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.
Monday, January 17, 2011
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.
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.
Saturday, January 1, 2011
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.
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.
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