Open Thinking

The transmission of the Great Depression provides the following lessons for the present. It is best to avoid macroeconomic shocks. But when they hit, then the second-best alternative is to suspend or discard the fixed exchange rates that linked economies together in the early years of the Great Depression. When is a shock large enough to abandon a framework like the EMS? How soon should governments and central banks respond? Clio, the muse of history, stands silent on this issue. She says only not to wait too long. 

Peter Temin’s article in the Journal of Economic Perspectives appeared just after the unravelling of the European Monetary System (EMS), the precursor of European monetary union. The citation is:

Temin, P., “Transmission of the Great Depression”. Journal of Economic Perspectives 7:2 (Spring, 1993), pp. 87-102 (100).

Stephen King (HSBC) in the FT:

In Japan’s case, previous experiments with QE – admittedly not on the same grand scale – mainly served to boost exports without any significant impact on domestic demand. In a world where other nations are struggling for growth, a yen-induced export-led Japanese economic recovery might not be enthusiastically received.

We are promised by Shinzo Abe, Japan’s new prime minister, a three-pronged attack on deflation. Today, we saw one of those prongs: an easing in monetary policy. More on that in a second. But what I really wonder is whether we’re going to see the other two prongs: fiscal expansion and deregulation. It might be quite convenient to allow the Bank of Japan’s dynamism to weaken the yen enough to re-energise the traded sector, neatly circumventing any of the more politically difficult policies like higher spending and deregulation. 

If this is what happens, then Abe will have pulled a fast one — and precious little else will have changed. A big yen depreciation would juice up the economy plenty and, although it won’t be enough to achieve the 2% inflation target, it could easily reach the goal of turning mild negative inflation into mild positive inflation. 

Now, about that monetary policy. The Bank of Japan’s policy communication (pdf) today reports that the Bank will double the monetary base over the coming two years. The monetary base is simply that part of the money supply over which the central bank has control: cash in circulation plus the banking system’s deposits at the central bank. It will use this increase to fund the purchase of a wider variety of assets: longer-dated Japan government bonds (JGBs) as well as equities through exchange-traded funds (ETFs) and real estate through Japan real estate investment trusts (J-REITs). 

How radical is this “doubling” of the monetary base? Not that radical. The US central bank doubled the monetary base within five months of beginning its own form of quantitative easing (QE); the UK took ten months and the ECB took three years. In fact, since August 2008 (on the eve of the most acute phase of the financial crisis), Japan’s monetary base has only grown by half, while the UK’s has quadrupled and America’s has trebled. Does any of this matter? Probably less than you might think. With the private sector desperate to improve or maintain its financial position on a net basis, this policy remains akin to “pushing on a string” (as you-know-who put it). 

Where it does matter is if such policies succeed in depreciating the currency (and it is not clear why they would, if the monetary base has no expansionary impact on broader money aggregates via the money multiplier, except through the perceptions of market participants, who may be over-impressed by whole-number multiples of base money supply). 

Which brings us back to the real Abenomics. If all we get is a weaker yen but no serious fiscal expansion, the race is on to see who can impress the markets most with their central bank balance sheet growth. This is not how you’re supposed to deal with a global economic recession. 

Reading this update on Greece’s fascist Golden Dawn party.

Be clear that a group like this, in power, is not consistent with being in the euro-area: they would not want to be in, and they would not be welcomed to stay in the EU. 

But let’s make it clear right now: membership in the euro-area should not be conflated with liberalism.

Quite the opposite: membership in the euro-area, for those economies not suited to it, will be associated with illiberalism. Yes, that will coincide with departure from the euro-area. But this will be a mere correlation. Causation runs from euro-membership to illiberalism.

Does globalization undermine workers’ income in the developed economies? Put slightly differently: Does globalization Gatsby-ize the developed economies, insofar as the rewards from productivity growth are reaped by owners of capital rather than labour?

The logic of this proposition seems pretty straightforward. In a world of tradable goods and services, wage competition is a lever against labour. Timothy Taylor points us to the recently released Economic Report of the President, which features a discussion on the falling labour share of income. In particular, 

(In the United States,) the labor share has declined since 2000 in every major private industry except construction. 

And, of course, construction is a key non-tradable sector. 

The Economic Report of the President cites the OECD 2012 Employment Outlook, which discusses the declining labour share at length. In both cases, globalization is seen as one possible factor. But the empirical case is hard to make. In the scatter below, I show the change in labour share of income for OECD economies mentioned in the 2012 Employment Report, against the level of imports in 2009 (as a share of the economy). 
In his text on the “great doubling” (pdf) of the global workforce, Richard Freeman, the Harvard labor economist, wrote in 2006 that,

The world has entered onto a long and epochal transition toward a single global economy and labor market. There is much to welcome in the new economic world but also much to  fear. The country needs to develop new creative economic policies to assure that workers fare well during this transition and that the next several decades do not repeat the experience of the past twenty or thirty years in which nearly all of our productivity advance ended up in the pockets of so few. 

What kind of policies will be embraced to make the next twenty years different from the past twenty years? On the whole, I’ve grown disillusioned at the notion that the super-rich have the nous to make sure everyone wins from globalization. They might just suffer from a collective action problem, or they might just not be that smart. But the longer our recessions drag on, the more I realise that enlightened self-interest won’t get us there. 

Update: Here is Freeman’s longer essay (pdf) on the Great Doubling of the global labor force, with a special warning to highly-skilled workers. H/T Nancy Folbre.

Update Update: Andrew Berg and Jonathan Ostry at the IMF find that, “Over longer horizons, reduced inequality and sustained growth may be two sides of the same coin.”

So the debate is on. Should Cyprus leave the euro-area (i.e. issue its own currency)? 

Alexander Apostolides says No. 

I’ve suggested recently that even the best-performing of the euro-adjustment group (i.e. Ireland, Spain, Italy, Portugal, Greece and now Cyprus) hasn’t performed as well as the least-well-performing East Asia crisis group. 

For Cyprus, the comparators are all-too-closer, both in space and time. Ireland and Iceland also witnessed large growth in their banking sectors before suffering a crisis, and having to make extraordinary adjustments. 

Iceland devalued; Ireland did not (it would have to leave the euro to devalue). Here is the state of play for these economies. In the graph above, the y-axis is annual change in log-levels of GDP (in PPP terms). So the units should be read as “.05 is 5%”. 

And below are the employment differences. 
The source for all of the above is IMF WEO October 2012. 

One more go at the East Asia 1997 versus Euro Area 2008 comparison. 

The back story is that East Asia underwent a severe crisis in 1997-98, which saw the collapse of its overvalued currency pegs. But, surprise surprise, this “devaluation devaluation” was followed by robust growth. 

By contrast, the “internal devaluation” (ID) strategy is to achieve the same real-effective devaluation through the price level alone. This is what the likes of Spain, Italy etc must do if they choose to stay in the euro area.

The scatter plot shows the real-effective devaluation in the initial year of crisis (x axis) versus the change in GDP (ppp terms) from pre-crisis to crisis+5 years.

Even the darling of the ID gang, Ireland, hasn’t fared as well as the least-successful Asia-6 economy.

The problem in Cyprus is the banking sector. To get this, you just need to look at the balance sheet of a bank, as above. 

Cyprus banks saw the value of their assets fall in several categories above. They were exposed to mortgages in Cyprus itself (in other words: they were mortgage lenders), which has seen a decline in property prices. You know how people say, “You don’t own your house, your bank does”. If the bank were to recognise the market value of your house, then clearly the value of this asset has shrunk. 

This would be bad enough. But other items were also souring on the asset side. Cyprus banks lent to Greek businesses and to Greek property. They also held Greek sovereign debt and maybe — I’m not sure — equity in Greek banks. (I haven’t listed equity holdings in other banks above, but you can slot it in somewhere on the asset side.) 

One reason the above is called a “balance sheet” — actually the reason — is that the two sides must be equal. So, if the asset side is shrinking, the question becomes: Where are you going to distribute the losses on the liability side? 

You can keep a bank on “life support” by purchasing its bad assets. The government can do this (i.e. the finance ministry / treasury) by replacing these bad assets with good ones. The central bank can do this by taking the bad assets in return for increases in the bank’s balance at the central bank. (Banks keep an account at the central bank, and this account is called their “reserve”.) 

The ECB is Cyprus’ central bank. It has said, No more life support. In which case, we’re back to distributing losses. In Cyprus, the assets were funded almost entirely by customer deposits. Hey, it was a big offshore banking centre; of course it had plentiful deposits. And this explains why deposits simply could not be un-touched. The initial idea was to try not to destroy Cyprus’ appeal as an offshore banking centre, by “only” erasing 9.9% of deposits over EUR 100,000. To keep this below 10%, it meant you had to take something from deposits under EUR 100,000. That was outrageous, and didn’t make it through Parliamentary approval in Cyprus. 

So the result is no loss for deposits under EUR 100,000 and about a 40 or 50% loss to deposits over that amount. Bear in mind, in exchange, Cyprus will be getting financial assistance from the three international organisations with whom it has been in talks, the so-called Troika constituting the European Commission, the IMF and the ECB.

The IMF has been taking a firmer stance on the amount of “fudge” it is willing to condone. In other words: it has stopped acquiescing in rescue plans that merely pile up an unsustainable debt burden on the rescued economy. Berlin is of a similar mind, and the two of them have pushed through the “rip-off-the-band-aid” approach. 

What this means for Cyprus is presumably the loss of its business model: offshore banking. Where GDP will come from is uncertain. I have seen estimates of GDP contraction which range from 20-50%. Naturally Cyprus will soon find it impossible to refinance its sovereign debt: it starts with a debt/GDP ratio of 140% and the denominator is about to fall. My guess is that a TARP-like plan will be deployed to lessen the burden on Cyprus’ creditors when its sovereign debt is written down, at least partially. It will be given whatever other assistance is necessary to stay in the euro-area, because its exit would have the perverse consequence of incentivised failure: Brussels would not want for its success to be a template for other benighted euro-periphery economies. (Although, according to the prevailing dogma, euro-exit can only be calamitous, in which case perhaps exit will be condoned as an object lesson for other economies…)

What this means for the euro area is greater ECB involvement. The Troika have confirmed that “bail-in” is in store for other troubled economies. What “bail-in” means is distributing losses to private-sector creditors. In Cyprus’ case, these happen to be depositors (when you put funds on deposit, you are loaning that money to the bank). The reason financial markets reacted so negatively to the statement by Jeroen Dijsselbloem, head of the eurogroup of finance ministers, that the Cyprus deal is a template for future rescues (a statement upon which he later had to row back), is that, for other euro-area countries, these “private-sector creditors” are bondholders. For banks which rely on bond markets for funding, this was poisonous. Dijsselbloem’s rowback does not solve the problem. Expect ECB President Mario Draghi to reassure markets that his institution will not hesitate to liquefy as and when needed. The ECB, like any central bank, has this power because it alone creates the money for which there is no counterpart liability: the ECB can create money out of thin air. 

What this means for non-euro-area. For a start, I would expect renewed weakness in the euro, and strength in the GB pound particularly, as people exercise sensible precautions. I would also expect strength in the gold price. As the saying goes, in bad times it’s not the return on your money that worries you. It’s the return of your money.

Probably for anyone with an expertise not shared widely, there are frustrations about what people seem to “know” about your field. I’ll be less oblique:

People seem to “know” that one of the causes of the Great Depression (globally) was competitive devaluation (a.k.a.  “beggar-thy-neighbour” policy). 

It wasn’t. But let me back up and re-tell the story that people have been told. I guess this stuff is in the secondary school textbooks; I really should check. The story goes: In order to divert spending toward home-country output, the government devalues the currency. This then robs the neighbour of spending, and pushes up unemployment. In order to fight this rise in unemployment, the neighbour government also devalues. If this is the chain of causation (devaluation–>depression), then it stands that countries shouldn’t devalue. At least, for the system as a whole, devaluation is not Pareto-efficient. 

This viewpoint fundamentally confuses causation in the Great Depression. Academically, it was dismissed by the work of Eichengreen, Sachs, Temin and others about twenty years ago. This work established that countries were driven by depression to seek devaluation. The depression itself happened because of their reluctance to devalue in the first place.  

People seem to “know” that trade barriers caused the Great Depression. 

They didn’t. Trade barriers were a consequence of the depression. See above. The infamous trade barriers of the 1930s would have been much less in evidence had the devaluations come earlier in the story.

‘Keynesianism’ didn’t work — just look at the New Deal

Expansionary fiscal policy wasn’t tried, except in Germany where it suited the re-militarization. Roosevelt’s New Deal was financed through cuts elsewhere — the US Treasury was trying to balance the budget throughout the 1930s (it failed, but due to cyclical conditions). The real test (proof) of Keynesianism was the outbreak of war in 1939. As countries moved to a wartime footing, thoughts of balancing the budget went out the window. The ensuing fiscal expansions did wonders for the economy. The shame of it is that some exogenous, and deadly, event like war has to justify a genuine fiscal boost (amidst a de-leveraging recession). What we really need is an attack from outer space. 

and for those true anoraks, there’s this:

Sweden ran the world’s first inflation-targeting regime 

It didn’t. Rathke, Straumann and Woitek have put this issue to rest, in the wonderfully titled “Overvalued: Swedish monetary policy in the 1930s.”

A friend recently mused that, if the euroarea periphery were not in a single currency area, the crisis we’ve seen so far would look a lot more like the 1997-98 East Asia crisis. Greece would have ‘fallen’, and contagion would have knocked down the remaining ‘weak’ countries. Bear in mind the endogeneity of such contagion: even if Neighbour n looks good at time t, it probably looks different at t+1, after the first-faller has been knocked down, because Neighbour n has suffered a trade-weighted appreciation. Suddenly the outlook has changed … 

My friend made this remark, I believe, in the spirit of, “Whew. It could’ve been a lot worse: It coulda been like Asia ’97”. At least that’s how I took it. But with a moment’s reflection, I thought it worthwhile turning that around: If you were a eurozone-5 citizen, would you rather be where you are, or where you would be if your path resembled that of an Asia-Crisis-5 economy? 

Plenty of good commentary out there. See here and here especially. 

Cyprus’ EU partners are saying: “Not me — we didn’t insist on a haircut for small depositors.” 

So Nicosia wanted to protect its position as a banking centre. This is less permissible in view of the fact that it has simultaneously agreed to shrink its banking sector’s share of GDP. 

This is a “bail-in” to the extent that creditors are being directly drawn into the rescue. Depositors are among a bank’s creditors. You are lending money to the bank when you put funds on deposit. However, I’ve always understood the PSI/bail-in to imply financial market creditors — i.e. bondholders. Trouble is, the Cypriot banks don’t seem to have many of them. 

Should the sovereign’s creditors have been bailed in? 

After-effects:

• As I tweeted on Saturday, I’m looking for a big presence from the ECB (or from the national central banks in the form of ELA). It will simply have to step in to ensure liquidity if people take fright across the peripheral eurozone. 
• Say au revoir to that wonderful GBP depreciation. Merv might not have liked it, but it was truly a great thing for this (UK) economy. That’s over now. Where do you think fleeing EZ deposits will go?

More later, with time.