unemployment low has proven tricky enough. A more promising direction, I think, would be to consider whether regulatory tools, like bank leverage requirements, could be applied in a countercyclical fashion.

Not Fast Enough

According today's advance estimate from the BEA, US real GDP grew at a 3.2% annual rate in the first quarter.In normal times, that would be a respectable showing - pretty much in line with the historical average. But these are not normal times, and 3.2% growth is not fast enough to make much of a dent in unemployment. According to the rule of thumb known as Okun's Law, roughly 3% output growth is needed just to keep the unemployment rate from rising, because of increases in the labor force and productivity. At this rate, unemployment will be very high for a long time.

The last severe recession - 1981-82 - was followed by a rapid recovery; real GDP grew by 4.5% in 1983 and 7.2% in 1984, and unemployment fell from its postwar peak of 10.8% in Dec. 1982 to 7.3% two years later. This recovery, so far, looks like it may disappoint those of us who were hoping for a similar (or better) showing. It does at least appear to be a little stronger than the "jobless recoveries" in the wake of the relatively mild 1990-91 and 2001 recessions, where the unemployment rate actually continued to rise for some time after the business cycle trough.

Looking inside the numbers shows a couple of good signs: consumption grew at a 3.6% rate and investment in equipment and software increased at 13.4% rate, which suggests some business optimism. Inventory "investment" also added to growth, as, for the first time in a while, businesses actually added to inventories (last quarter it made a positive contribution because firms reduced inventories at a decreasing rate). However, construction continued to be a drag as investment in both structures and housing dropped (how low can they go?). Net exports made a negative contribution as imports grew faster than exports, and Europe's woes may hinder export growth in the future. The most troubling item is a negative contribution from government, because state and local spending was off 3.8%. That's a further reminder that, while the stimulus bill did include substantial money going to states, it wasn't enough. Washington should find a way to do more.

How Do You Say "Riesgo Pais" in Greek?

My international economics students have been reading And The Money Kept Rolling In (And Out), Paul Blustein's excellent chronicle of Argentina's 2001 financial crisis. Blustein tracks the "riesgo pais" (literally, country risk), the yield gap between Argentina's dollar-denominated debt and US Treasuries, which rises inexorably as confidence in Argentina's ability to maintain its Dollar peg and fully repay its debts ebbs.

This Times story on the Greek crisis included a graph of the extra yield on Greek relative to German government debt:Yikes!

Paul Krugman suggests that a Greek exit from the euro would be similar the end of Argentina's "convertibility" system. He writes:

[T]he Greek government cannot announce a policy of leaving the euro — and I’m sure it has no intention of doing that. But at this point it’s all too easy to imagine a default on debt, triggering a crisis of confidence, which forces the government to impose a banking holiday — and at that point the logic of hanging on to the common currency come hell or high water becomes a lot less compelling.

And if Greece is in effect forced out of the euro, what happens to other shaky members?

I think I’ll go hide under the table now.

But R.A. of Free Exchange believes there is good reason to think the crisis will be defused:

The situation is troubling, but I think it's worth taking a step back and a deep breath. It is fairly easy to sketch out the ways in which the current crisis could develop into a real economic catastrophe. Sovereign debt and bank concerns in Greece and Portgual could generate pressure on borrowing costs for Italy and Spain and trouble for Italian and Spanish banks. Italy and Spain are big economies, however, and so the sums involved are quite large (in terms of potential bail-out sizes and debt exposure). Real trouble in Italy and Spain would place significant pressure on northern European political systems and economies, and on the euro zone. Depending on how the chips fall, Europe could face capital flight and a new wave of real economic pain. Given the size of the European economy, that would mean trouble for the global financial system and unpleasant headwinds for the global economy.

But things needn't turn out like that. Germany has behaved wildly irresponsibly over the course of this crisis, but its leaders may yet come to their senses (certainly IMF leaders are spinning doomsday scenarios for them, much as American officials laid out the apocalyptic potential of a defeat of the TARP legislation). A Greece restructuring is all but inevitable, but the cost associated with making Greek creditors whole is very small relative to the potential losses associated with continued chaos. While Greece is beyond the brink, other countries have room to rein in their deficits if given time; all that's needed is an effort to avert a liquidity crisis.

The risk is real, but the potential consequences are clear, and it is within the ability of the IMF and European finance ministers to avoid a disaster.

Furthermore, as noted by Matthew Yglesias, a "bailout" of Greece is really a bailout of Greece's creditors. As a side effect of its current account surpluses, many of those creditors are in Germany, so even though its tough politics, Chancellor Merkel now seems to recognize she has strong incentives to do something. See also Felix Salmon, who is not optimistic.

The Daily Show on Global Rebalancing

The reduction in the trade deficit means a shift in tradable goods production to the US. Or, as the Daily Show's Aasif Mandvi puts it: "you're telling me that we Americans have to make our own cheap plastic crap?"

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Even before China's recent decision to allow the Yuan to resume appreciating, increasing costs due to higher inflation meant it was becoming less undervalued in real terms.

Looking at the factory in the background suggests that Wham-O's manufacturing in the US is very capital-intensive, as standard trade theory would predict since the US is, relative to China, a capital abundant country (however, this may be an example of a violation of the "no factor intensity reversals" assumption...).

See also this report on the Daily Show's visit from Wham-O's local paper.

Somebody's Watching Me

E-mail from big brother Borders:
Like Rockwell said.

Keynes on Casino Capitalism

In the Times, Roger Lowenstein considers "How Wall Street Became a Giant Casino," which, yet again, reminds me of ch. 12 of the General Theory, in which Keynes says:

Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. The measure of success attained by Wall Street, regarded as an institution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield, cannot be claimed as one of the outstanding triumphs of laissez-faire capitalism - which is not surprising, if I am right in thinking that the best brains of Wall Street have been in fact directed towards a different object.

Bush Tax Cut Time Bomb Ticking Louder

The Times reports that Congress is preparing to deal with the scheduled expiration of the 2001 and 2003 tax cuts at the end of this year. That is, without congressional action, tax rates will increase to their pre-2001 levels (more detail in this previous post). President Obama wants to extend the cuts for households earning less than $250,000, but EconomistMom suggests he rethink his position:

For all the complaining you have done on your Senate campaign trail, and then your presidential campaign trail, and now even as President about how unaffordable and unfair and in general not very smart the Bush tax cuts were, why is it that the centerpiece of your–emphasis on your–tax policy thus far is the deficit-financed extension of the vast majority of these very same (not very smart) tax cuts?

Why do you spend over $2 trillion in your budget–the most you spend on any single policy item–on your predecessor’s tax policy, which you repeatedly explain is to blame for the deterioration and unsustainability of our nation’s fiscal outlook? Meanwhile, you took back your own ideas for new tax policy–such as the permanent extension of the Making Work Pay tax credit–because you decided to put higher standards on your own tax cuts and actually pay for them (offset their cost with offsetting revenue increases such as climate change revenues), and Congress (even your own Congress) therefore balked.

I have news for you: you’re in charge now! You aren’t stuck with the (not very smart) Bush tax cuts–not any part of them! You are the one who will have to sign an entirely new piece of legislation in order to keep any part of the Bush tax cuts after this year. You hold the reins. You don’t have to stay on the Bush path. You don’t even have to stay on the Bush tax policy horse. You can switch horses altogether and go down a better path on your better horse.

From a cyclical point of view, letting the cuts expire (i.e., increasing tax rates) next year would not be a good idea because it would reduce demand at a time when unemployment is still likely to be elevated. However, permanently extending the cuts contributes significantly to the long-term deficit (see the graph in this earlier post). A reasonable stopgap might be to extend the "sunset" of the tax cuts a couple of years while working out a "reform" that would bring revenues more in line with spending, and hopefully simplify the tax code, too. That is why I was encouraged by this, from the Times' story:

[T]he White House and Democrats in Congress have given some thought to limiting an extension of the popular middle-class tax cuts to a year or two in the hope that they can overhaul the tax code in the meantime. That also would have the effect, at least on paper, of making projected big deficits look smaller over the long run than if the tax cuts for the vast middle class were continued indefinitely — an important political consideration when the nation’s debt is building to what many economists consider dangerous levels.

On the politics, see Jonathan Chait.