Tag: Greece

Brexit

The reality of Brexit unleashes a flood of questions, most of which cannot be answer for quite a while. The near term consequences of the UK’s exit from the European Union will depend on the details of the divorce, which will take several years to unfold. Divorces can take place smoothly and amicably or not. The result—the new reality—can be seen as fair (but invariably diminished on both sides, at least economically) or not.

My concern in this note is whether the underlying public sentiments that pushed Brexit over the finish line—the fear of job losses and cultural dilution as a result of excessive immigration—herald a retreat from the globalization that has dramatically raised standards of living and reduced poverty around the world in the last several decades.

As we know from Adam Smith, our ability to increase our output and thus income rests heavily on the productivity gains made possible by specialization. But we can only specialize in our work and output if we are able to trade what we produce for the other things we need and want to consume. The freer and more extensively we can trade, the more we can specialize and prosper. As I never tire of pointing out, the boundaries of trading within the family, the village, the province and the country and beyond are largely arbitrary. However, trade requires shared rules and standards. Within the family these can be more informally developed and understood. Even within villages customary understandings of weights and measures and value may suffice among people who know each other. But as the domain of trade expands and buyers and sellers no longer know each other, such standards and rules need to be formalized into laws and their enforcement supported by courts and impartial judges. Parties to agreements need to be confident that their contract will be enforced as agreed.

The U.S. Constitution gives our federal government the power and responsibility to establish standards of weights and measures and the monetary unit without which trade within the United States would be greatly encumbered. Agreeing on the voltage standard for electrical devises is one of thousands of examples. Businesses themselves recognize the benefits to themselves and their customers of harmonizing many elements of the products they produce and trade. Thus bottom up negotiations over many years have produced the Uniform Commercial Code, which removes many unnecessary costs of trading across different legal jurisdictions through standardization.

Trade across national borders could not exist without international laws and understandings about the nature of contracts and their enforcement, the description and measure of content and statements of value (unit of account), etc. Leaving the EU does not free the UK from the need to conform to such standards if they wish to continue trading with the rest of the world.

In their efforts to facilitate free trade within Europe by harmonizing product standards, the European Commission bureaucrats in Brussels got off to a bad start by failing to distinguish between those standards that facilitated trade from those that unnecessarily limited product diversity and competition. Their definition of the acceptable features of bananas has become the poster child of their misguided and laughable efforts. This does not mean, however, that the facilitation of international (or intra EU) trade does not need harmonized standards (weights and measures of food content, length, volume, etc.) in order to remove unproductive and unnecessary costs of trade.

The huge benefits of trade—global trade—also require that each of us can produce (work at) whatever we do best. The fullest measure of such freedom—free labor mobility—would require the free movement of labor to the best jobs they can find and this is what the EU required of its members within Europe. It is also what has raised fears and reactions within the UK of having, for example, too many Polish plumbers. As the vote for Brexit dramatically demonstrates, we dare not ignore these fears and they are not easily dealt with. See my earlier discussion of this challenge: https://wcoats.wordpress.com/2016/06/11/the-challenges-of-change-globalization-immigration-and-technology/

The growing anti-immigrant sentiments in continental Europe have little to do with free labor mobility within the EU and are more directed to the refugee problem created by the wars in the Middle East. The British vote to leave the EU seems to reflect some mix of a reaction to ill informed harmonization measures taken by the EU (largely some time ago) and a lack of appreciation of the benefits of properly directed harmonization of codes and standards as well as of fears of losing jobs to immigrants (and on the part of some, a natural fear of strangers). The key question for the future of free trade and globalization and the enormous benefits they bring is whether Brexit is the beginning of a closing of that door. We need to make every effort to address and mitigate these fears so that that does not happen.

The establishment of an efficient international trading order (the international establishment of rules and laws and their enforcement) can come about in a variety of ways. The international agreements and organizations established after World War II to perform this role (e.g., UN, WTO, IMF, World Bank) have generally served this international order well though they are not perfect. The statement by Boris Johnson, former mayor of London and possible successor to British Prime Minister David Cameron, that: “I believe we now have a glorious opportunity: We can pass our laws and set our taxes entirely according to the needs of the U.K. economy,” either reflects stunning ignorance of the role of international law in underpinning globalization or blatant dishonesty. The international institutions that oversee our liberal international order need to be preserved and where appropriate strengthened, not destroyed.

The European Union itself was always much more than an economic (free trade) project. Following WWII after centuries of devastating wars, the European project was always more about establishing the mechanisms of political cooperation that would avoid another European war. It has been stunningly successful in this endeavor, but still struggles to find the right balance in the devolution of authority and the best formulation of European wide governments for preserving peace and promoting economic well-being. An excellent discussion of these issues can be found in Dalibor Rohac’s Toward an Imperfect Union: A Conservatives Case for the EU.

The consequences of Brexit for Britain (what ever might be left of it) and for the EU (what ever might be left of it) will not be known for many years. But the risks of an inward looking nationalism and a retreat from a liberal international order that it seems to reflect should be taken seriously and resisted vigorously.

Work-Leisure Choice and growth

A recent dinner companion inquired whether an economy that was not growing was necessarily a problem. What she had in mind was whether people choosing more leisure to enjoy their incomes rather than continuing to work the same or longer hours created an economic problem. The short answer is no. I will explore that issue further and then make a point about the propriety of governments making work/leisure choices for us rather than leaving the choice to us.

Our incomes grow when we work longer hours, acquire improved skills, work with more tools, or work with better tools. The economy as a whole grows without individual incomes necessarily increasing when more people work (i.e., when the population grows). Unless you are very pessimistic about the prospects for continued innovation and technical improvements in each worker’s productivity, our incomes will continue to increase even if we don’t work longer hours.

Over the last 65 years the average annual hours worked by employed Americans dropped from 1,910 to 1,710 while real disposable personal income per capita (in 2009 dollars) increased from $10,000 to over $38,000. Over the longer period of a century or two the drop in hours worked and the increase in per capital income have been much more dramatic. This dramatic increase in income reflects better skills, more capital (tools) and better capital. But it is less than in would have been if people had not chosen to enjoy that income by working less and playing more. The over all economy can adjust to any of these – growing, stagnate, or shrinking income.

While Bernie Sanders may think that the best way to increase the standard of living for the poor is to redistribute to them some of the high income of the wealthy, most everyone else would agree that only economic growth has and can continue to lift large numbers of the poor out of poverty. Global poverty (per capita income below $1.25 per day) dropped from 50% in 1980 to 20% in 2011, an astonishing achievement totally beyond what any amount of redistribution could have accomplished. Most of us think that the proper purpose of redistributing income is for the better off to finance a safety net floor for those unable to work. This dramatic increase in income was the result of improvements in worker productivity (i.e., better skills and more and better capital) not working longer hours.

But what about the choices workers have made and are making about the hours they work vs. the hours they play with the proceeds of that work once they are well above poverty? Over time as most people’s incomes have grown they have generally reduced the long hours worked six or more days a week. Employers and workers strike deals that maximize the profits of the firm and the happiness and well-being of employees. Why then do many governments feel that they need to legislate the matter? Why, for example, did French Socialists feel compelled to legislate a 35-hour workweek a few years ago?

In limited cases, a public safety argument might make sense to over ride the preferences of workers and their employers, for example, if truck drivers felt included to push themselves more hours than they could safely stay awake at the wheel. Mr. Hollande’s French government is now proposing to remove the 35-hour limit and relax other labor market restrictions. I hope they succeed, as leaving more of such decisions with the people themselves will result in happier workers and a more productive economy.

This issue came up a few years ago in connection with the Greek financial crisis. Here are two of my blogs written three years apart on the situation in Greece: https://wcoats.wordpress.com/2012/02/26/saving-greece-austerity-andor-growth/,     https://wcoats.wordpress.com/2015/02/08/greece-debt-and-parenting/ To over generalize, it is often the case that people living in temperate climates (such as Greece and the Southern cone of the EU) work less and have lower incomes. If they are freely choosing to enjoy more leisure in the lovely climate in which they live, they are no doubt happier and better off because of it. Greece’s problem was not that its many Zorba’s had a great zest for life and played more than they worked. Its problem was that after getting away with playing on other peoples’ work/money, they thought they should be entitled to continue doing so. The balancing of work and leisure that is optimal is a person-by-person decision. The economy will be fine and will adjust to whatever these preferences are. People at different income levels and/or different preferences within the same economy will likely make different choices. There is no justification for the government to impose its notion of what is optimal uniformly on everyone. This is just another example of government over stepping its proper role.

 

Greece: What should its creditors do now?

Following Sunday’s NO vote in Greece, what ever that might have meant, it is tempting to tell Greece to get lost and be done with them. Aside from the unseemly lack of compassion for our suffering fellow man, the further collapse of the Greek economy and society that would likely follow Grexit (the Greek exit from the Euro and introduction of its own currency) would open unknown and potentially very dangerous risks to the rest of Europe from its southern periphery. However, any new deal between Greece and its creditors should be mutually beneficial for Greece and the EU in the long run and achievable and practical in the short run. What are the key elements needed for such an agreement?

Greece’s second bailout program with its creditors (the EU, ECB, and IMF) expired June 30 after a four-month extension without disbursing the final installment of around $8 billion dollars. It cannot be resurrected. Thus any further discussions between Greece and its creditors will concern a third bailout program.

Greece’s recently replaced and unmissed Finance Minister, Yanis Varoufakis’, stock speech said basically that Greece does not need or want more loans because it is bankrupt rather than illiquid. In short, it wants debt forgiveness. In fact, many European officials have acknowledged the possible need to write off (reduce the present value one way or another of) existing Greek debt but insisted that any such consideration be put off for a new program. Discussion of a new program has now arrived.

The foundation of any financial assistance program with the IMF is its assessment that the borrowing country can repay the loan. This assessment is contained in the IMF’s “Debt Sustainability Analysis.” This analysis imbeds the agreed (or assumed) level of government spending and estimated tax and other government revenue and of the level of economic activity (GDP growth) upon which it depends in a forecasting model of the deficit and debt/GDP ratios expected from implementation of the agreed policies. The IMF was badly embarrassed by its acceptance of overly optimistic assumptions about income growth government revenue in its first bailout program in 2010 with the EU and ECB. Under political pressure from the EU and ECB, these assumptions allowed the IMF to conclude that Greece’s debt would be sustainable thus avoiding the need for some debt write off favored by the IMF but opposed by Germany and France, whose banks held large amounts of that debt. The second bailout program included a write off of about 70% of the privately held Greek debt. However, this came too late and the adjustment in the Greek government’s annual deficits required by the first program proved too severe causing a much larger and longer lasting contraction in the Greek economy than expected and assumed in the IMF Debt Sustainability Analysis at that time.

On June 26, 2015 (i.e. prior to Greece’s default on its $1.7 billion payment to the IMF and to the July 5 referendum) the IMF released a draft Debt Sustainability Analysis based on the information available at that time. It concluded that “If the program had been implemented as assumed, no further debt relief would have been needed under the agreed November 2012 framework…. At the last review in May 2014, Greece’s public debt was assessed to be getting back on a path toward sustainability, though it remained highly vulnerable to shocks. By late summer 2014, with interest rates having declined further, it appeared that no further debt relief would have been needed under the November 2012 framework, if the program were to have been implemented as agreed. But significant changes in policies since then—not least, lower primary surpluses and a weak reform effort that will weigh on growth and privatization—are leading to substantial new financing needs. Coming on top of the very high existing debt, these new financing needs render the debt dynamics unsustainable…. But if the package of reforms under consideration is weakened further—in particular, through a further lowering of primary surplus targets and even weaker structural reforms—haircuts on debt will become necessary.”

In short, the Greek economy was finally beginning to recover by the end of 2014 but the reversals by the new Syriza government of some of the policies contributing to that gain and the loss of market confidence in the muddled and amateurish behavior of the new government reversed the recovery and further increased Greek deficits. In addition, increasing capital flight has been financed by short-term emergency liquidity loans from the ECB, thus adding to Greece’s over all indebtedness. Capital flight per se should not reduce banks’ capital, as they lose the same amount of assets and liabilities, as long as they are able to liquidate sufficient assets by selling them or by using them as collateral for loans from the ECB or other banks. These loans and the process of transferring Euros abroad are described in the paper I presented in Athens May 19 at the Emergency Economic Summit for Greece: http://works.bepress.com/warren_coats/32/.

Under these circumstances it would be desirable (i.e. consistent with and/or required by a European desire to keep Greece in the Euro Zone while returning it to fiscal balance and sustainability over a reasonable, if somewhat longer, period of time) for Greece’s creditors to forgive some of the debt held by the ECB and IMF and to lower the structural fiscal surpluses initially required in a follow on program for the next few years (this latter element had already been offered by the creditors before the referendum). In short, by reducing Greece’s debt service payments and lowering its primary fiscal surplus, it would endure less “austerity.” Former Finance Minister Varoufakis actually proposed a sensible risk sharing form of refinanced Greek debt indexed to the economy’s economic performance. Creditors would do better than expected on their concessional loans if the economy performed better than forecast and would suffer losses if it did worse. This would give both sides a financial incentive to get the pace and balance of fiscal adjustment right (growth maximizing). While Europe’s political leaders sort out the details, the ECB should continue to provide liquidity credit to the extent that, and as long as, Greek banks can provide realistically valued collateral.

The purpose of these adjustments by the creditors should not and must not be to throw more good money after bad allowing a continuation of decades of corruption, rent seeking and government inefficiency. Long before it joined the Euro Zone, Greece suffered poor government services by a bureaucracy overstaffed by friends and supporters of the government in power at the time. Not receiving expected government services, many Greeks have decided not to pay for what they are not getting. Hence tax evasion and a large underground economy added to Greece’s deficits. Quoting from Bret Stephens’ July 6 column: “Greeks retire earlier and live longer than most of their eurozone peers, which means they spend close to 18% of GDP on public pensions, compared with about 7% in Ireland and 5% in the U.S…. As of 2010, Greek labor costs were 25% higher than in Germany. [As a result of internal devaluation since then, this is no longer true.] A liter of milk in Greece costs 30% more than elsewhere in Europe, thanks to regulations that allow it to remain on the shelf for no more than a week. Pharmaceuticals are also more expensive, thanks to the cartelization of the economy…. Greece wanted to be prosperous without being competitive. It wanted to run a five-star welfare state with a two-star economy. It wanted modernity without efficiency or transparency, and wealth without work. It wanted control over its own destiny—while someone else picked up the check.”

Changing this behavior by Greek governments and the Greek public will not be easy if it is possible at all. The still very strong support by the Greek public for keeping the Euro suggests a strong awareness of the need for some restraints and discipline of its government’s spending. But is the desire for a truly better deal (from their own government) strong enough to overcome the resistance of the entrenched and favored interests, who would lose from liberalizing the economy and cleaning up the patronage mess and tax non compliance, etc.? The best hope is the formation of a unity government that strongly endorses a well balance program of gradual further fiscal adjustment and the continuation of the structural reforms so badly needed. Close monitoring by the creditors of Greek compliance with its promises and the phasing of financial assistance tied to such performance benchmarks, is the IMF’s standard approach to enforcing compliance with the measures the government agrees to. There are risks in agreeing to a third program and risks in not doing so and thus Grexit.

Grexit, even with total default on all external debt, will surely force more austerity on Greece than would any program now contemplated, even before taking account of the almost certain collapse of all of Greece’s already “temporarily” closed banks. The Greek government will hardly be in a position to bailout its banks suffering a surge of non-performing loans. Depositor bail-ins will need to cut all the way into “insured” deposits. The pain will be largely felt only in Greece, and unfortunately mostly by the ordinary Greek citizen.

Greece—how could they?

Today Greece is voting whether its government should accept the conditions required by the “Institutions” (EU/ECB/IMF) for the final installment of its second “bailout” package—a yes vote, or to reject them—a no vote. No one is quite sure what it all means. The program to which these conditions and the final installment of $8 billion applied expired on June 30 and those funds are no longer on offer. A yes vote would presumably indicate support by the majority of Greek voters for accepting the conditions (a modest primary budget surplus by the Greek government in coming years and structural reforms to improve the quality of government services and the productivity of Greece’s economy) likely to be offered for a third bailout program. The alternative—no more financial assistance from the Institutions—would force even greater “austerity” on the Greek government even after repudiating all of its external debt and thus saving the funds that it would otherwise needed to pay to service it. If Greek tax payers won’t cover the cost of the government’s promises and the market will no longer lend the shortfall, the government is likely to resort to augmenting its Euro tax income with IOU claims on Euros, i.e. introducing and inflating its own currency.

What were the Greek government and the Greek people thinking when they borrowed all that money in the first place, and it must be added, enjoyed spending it on an inflated, unsustainable lifestyle rather than investing it in a more productive future? But Greek politicians (and public) are hardly the only ones in the world to ignore future costs when making current promises they have no way to keep.

Take the United States, for example. For decades, the U.S. Congressional Budget Office has forecast ever-increasing deficits from American entitlement programs (Medicare, Medicaid, and Social Security) as expenditures increasingly outstripped revenue. This reflects both the growth in the generosity of these programs and demographics (increasing life expectancy and the baby boomer bulge in retired people relative to those working to pay for them—anyone who still thinks that the retired are receiving what they paid in while working just hasn’t been paying attention). I have written about this from time to time such as four years ago in: https://wcoats.wordpress.com/2011/04/23/thinking-about-the-public-debt/

The future unsustainability of Social Security promises has been the subject of public debate for at least fifty years. The “future” retirement of the WWII baby boomers and their pension expectations has been known since the end of WWII. But one congress after the other has kicked the ball down the road. Seven years ago I outlined the issues and the relatively simple solutions to Social Security deficits in: https://wcoats.wordpress.com/2008/08/28/saving-social-security/ Since then Medicare and Medicaid promises have only increased.

President Obama established the National Commission on Fiscal Responsibility and Reform (the so called Simpson-Bowles Commission) in early 2010 to develop bipartisan proposals for reducing future entitlement driven deficits. He ignored their modest proposals made in the Commission’s final report on December 1, 2010.

The Economist magazine last week reported that the assets available to cover U.S. public sector pensions covered only 75% of their obligations. In fact, the short fall is much greater than that because they are computed assuming a 7.6% return on their assets, which greatly overstates the actual experience of recent years. Private pensions are in much better shape. “But if public plans used the same discount rate as private ones, the deficit would increase to $3.9 trillion and the funding ratio fall to 45%.”

So what are our elected representatives thinking? “Deficits have eventually to be closed. That means lower benefits for the retired, bigger contributions from existing employees (a pay cut) or higher contributions from the employer—which means tax increases for state or city residents, or cuts to other services.

Why is it that our political representatives have such shorter policy horizons than does the public in general? The Economist provides a reasonable summary for the U.S..

“No wonder that no one is getting to grips with the problem. Unions do not like to draw attention to the deficits, for fear benefits will be cut. Politicians do not want to pick a fight with the unions, or increase taxes and annoy voters. Instead, states and cities tend to hope that rising markets will make the problem disappear.”

http://www.economist.com/news/finance-and-economics/21656202-betting-equities-has-not-eliminated-americas-pension-deficit-wishful-thinking?frsc=dg%7Ca

Emergency Economic Summit for Greece

I just returned from a conference in Athens on the Greek economy. Yanis Varoufakis, Greece’s controversial Finance Minister, gave the (almost) final presentation to the 500 attendees making his usual point that Greece is insolvent not illiquid, meaning that its unsustainable debt should be written off (partially at least). While he is surely correct in that assessment, as usual he failed to discuss or even mention the structural reforms Greece needs to make to improve its productivity and thus lift its standard of living, which are also part of the conditions of the existing assistance program with the IMF/EU/ECB. He wants Greece’s creditors to forgive its debts first with reforms (which the new government says it wants to revers to some extent anyway) to come after. As past Greek behavior has destroyed any trust by its creditors and potential investors, the Troika (IMF/EU/ECB) is unlikely to agree to the Minister’s demands. The highlight of the conference was the critic of the Minister’s remarks by Nobel Prize economist Tom Sargent given immediately after and providing the actual concluding remarks for the day.

Here is an article on the conference that includes a short TV interview that I gave on the side.  http://fnf-europe.org/2015/05/20/fnf-greece-emergency-economic-summit-for-greece-stirs-up-unprecedented-media-coverage/

A video of the full conference and my presentation with be on the Atlas Network website later. https://www.atlasnetwork.org/news/article/how-greece-can-escape-from-economic-crisis?utm_source=AtlasNetwork+World10%3A+Highlights+from+the+global+freedom+movement&utm_campaign=a14b0b99fb-World10_5_6_15&utm_medium=email&utm_term=0_d4bce382cb-a14b0b99fb-26641201

The paper that I prepared for the conference can be found at: http://works.bepress.com/warren_coats/32/

All the best,

WarrenGreece EESG

Greece, Debt, and Parenting

If you are a parent, you may have experienced something like the following:

Son number 1 and his children live in a much nicer home than you did at his age. It is the biggest house he could qualify to buy and you put up the down payment to assist him in his purchase. He worked hard as an auto mechanic earning a decent income. His wage was increased modestly each year as his productivity gradually increased with experience, though barely keeping up with inflation. He and his wife were loving parents with three wonderful children and enjoyed their family time together spending what they earned on their children. However, they spent his income as he received it and borrowed the maximum possible to buy a nice second hand family van. When the car needed more than the normal repairs, he had no savings and borrowed the money from you. The occasional family illnesses were paid for by additional loans from you as well and rather than paying off their mortgage and other debts over time these debts grew larger. When his children reached college age they took jobs that did not require college educations as no money had been saved for college.

Son number 2 was also an auto mechanic but ran his own repair shop. His wife and two children lived in a more modest home with lower mortgage payments and they consumed his earnings carefully and modestly in order to save for emergencies, the children’s college fund, and his retirement, and to invest in equipment that would make his repair shop more productive. For a number of years they enjoyed a lower standard of living than did son number 1, but gradually paid down their mortgage without incurring additional debt. More importantly, his income rose more rapidly than did his brother’s because of his investments in tools and equipment. Within 24 years his income was twice his brothers as a result of its growing 3% per year faster.

With the bursting of the housing bubble in 2007 and having his hours of work reduced because of the slowing economy, son number 1 was forced to sell his house in a short sale arranged with the mortgage holder and you wrote off what he owned you. His family was forced to cut many of their expenditures because no one would lend them the money needed to continue living beyond their means. They were forced to cut their consumption even further in order to have some savings when the inevitable health and mechanical emergencies occurred because you decided that your earlier financial help had only perpetuated their shortsighted behavior and refused to lend him more. They complained about the fall in their standard of living as they were now forced to consume within their means. Your son number 1’s family was now poorer. Or more accurately, their standard of living matched reality and became sustainable. Their earlier, higher standard of living was an unsustainable illusion.

Needless to say, son number 2’s future was brighter. His family took advantage of the fall in housing prices by 2008 to buy a larger home, keeping their original one for its rental income. His two daughters went to and graduated from college. His higher standard of living was real and sustainable (i.e. he paid for his higher consumption fully out of his higher earnings).

If you rename son number 1 “Greece”, and son number 2 “Germany” you can begin to understand the difference between the situation of each economy and the difference between competitiveness (exports that match and pay for imports) and productivity (the level of wages and income). For a while Greece enjoyed an artificial and unsustainable standard of living. It needed to “adjust” to reality, i.e. to bring its expenditure in line with its income both internally (the government and each household better matching their incomes and expenditures) and externally (imports matched by –i.e., paid for by—exports) and thus to recognize that it is really poorer than it had pretended. This is what is meant by being competitive. To raise its standard of living it must become more productive by creating a more business friendly environment, reducing its blotted government bureaucracy, and liberalizing labor and product markets. For more details see my earlier articles on Greece: https://wcoats.wordpress.com/2010/05/30/greeces-debt-crisis-simplified/ and https://wcoats.wordpress.com/2012/02/26/saving-greece-austerity-andor-growth/

My Key stories of the world in 2014

Twenty fourteen was a busy year for the planet and in general a rather unhappy time. But believing as I do that when the pendulum swings too far in one direction (big brother) it swings back (personal freedom), I am such an optimist that I see some hopeful signs for 2015. These are the developments that I think are important (and/or felt like writing about).

Torture: A big plus this year was the eye-opening report of the United States Senate Select Committee on Intelligence Report on CIA Torture. It found that the CIA used torture (violating the Universal Declaration of Human Rights, the United Nations Declaration Against Torture, and the I, II, and IV Geneva Conventions of 1949 all of which were signed by the United States and are thus binding laws of the land) and that it was not effective in gathering actionable information that couldn’t have been obtained with traditional interrogation techniques. Admittedly Senator Diane Feinstein was angry about CIA illegal hacking of computers of the Committee staff who have the legal responsibility of CIA oversight and may have been settling some scores. But if you do not find these abuses of power frightening, you live in the wrong country. While the report might not have been fully balanced, its findings on the ineffectiveness of torture are consistent with the earlier findings. https://wcoats.wordpress.com/2010/02/26/torture-is-immoral-and-doesn’t-work/

Our common sense assumption that a prisoner being tortured will tell his captures whatever they want to hear in order to stop the pain was dramatically confirmed by the recent news that Nian Bin was released by the Chinese government after eight years in prison for murders he did not commit. He was originally tortured into admitting the alleged crimes. http://www.washingtonpost.com/world/asia_pacific/in-china-a-rare-criminal-case-in-which-evidence-made-a-difference/2014/12/29/23f86b80-796b-11e4-9721-80b3d95a28a9_story.html

Hopefully these disclosures will reign in these embarrassing and appalling abuses by the United States government.

Greece: Since joining the EU and adopting the Euro (still very popular in Greece as protection against the bad old inflation days), Greece has enjoyed and unfortunately recklessly indulged in a higher living standard (consumption) than it earned (produced) by borrowing from the rest of Europe at the low interest rates paid by Germany. This mispricing of the risk of lending to Greece by financial markets resulted in part from the failure of the European Central Bank (ECB) to rate Greece sovereign debt realistically (treating all sovereign debt of its members alike). It also reflected the moral hazard of the wide spread belief that the EU, ECB, and international financial institutions such as the IMF would bail out holders of such debt. But no one and no country can live beyond its means forever. What can’t go on forever, won’t. https://wcoats.wordpress.com/2010/05/30/greeces-debt-crisis-simplified/, https://wcoats.wordpress.com/2012/02/26/saving-greece-austerity-andor-growth/

The balance between what Greece (short hand for individuals, firms, and government domiciled in Greece) imports and (pays for with) exports can be restored by lowering the cost of Greek goods and services. This will increase its exports and decrease its imports. This can be achieved by lowering wages and other costs of production or increasing productivity. Lowering wages without an increase in productivity simply acknowledges the reality that Greeks are poorer than most other Europeans. Increasing productivity improves Greek competitiveness and thus exports while also increasing its real standard of living.

The loans provided to the Greek government by the troika (EU, ECB, and IMF) tied to (i.e. conditional on) reductions in the government’s borrowing needs (reducing government employees, increasing tax revenue, etc) and structural reforms to make the economy more productive, provided an alternative to its default and forced sudden cut in government spending that markets would have forced on it otherwise. There is debate about which approach would be best for Greece in the long term. Hopefully Greek voters will face and debate this choice honestly in the presidential elections in January: http://www.washingtonpost.com/world/europe/greek-impasse-forces-early-elections-and-fears-of-euro-crisis-return/2014/12/29/3be75924-8f4e-11e4-ba53-a477d66580ed_story.html The implications for the EU and the Euro are huge. https://wcoats.wordpress.com/2011/11/02/the-greek-referendum/

Cuba: President Obama has decided to diplomatically recognize Cuba after a half century long failed policy of sanctions. Not only have our economic sanctions failed to displace the Castro brothers and their pernicious regime (most other countries do not observe our sanctions and trade and invest with Cuba anyway), we have no business (or national self interest) in adopting and promoting a regime change as national policy, however much we might wish for it. Moreover it is very much in our national interest to have good information on and channels of communication with every country with a government no matter how chosen. The linked article by Marc Thiessen illustrates the arrogant and dangerous thinking of our neocons. If Thiessen supports something, I start out against it until convinced otherwise: http://www.washingtonpost.com/opinions/marc-thiessen-cuban-dissidents-blast-obamas-betrayal/2014/12/29/cc68ffcc-8f5b-11e4-ba53-a477d66580ed_story.html

Crony capitalism: President Eisenhower famously worried about the dangers of the military industrial complex as he sought to conduct a cold war with the USSR: https://wcoats.wordpress.com/2011/01/17/eisenhowers-farewell-address-50-years-later/. It is difficult for the government to objectively serve the public interest while dealing with or regulating industry. https://wcoats.wordpress.com/2014/12/18/free-markets-uber-alles/ The relationship that develops in such a situation often serves the interests of the regulated industry more than the general public. The result is what we call crony capitalism and it is the enemy of true capitalism as much as its variants– socialism and fascism. One of the particularly alarming examples of truly disgusting and damaging crony capitalist deals is described in the following article. It involves JPMorgan Chase CEO Jamie Dimon and Eric Holder’s Justice Department agreeing on what seems like a large fine, but is more accurately described as a bribe, to suppress evidence of criminal behavior on the part of Chase. http://www.rollingstone.com/politics/news/the-9-billion-witness-20141106.

Twenty fifteen will be a better year than was 2014 if public outrage at the use of torture, the abuse of the privacy of American’s, the bailing out of and favoritism toward Wall Street and the costly and counter productive deployment of American military around the world, result in rolling back these dangerous excesses. My fear is that nothing will be done and that there will be more the same. I hope that I am wrong.

Cyprus and the Euro

Does the Euro need to be supported by closer European fiscal integration? Many countries do just fine without their own currency and no fiscal coordination with their currency’s issuer. Panama has used the U.S. dollar for well over a century with good success. Ecuador and El Salvador have used the dollar as their own currency for a much shorter time and are doing better for it. Etc.

The major failing of the Euro, along with its considerable benefits for the Euro zone countries and those doing business or traveling among them, has been the failure of lenders to properly price the risk of lending to the Greece’s and Italy’s of the world. The spread between Greek government bonds over German government bonds collapsed to near parity after Greece replaced its inflation prone currency with the low inflation Euro. Greeks, both private and public, responded by borrowing with abandon. Greece has many other structural problems that keep its productivity lower than its neighbors, but credit markets indulged its borrowing binge on the assumption that there was little to no risk that the Greek government would be allowed to default on its debt.  This gave Greece the illusion of a higher standard of living for a while. Richer brothers to the north would surely step in and bail it out if it couldn’t repay its debts. And so it was for a while.

Against German resistance, Greece finally defaulted on much of its debt (the so-called voluntary haircut – write down — of its debt held by banks to about 30% of its full value). This was an important restoration of market risk and hence market discipline of Greek and other EU periphery countries’ borrowing. It will potentially help save the Euro. Most banks were able to absorb their resulting loss, but some big Cyprus banks apparently were not.

The EU/ECB/IMF (the troika) have offered conditional financial assistance to Cyprus but not to cover the cost of recapitalizing Cyprus’s underwater banks. Cyprus is required to raise those funds themselves. At least this is my assumption. Press reports on what the external support covers are almost totally lacking and the conditions for the deal are not yet final anyway. There is a relatively straightforward approach to resolving these banks, though the details would depend on the particulars of its banking and bankruptcy laws. I do not know the details of these laws nor of the conditions of these banks (Laiki and Bank of Cyprus), but I assume that they are viable if recapitalized and worth more as going concerns than from liquidating them.

The insolvent banks should be put into receivership and instantly split into a good, fully capitalized, bank and a bad bank (i.e. what ever is left) to be liquidated. The good banks would be fully capitalized by leaving some of their liabilities with the bad bank, starting with its shareholders, then bondholders (of which there are not many), then uninsured depositors. These creditors would, in effect, be written off. This would enable the new good banks to continue operating without serious interruption. The only real debate should be about how far to cut into depositors (so-called bailing creditors in) to rebalance assets and liabilities. The Economist argues that the write-offs should stop with shareholders and bondholders and all depositors should be made good via bailout funds from the European Stability Mechanism.

Depending on the particulars of the banking law, an insolvent but otherwise viable bank is put into receivership. This removes the shareholders from any control over the bank. Immediately the good assets of the bank, including its branch network and equipment, and staff would be sold to a new bank, which would assume all insured deposits and a proportionate amount of the uninsured deposit sufficient to match the value of the assets purchased. Ideally the new bank would be sold immediately to new private owners. But if more time is needed to organize its sell, it would be sold temporarily to the government for one Euro. What remains of the old bank would be liquidated and the proceeds would be apportioned in accordance with the priorities provided in the law to the credits (deposits that were not transferred to the new bank). As all of the good assets were transferred to the good bank, there would be virtually no further assets in the bad bank to recover and the remaining creditors would receive little to nothing.  The overall loss to depositors will depend on the losses incurred by the bank on its assets that made it insolvent in the first place. The orderly resolution described above almost always result it much smaller losses to creditors than a disorderly default in which the bank closes its doors totally.

Market discipline would clearly be more strengthened if uninsured depositors were also at risk of losing money. But increasing that risk unexpectedly and to too large an extent could cause deposit runs throughout Euro (and the world). Ultimately, but maybe not at the moment, this would be a good thing for the banking sector. Banks would have to behave more prudently or run the risk of losing deposits. Such market discipline is more effective in limited excessive risk taking by banks than is tighter supervision; though required capital and senior convertible bonds should be significantly increased in the future. In my view, the full recapitalization of all insolvent banks should be financed by bailing in as many uninsured depositors as needed to cover their capital deficiency. The IMF’s position, opposed by the EU, was that a good bank should assume only the insured depositors and receive sufficient good assets to cover them. This would leave all uninsured deposits in the bad bank, which were expected to suffer losses of 20 to 40 percent of their value.

The Cypriote officials originally proposed something quite different. They proposed a one-time levy on all depositors with a lower tax rate on smaller insured deposits. Thus both insured and uninsured depositors in good banks as well as bad ones would be paying to cover the losses of insolvent ones. Not exactly a boost to market discipline of banks. Depositors everywhere and especially in the Euro zone were shocked and the Cyprus Parliament rejected the proposal.

It will be interesting to know what motivated this crazy idea. For one thing it protects the shareholders from the loss of their shares and control of their banks, which is not a good idea from the point of view of the health of the banking system, though it may have been a deliberate goal of the plan (the shareholders are likely to be influential people in Cyprus). Antonis Samaras, the President of Cyprus, suggested that he wished to diminish the loss to large depositors (which include many wealthy Russians, some of whom have dealings with his law firm). Steve Hanke states that about half of Cyprus banks’ deposits are owed to Russians (including those of Russian subsidiaries established in Cyprus).

Whether lightening the burden of large depositors (sharing the burden more equitably according to the President) involved murky deals with Russians or the mistaken belief that it might save the large offshore deposit business Cyprus had developed (the deposit liabilities of its banks were eight time Cyprus’s GDP) only time will tell (maybe). Cyprus’s banking business is more like that of Iceland or Ireland before they crashed and burned several years ago, than the typical off shore financial centers like Cayman. The deposits in Cyprus are with Cyprus banks. If they become insolvent, depositors (or tax payers somewhere) lose. Foreign depositors in Cayman banks are actually depositing in branches of international banks with headquarters and assets elsewhere. Loses incurred by Cayman branches would be a small fraction of the total assets of the global bank and more easily absorbed.

Cyprus’s misguided attempt to spare large depositors at the expense of depositors in general, even if rejected in the end, greatly unnerved depositors everywhere and is likely to weaken rather than strengthen market discipline of bank risk taking.  By making the depositor haircut a levy/tax, Cyprus intended to bypass the bankruptcy/resolution provisions of the banking law and deposit insurance provisions. They created a mess.

Has the ECB provided the missing piece to resolve the EU debt crisis?

On September 6, Mario Draghi, president of the European Central Bank (ECB), announced that the ECB would engage in unlimited secondary market purchases of government bonds of member countries adhering to the policy conditions agreed to with the IMF and EU (and thus qualified to borrow from the European Financial Stabilization Fund – EFSF – or the European Stabilization Mechanism – ESM) to the extent needed to promote the efficient transmission of monetary policy throughout the Euro area. The over all liquidity impact of such purchases will be sterilized (offset by the sale of some other ECB assets), as needed, in order to preserve the ECB’s inflation objective of an inflation rate below but near 2% over the next two years. What does this add to the existing European tool kit and is it enough to resolve the EU debt crisis?

All responsible government officials recognize and accept that in the long run nations, like individuals, must live within their means (pay fully for what they consume). Their standard of living will depend on what they are able to produce (productivity).  Eliminating government deficits requires reducing government spending and/or increasing its tax revenue. Increasing the sustainable standard of living of its people (the level of consumption they can fully pay for with what they produce) requires liberalizing restrictions on labor and product markets and investment that will increase the productivity and thus output of workers and businesses. The debate is primarily over the optimal pace of introducing the measures needed to balance budgets and increase productivity and competitiveness.  This matters in that it takes time for the economy to adjust to reforms before it enjoys the benefits of more rapid growth. In the interim continuing but declining deficits must be financed either in the market (if market lenders have confidence in the effectiveness of the measures being taken), or by the IMF/EU/ECB until market confidence can be established.

I have elaborated these points in earlier blogs: “European debt crisis: causes and cures”; “Saving Italy and the euro”;   “Buying time for Italy”; and “Saving Greece-Austerity and/or Growth”.

Throughout the crisis Germany has demanded that Greece and other over indebted and uncompetitive countries undertake the needed corrective measures before being granted the financing needed for the transition back to normal market borrowing.  Events have proven Germany to be right as earlier “bailout” commitments have led to a suspension or slow down in policy reforms thus prolonging recovery.  For the same reason Germany has vigorously opposed (correctly in my view) the adoption of Eurobonds, which would allow Greece and others to borrow at the same interest rate as Germany and all other EU members. The moral hazard of bad fiscal behavior when market discipline of over borrowing is removed is a real and serious issue.

On the other hand, Germany is also pushing for Fiscal Union in order to gain better EU wide control over excessive national deficits. This may or may not be a good idea for Europe (I have my doubts) but it is certainly not, contrary to much opinion, essential for the viability of the Euro. The idea behind the German push for Fiscal Union stems from the markets’ failure to properly price the risk of lending to Greece, Portugal and some other overly indebted countries and Germany’s belief that the only way it can protect its tax payers from supporting inflated living standards to the South is by gaining control over their governments’ expenditures. Until the last few years, the governments of Greece and Portugal could borrow in the market at interest rates very close to the rates paid by the German government, which by the way has borrowed quite a lot itself (the ratio of German government debt to its GDP is currently above 81%). These governments spent and over promised future benefits recklessly on the (temporary) basis of relatively cheap debt financing in the market.

It is certainly a fair question to ask why the market failed in this regard and over lent to a number of governments that now have difficulty repaying. The expectation that Germany and other Northern EU countries would not allow the profligate southern ones to default made such lending seem risk free and the market priced it accordingly.  Fiscal Union and/or EU-wide fiscal rules are one way to limit such excessive borrowing and unfunded future promises. Improved market discipline of borrowing via more accurate risk premiums on market lending is another, and in my opinion, superior approach. Greece’s orderly default (75% haircut) on its publicly held debt and the current crisis have restored a large measure of market discipline to sovereign borrowing. Greece and Portugal do not need to borrow from the market for several more years as long as they implement and adhere to the reforms demanded by the IMF/EU/ECB. However, Spain and Italy closely watch the now far more sensitive interest rates demanded by the market when lending to them. Given the substantial outstanding debt of these countries, those interest rates can make the difference between the success or failure of reform efforts. Ireland, which has successfully, though painfully, implemented all of the conditions of the IMF et al “bailout,” is well on the way to full recovery and is now able to borrow again in the market at reasonable interest rates.

The missing piece in the EU/ECB tool kit to manage the ongoing debt crisis is the availability of sufficient temporary adjustment financing for larger countries such as Spain and Italy should markets loss confidence in one or both of them before their reforms have had time to bear fruit. The resources of the EFSF/ESM, still waiting for the German constitutional court’s approval, are not sufficient to finance stabilization programs with both countries. This leaves markets uneasy and volatile.  Market interest rates on ten-year Spanish government bonds have varied this year between under 5% to 7.6%. German government bond rates have varied between 1.24% and 1.85%.  Mario Draghi’s commitment of ECB funds to buy short-term sovereign debt (with maturities of up to three years) in secondary markets does not augment the resources available to the EFSF/ESM to finance adjustment programs with the IMF, but by buying such bonds in the secondary market should liquidity in a program country dry up, the ECB should be able to significantly reduce the prospects of what it considers unrealistically high risk premiums for such bonds. The ECB would only buy bonds of countries meeting the conditionality of an IMF supported adjustment program. Outright secondary market purchases are a standard and traditional liquidity management tool for central banks. What is unique in the European context is that open market purchases must be for the bonds of individual countries and the choice of countries matters. It is for others to determine whether, as Mr. Draghi claims, the new initiative is consistent with the ECB’s mandate.

This past week I attended a meeting of the Mont Pelerin Society in Prague. Friedrich Hayek, Milton Friedman and a few other free market champions founded the MPS in 1946. Czech President Vaclav Klaus, also an MSP member, hosted this year’s meeting. President Klaus has opposed the Czech Republic’s adoption of the Euro. It has kept its own currency, which the Czech National Bank has managed very well under an “inflation targeting” policy regime. However, Spanish economist Jesus Huerta de Soto spoke at the meeting in defense of the single currency. He favors a return to the gold standard but convincingly argued that the monetary discipline on Spain provided by giving up its own currency to the Euro was a good second best.  The key to success or failure of the Euro for the overly indebted countries that use it is whether they reform deeply enough to live within their own means within a few years and to sufficiently improve their competitiveness with the rest of Europe and the rest of the world. Failure to do so will harm the defaulting country far more than it will harm the Euro.  I wish them well.

The Hutchinson Lecture at the Universtiy of Delaware

Tuesday (April 17) I spent an enjoyable day in Newark, Delaware as the guest of the Economics Department of the University of Delaware. My afternoon, more technical, lecture to the graduate students and faculty covered my proposal for the reform of the international monetary system: http://works.bepress.com/warren_coats/25/

My evening lecture, this year’s Hutchinson Lecture, is reviewed here by the U. of Delaware newspaper (in which there is also a link providing background on the Hutchinson Lecture): http://www.udel.edu/udaily/2012/apr/HutchinsonLecture042012.html.