Long Live The Euro!

As the European debt crisis continues to worsen, a growing consensus seems to be emerging that Europe must either form a fiscal union to rescue countries mired in debt or suffer a devastating dissolution of the currency union. The first choice is unappealing to citizens of wealthy Northern European countries because they do not favor paying for the excesses of foreign governments. And few Europeans seem keen on the idea of surrendering economic sovereignty to foreigners.

The second choice - in which some or perhaps even all Eurozone members would ditch the currency - would cause all sorts of economic hardship. Changing currencies from the Euro to some new national currency would be a chaotic process. A country would most likely need to freeze bank withdrawals and convert the currency denomination of contracts. So, if someone had 30,000 Euros saved in the bank and still owed 9,000 Euros on a car loan, both balances would be legally converted from Euros to the new monetary unit. This new currency would be worth less than the Euro. Families that had been saving money in banks could see the value of their savings slashed. Investors would flee in the short term and quite possibly stay away for years, leading to a dearth of capital to fund investment in new businesses. Because many contracts denominated in Euros involve parties from more than one country, some very thorny legal issues would arise about what currency the contracts should be denominated in going forward.

Throughout the financial crisis, policy makers have employed scare tactics to justify aggressive interventions and bailouts: If the banks are allowed to fail, economic catastrophe would result. If Greece defaulted, the entire financial system would collapse (a contention that seems inconsistent with Europe's latest rescue plan, which calls for banks to "voluntarily" concede a 50% haircut on their Greek positions). I suspect that European leaders portrayal of only two options - fiscal union or Eurozone breakup - is yet another scare tactic. A Eurozone breakup would indeed be chaotic. But it is hardly the only viable alternative to fiscal union.

A country can default within the Eurozone. In reality, Greece already has. Banks have agreed to accept less than they are owed on Greek government bonds. The Euro is still around.

The argument that a country cannot default within the Euro system remains one of the least thoroughly explained notions in current policy debates. Perhaps the best explanation I've seen of such logic appears in The Economist:

If a messy default is forced upon a euro-zone country, it might be tempted to reinvent it own currency. indeed it may have little option. That way, at least, it could write down the value of its private and public debts, as well as cutting its wages and prices relative to those abroad, improving its competitiveness. The switch would be hugely costly for debtors and creditors alike. But the alternative is scarcely more appealing. Austerity, high unemployment, social un-rest, high borrowing costs and baking chaos seem likely either way.

In other words, a country might prefer to simply convert all contracts into a new currency and print that currency to service debts. Unfortunately, this would most likely lead to massive inflation and capital flight, causing families to suffer a severe loss in the value of their savings, among many other unwanted consequences of high inflation. There is little reason to think that citizens would actually be better off.

The fact of the matter is that Greece cannot honor its debts and should haircut them even more than it already has. Owners of that debt will suffer losses. The Greek banking system may need to be recapitalized. All of this can be done within the Eurozone without imposing severe hardship on the Greek people, though they will have to stop spending above their means. By writing down the debt, the amount of austerity required will be greatly reduced.

Banks and politicians are arguing that if the people of Europe do not use their money to avoid defaults and rescue the financial system, calamity will ensue (in the form of a chaotic Eurozone breakup). However, this argument is unconvincing. It is easy to imagine a country applying a haircut to its debt while continuing to use the Euro. Such a result will lead to some bankruptcies and a significant loss to investors. But it need not lead to economic chaos. It has the added benefit of bringing back some level of fairness to the financial system. Investors who chased profits without properly accounting for risks should not be made whole at everyone else's expense.

None of this is to say that a default within the Eurozone will be a simple and painless affair. But for countries that are unable to honor their debts (Greece certainly and maybe Portugal and *Ireland), it is the best path forward.

*Ireland actually entered the financial crisis in decent fiscal shape. Only after assuming the liabilities of financial institutions did the government find itself mired in debt. The people of Ireland would be far better off today had their government not acquired massive debts in order to bailout bank investors.

Occupy Wall Street

When I take the subway to the office, I get off at the Fulton Street stop in downtown Manhattan and then walk about half a block south to Zuccotti Park, home of Occupy Wall Street. I usually take a quick look at the protesters to see if anything notable is going on. But on most days it is too early for real action. So I cross the street, ascend to the 48th floor of a skyscraper and trade bonds all day. After work, I usually head to a gym on John St., meaning I walk by the Federal Reserve Bank of New York. Located at 33 Liberty Street, the FRBNY is an imposing stone structure built in the 1920's. Its vaults contain $415 billion of gold bullion, making it the word's biggest repository of the precious metal. The most awesome power of the Federal Reserve, however, is its ability to create money. This has enabled the Fed to save banks, prop up the prices of assets held by banks, and lower interest rates across the country. Although Zuccotti Park is only a few blocks away, the area around the FBRNY remains devoid of protesters. And I have not heard much dialogue from Occupy Wall Street about specific changes that the Fed should implement. This daily cycle of walking past the protesters, trading bonds, and then walking past the fortress-like Fed leaves me thinking that the Occupy Wall Street Movement is not on the right track.

The OWS protesters have a diverse array of views, many of which I agree with. But the central thrust of the movement has somehow become about the divisions between what they call the 99% and the 1%. The following is from the main page of OccupyWallSt.org: Occupy Wall Street is [a] leaderless resistance movement with people of many colors, genders and political persuasions. The one thing we all have in common is that We Are The 99% that will no longer tolerate the greed and corruption of the 1%. I believe this is an unfortunate unifying theme. Most of the 1% are not corrupt. And I doubt they are particularly more greedy than the 99%. One datapoint to consider is from exit polls in the 2008 presidential election showing that of voters earning over $250,000 per year, 52% supported Obama. I reject the notion that the 1% is the problem.

OWS is correct that the government's stance toward Wall Street has been too generous. One can make a strong case that Congress and the Federal Reserve have been alarmingly obsequious in their dealings with the financial sector. I have tried to make that case in other posts in this space. But the movement ought to focus on some of the specific policy mistakes that have been made and continue to be made. Ending tax breaks for hedge fund managers, oil companies, and corporate jets would be a great place to start. In order to accomplish policy change within our democratic system, we need to figure out where Americans from across the political spectrum can come together and agree. Polls indicate that abolishing special tax breaks, ending Wall Street bailouts, and raising the top marginal tax rates are all issues where that could happen. But a vaguely defined condemnation of the 1% is not going to attract the support of the many conservative Americans who would also like to make the system fairer.

Occupy Wall Street has the world's attention. It should quickly establish a simple platform of policies that will make the United States a better place. Then it should use its publicity to promote those policies and educate people about why they make sense.

Sheila Bair

Today's NY Times Magazine has a noteworthy profile of Sheila Bair, the head of the F.D.I.C. during the financial crisis. Bair recently stepped down from her post and now appears more willing to speak openly about her opinions. Bair favored a tougher handling of the big banks than did her colleagues at the Federal Reserve and Treasury. She thought that bank bondholders should suffer haircuts if banks needed government aid. Indeed, that is how the F.D.I.C. handles troubled smaller banks on a regular basis. Depositors are covered by F.D.I.C. insurance and the creditors take a hit. Executive compensation can also be slashed because many of the bank's contracts are rendered null and void due to the insolvency. This occurs just about every week somewhere in America, but financial chaos does not result.

Proponents of the generous bailout terms offered to the biggest banks back in 2008-09 often said that such a process would not have been possible because the appropriate legislation did not exist. However, the government was engaged in various other bailout actions of questionable legality. And Congress was enacting major legislation - such as TARP - on a very tight schedule. Had the administration wanted to be tougher on banks, avoid financial chaos, and maintain market discipline by forcing losses on investors whose firms were insolvent, it could have done so. Unfortunately, Bair never really came out in public during the crisis and spoke as forcefully as she does in this NY Times interview. In the middle of the crisis, she argued that she favored an F.D.I.C style approach to the big banks in the future, but she failed to publicize the view that the government's current policy was deeply flawed, unfair, and unnecessary.

Icesave Referendum

Iceland does it again. The small country's leaders continue to buck the trend by refusing to force citizens to pay for banks' losses. The latest news relates to the Icesave dispute. When Iceland's Landsbanki went bankrupt in 2008, Iceland declined to reimburse overseas depositors. The United Kingdom and the Netherlands subsequently stepped in and used their own money to reimburse Landisbanki depositors in their countries. They have been pressuring Iceland to repay their costs ever since. In the latest chapter of the Icesave saga, President Ólafur Ragnar Grímsson is putting the decision of whether to reimburse the United Kingdom and the Netherlands to a public referendum in Iceland, thereby giving citizens control over the outcome.

You can read more about the Icesave dispute at Wikipedia and Bloomberg

During the last few years of financial turmoil, Iceland has tended to protect taxpayers while forcing bank creditors to suffer losses. The economy has suffered, but has not been the victim of the sort of crippling collapse that leaders in Europe and the United States continue to insist would occur if we did not bailout banks. Unemployment in Iceland is still lower than it is in Ireland, where politicians have imposed severe hardship on taxpayers to keep banks afloat.

Costs of the Fed, Part 2

In the previous post I discussed how lowering interest rates adversely affects people with money in savings accounts. I argued that because savers receive less interest income, they have less money to spend, which dampens economic activity. In this post I will return to the idea that lowering interest rates can cause consumers to spend less money. But whereas Part 1 discussed how a decline in interest income affects people who have already saved money, this post will examine how the Fed's actions can change the behavior of people who are trying to build savings.

Economists often teach that lowering interest rates causes consumers to save less and spend more. "Low interest rates provide a powerful incentive to spend rather than save," declares one Federal Reserve publication. The logic underlying this assumption is straightforward: When rates are lower, saving is less attractive and spending is more attractive, so people save less and spend more. If true, this makes Fed policy more effective because when people spend more, the economy grows. And growth is exactly what the Fed is hoping to achieve by lowering rates.

But there is another way to look at this. Consider a family that is trying to save $25,000 for college and $250,000 for retirement over the next 20 years. If interest rates are 5% for the next 2 decades, the family will need to save about $547 per month. With rates at 2%, they will need to set aside $762. The lower the rate, the more they have to save. This runs counter to some of the dominant thinking about lowering interest rates.

Lowering rates probably does cause some people to save less, especially people who are deciding what to do with money that they do not need for basic expenses (ie., rich people). The thinking might go something like: "Should I buy a new Mercedes now or earn 5% for a year and then get the Mercedes with a moon roof? I'll earn the 5%. But if rates are only 2%, it's time to shop." Makes sense. Of course, that is not how a household of limited means and specific financial goals should go about making decisions. For the vast majority of Americans, lowering rates should cause savings rates to increase and spending to decline.

None of this is to say that there are not other factors that might cause people to save less when the Federal Open Market Committee lowers interest rates. When the stock market goes up, people feel richer. I do not dispute that, though I do intend to address some problems with the phenomenon in a later post. Additionally, if the economy does better, confidence rises, prompting people to spend more. However, Federal Reserve publications and Ben Bernanke's many recent statements would have us believe that monetary easing (lowering rates and printing money) categorically stimulates economic growth as long as inflation is not a problem. There has been very little discussion by Fed officials of the ways in which Fed policy causes some pockets of the economy to contract. A cost-benefit analysis that models who wins and who loses - and how much they win or lose - is sorely needed.

Costs of the Fed, Part 1

The U.S. Federal Reserve has created trillions of new dollars in the last few years. This has been controversial. Opponents of this policy usually argue that creating so much money could lead to massive inflation. However, as more and more time passes without any serious bouts of inflation, the Fed increasingly seems to be winning the debate. But what if the Fed is doing other sorts of damage to the economy? What if inflation is not the only metric by which we should judge Federal Reserve policy?

There are many other costs to the Fed's recent radical interventions - costs that deserve a lot more attention. I intend to write a series of posts on this topic, starting today.

Costs of the Fed, Part 1:

One of the most obvious costs of increasing the money supply and decreasing interest rates is that people who save money in interest-bearing accounts earn less money. The elderly and people without significant wealth often suffer the most from low returns on savings accounts and CD's. Because these savers are not able to bear the risks associated with stocks and bonds, they put significant amounts of their savings into safer interest-bearing accounts. When the Fed floods the banking system with money, banks have less need for deposits, deposit rates go down, and depositors receive lower returns. Obviously, this is bad for people with money in interest-bearing accounts.

But there are other consequences as well. If these savers have less money, they will probably spend less, hurting the entire economy.* According to data from the Federal Reserve of Philadelphia, American households' annual interest income has declined by 150 Billion dollars since 2008. That amounts to over a full percentage point of U.S. GDP. This does not mean that lowering interest rates caused GDP to shrink. Reduced rates can help borrowers. Indeed, the same data that shows households earned less interest income also shows that households paid less interest on their debts. Unfortunately, the decrease in interest income was over twice as large as the decrease in interest expenses, so American households were net losers in this regard.

The Fed contends that the benefit to borrowers leads to increased economic activity in aggregate. However, the Fed has not done a good job of proving this. A publication by the Fed's St. Louis branch entitled "Low Interest Rates Have Benefits . . . And Costs" provides a sensible list of some of the benefits and costs of lowering rates. Lacking from this paper is any attempt to quantify the benefits or reach a conclusion about the net effects on the economy. Have lower rates caused borrowers to increase economic activity enough to offset the loss of income suffered by savers? The right answer is probably that it depends on an array of factors including the outlook for business, economic expectations, and household financial health, among other things.

The Fed does not seem to be calibrating its policy to these ever shifting variables. Rather, the Fed seems anchored to the notion that decreasing rates increases economic activity as long as inflation is not a problem. Consider a scenario in which a country had invested too much in housing and households had not saved enough. It is possible that under those circumstances, decreasing savers' income in order to increase investment is the wrong response and will not lead to a stronger economy. If it is indeed true that lowering rates can consistently be relied upon to stimulate the economy, then the Fed ought to better job of proving it.

*Many economists often argue that lowering interest rates causes people to spend more and save less because the return on savings is less attractive. I will address some complications with this theory in the next post.

Krugman blames the Euro

In this weekend's New York Times Magazine, Paul Krugman offers his views on the European debt crisis. The thrust of his argument is that because Europe cannot devalue its currency - a point which is not altogether clear - its options are "Toughing it Out", "Debt Restructuing, "Full Argentina," and "Revived Europeansism." He concludes that Europe ought to seek a "Revived Europeansism," which means richer countries should give money to poorer countries. This seems unlikely given in current political climate. So, he seems to think that Europe will suffer some combination of debt restructuring and "Full Argentina." I will not attempt a full critique here - it would take too long. But I will highlight two major flaws in the Nobel Laureate's analysis. I believe Krugman's criticism of the European Currency Union is misguided and his assessment of how painful a European restructuring would be is exaggerated.

Krugman's comparison of Europe's monetary situation to that of Argentina at the turn of the century is unfair. Argentina had pegged its currency to the U.S. Dollar, meaning that it was essentially unable to control its own monetary policy. Krugman suggests that by adopting the Euro, member countries have likewise ceded their control over monetary policy, and are therefore unable to devalue their way out of the crisis. It is correct that countries that have adopted the Euro cannot unilaterally print Euros, but the European Central Bank can do just that. In fact, it has already done so, though not to as great an extent as Krugman probably prefers. Argentina, on the other hand, had no pragmatic means for creating U.S. dollars. Another crucial difference between Europe and Argentina is that the latter had promised the world that its currency could be exchanged for dollars at a fixed rate. As investors began to question its credibility on this promise, a run on the currency unfolded. Compounding Argentina's difficulties, the South American country had issued billions of bonds denominated in U.S. dollars. Europe has not fixed its currency to the dollar and most of its debt is denominated in Euros. Krugman's use of Argentine history to bolster his opposition to the European Currency Union is flawed.

Krugman also errs in his treatment of events in Iceland as they relate to Europe. Iceland decided not to bailout its banks during the current crisis. Investors suffered serious losses, but the economy did not collapse and appears to be rebounding quite well. At the same time, Iceland devalued its currency. Krugman says that the Icelandic path is appealing, but is unavailable to Europe because Europe cannot devalue its currency. However, he offers little evidence that devaluation of the currency has been important to Iceland's quick rebound. Although he claims that devaluation led to an increase in exports, the evidence does not support this conclusion. According to statistics at OECD.org, Iceland's exports did not expand any more than the exports from Eurozone members expanded. Iceland's recent success is a result of its refusal to save a banking sector that was too large for such a small country to bailout. Its ability to print money was of lesser consequence. The Icelandic path does indeed remain open to some European countries, particularly Ireland.

The Economist Recommends Restructuring

In this week's Economist, the publication concludes that Europe's ongoing attempts to solve its sovereign debt crisis "are failing." The article continues by arguing that unless rich countries become more willing to pay for the fiscal problems of their debt-ridden neighbors - a prospect the Economist deems a "political non-starter" - then the only reasonable alternative is to restructure debts. And the Economist believes this should all be done sooner rather than later.

I wholeheartedly agree.

However, the article goes on to argue that Europe's hitherto failed attempt to avoid default "was worth trying" and that "the dangers from debt restructuring have diminished." Because "Banks have had time to build up more capital - and palm off some of their holdings of dodgy sovereign bonds to the European Central Bank," restructuring will be a much more decent affair now, the magazine contends.

I wholeheartedly disagree.

Transferring the costs of a debt restructuring from bank investors to the citizens of Europe is hardly a good thing. Rather, it represents yet another forced expropriation of wealth from taxpayers to benefit the financial system.

European leaders seem reluctant to stick banks with the losses associated with sovereign restructurings. It is true that a good deal of financial turmoil would result if banks were made to suffer the full extent of the losses on their sovereign bond holdings. But there are far superior - and less costly - ways to avoid a major collapse of the European financial system than just transferring the losses to the public. For instance, the European Central Bank could recapitalize failing banks in exchange for massive equity stakes in any institutions requiring funds. These equity stakes might later be sold for a profit. Such a system is hardly ideal; it is a violation of free market principles and bails out failing institutions. But it is fairer and cheaper than the approach suggested by the Economist.

End The Fed?

I just finished reading Senator Ron Paul's "End The Fed." The book outlines the controversial libertarian's reasoning for wanting to shut down the Federal Reserve. Headed by Ben Bernanke, the Federal Reserve has the power to print U.S. dollars - a power the Fed has been using frequently in recent years. Paul argues that this is a form of tyranny enabling the Fed to covertly tax Americans by devaluing their money. And he believes the Fed uses this power to serve the interests of "the banking cartel" and "the most powerful politicians in Washington."

Perhaps Paul is correct that our central bank's manipulation of the money supply, interest rates, and asset prices does not benefit our economy. And perhaps it is true that the Fed enables a few powerful interests to enrich themselves at public expense. I increasingly suspect that he is onto something. But surely lowering interest rates does benefit some parts of the economy and can lead to growth and job creation in some industries, even if only temporarily. Paul would have us believe that the costs of monetary stimulus are higher than the benefits. Unfortunately, "End the Fed" provides little concrete evidence to support these conclusions.

Paul's best argument against the Fed is that it has a dangerous power in its ability to print money with little oversight by Congress. This does seem inconsistent with democratic values. But this is not new information. Americans appear willing to grant the Fed this power if the result is a stronger and more stable economy. Supporters of the Fed contend that the ability to change interest rates, help the financial system, and control the money supply is of great value to all Americans. After reading "End The Fed," I am not better able to rebut such assertions.

Paul deserves much credit for raising questions about the merits of our monetary system. His book has at the very least prompted more Americans to begin questioning the status quo. However, he fails to offer sufficient evidence to convince us that the Fed does more harm than good. We need to see some data showing that any gains are offset by economic losses elsewhere. The book does not even provide a theoretical explanation as to why any investment and spending spurred by monetary expansion is bad for the economy. More analysis is needed.