The real worry over Europe...

What's the most important thing to worry about in Europe - or with the economic crisis more generally? I think for many people -- especially economists of the Chicago school -- the biggest concern is that we might lose a couple of percentage points of cherished growth over the next ten years, leading to a tragic loss of GDP relative to where we might have been. But the really important thing about this crisis isn't about money or wealth, but about social stability. George Soros, as usual, sees more clearly than others:

I have been very concerned about Europe. The euro is in the process of destroying the European Union. To some extent, this has already happened, in the sense that the EU was meant to be a voluntary association of equal states. The crisis has turned it into something that is radically different: a relationship between creditors and debtors. And, in a financial crisis, the creditors are in charge. It is no longer a relationship between equals. The fate of Italy, for example, is no longer determined by Italian politics – which is in a crisis of its own, I would say – but rather by the creditor/debtor relationship. That is really what dictates policies.

The point is that this European crisis is NOT JUST a financial crisis. It is much more serious than that. It's a political and social crisis. We talk about it in financial terms, but the really important thing is a massive breakdown in cooperation and political function, obviously in Europe, but elsewhere as well. A few years ago, the idea of a global financial crisis seemed pretty hard to imagine. What are we failing to imagine now?

Soros also has a few thoughts on austerity:

The evidence is growing that austerity is not working. Sooner or later, I expect a reversal of the current fiscal policy – the sooner, the better. There is a political problem, namely that the creditors dictate economic policy. And there is a financial or an economic problem, namely that the policy the creditors advocate is counter-productive. The rest of the world, in the face of excessive unemployment, is no longer trying to reduce prematurely government debt accumulated during the financial crisis. And the rest of the world engages in quantitative easing. The latest convert is Japan, where the central bank has been forced to abandon its orthodox monetary policy. So I think it is only a matter of time. Something has to give in Europe, because Europe is out of touch, out of synch, with the rest of the world.

Prosecuting Wall St.

By way of Simolean Sense:

The following is a script of "Prosecuting Wall Street" (CBS) which aired on Dec. 4, 2011. Steve Kroft is correspondent, James Jacoby, producer.

It's been three years since the financial crisis crippled the American economy, and much to the consternation of the general public and the demonstrators on Wall Street, there has not been a single prosecution of a high-ranking Wall Street executive or major financial firm even though fraud and financial misrepresentations played a significant role in the meltdown. We wanted to know why, so nine months ago we began looking for cases that might have prosecutorial merit. Tonight you'll hear about two of them. We begin with a woman named Eileen Foster, a senior executive at Countrywide Financial, one of the epicenters of the crisis.

Steve Kroft: Do you believe that there are people at Countrywide who belong behind bars?

Eileen Foster: Yes.

Kroft: Do you want to give me their names?

Foster: No.

Kroft: Would you give their names to a grand jury if you were asked?

Foster: Yes.

But Eileen Foster has never been asked - and never spoken to the Justice Department - even though she was Countrywide's executive vice president in charge of fraud investigations...

See the video and transcript here.

Bail out everyone

I had wondered about this idea a couple years ago -- but that's all I did, wondered about it. The idea is that when banks need bailing out -- and sadly, we seem stuck with that problem for the moment -- we shouldn't bail them out directly, but indirectly. For example, just give every single person in the US $1,000. Or maybe a voucher for $1,000 that they have to spend somewhere, or put in a bank. This quickly amounts to $300 billion infused into the economy, a large portion of which would end up in banks. So cash would be pumped into the banks too, but only through people first.

You can imagine all kinds of ways to play around with such a scheme. Paying off some of peoples' mortgages. The amount injected could be much larger. Perhaps similar funds would be injected directly into banks and other businesses as well. Mark Thoma has thought through some of the details. But I'm quite surprised this is the first I've heard about any idea even remotely like this. It seems like a much better idea than just giving money to the bankers who created the problem in the first place. Why don't we hear more about such possibilities?

Modern European Tragedy

The endgame playing out in Europe is a tragedy in the usual sense, but also in the sense of Greek tragedy -- downfall brought about ironically through the very efforts, perhaps even well intentioned, of those ultimately afflicted. It's terrible to see Europe looming toward disaster, but also utterly fascinating that everyone involved -- Greeks, Germans, French, the European Central Bank -- has acted in what they thought was their own interest, yet those very actions have led the collective to a likely outcome much worse for all. A tragedy of the commons.

Philosopher Simon Critchley has written a brilliant essay exploring this theme more generally. Among the most poetic analyses of the situation I have seen:

The euro was the very project that was meant to unify Europe and turn a rough amalgam of states in a free market arrangement into a genuine social, cultural and economic unity. But it has ended up disunifying the region and creating perverse effects, such as the spectacular rise of the populist right in countries like the Netherlands, for just about every member state, even dear old Finland.

What makes this a tragedy is that we knew some of this all along — economic seers of various stripes had so prophesied — and still we conspired with it out of arrogance, dogma and complacency.  European leaders — technocrats whom Paul Krugman dubbed this week “boring cruel romantics” — ignored warnings that the euro was a politically motivated project that would simply not work given the diversity of economies that the system was meant to cover. The seers, indeed, said it would fail; politicians across Europe ignored the warnings because it didn’t fit their version of the fantasy of Europe as a counterweight to United States’ hegemony. Bad deals were made, some lies were told, the peoples of the various member countries were bludgeoned into compliance often without being consulted, and now the proverbial chickens are coming home to roost.

But we heard nothing and saw nothing, for shame. The tragic truth that we see unspooling in the desperate attempts to shore up the European Union while accepting no responsibility for the unfolding disaster is something that we both willed and that threatens to now destroy the union in its present form.

The euro is a vast boomerang that is busy knocking over millions of people. European leaders, in their blindness, continue to act as if that were not the case.

The end of the Euro?

Three interesting articles on what now seems to be considered an increasingly likely event -- the end of the Euro (in its current form, although some version might arise from the ashes).

First, Gavyn Davies speculates on several possible scenarios for the collapse of the Euro. It might persist as the new currency of a smaller union including Germany and The Netherlands (in which case the value of the Euro would rise significantly), or it might persist as the new currency of the periphery countries after Germany bolts (in which case the value of the Euro would fall significantly). Or the Europeans might finally find a way through the ongoing nightmare. Not betting on that one.

Second, Satyajit Das goes into a little more detail, and I think rightly sees some cultural issues as ultimately being most important. The three logical possibilities are easy to list:

The latest plan has bought time, though far less than generally assumed. The European debt endgame remains the same: fiscal union (greater integration of finances where Germany and the stronger economies subsidise the weaker economies); debt monetisation (the ECB prints money); or sovereign defaults. 

 Germany may be largely in favour of solution number 1. But the smaller periphery countries, and perhaps France as well, will favour solution number 2. Hence, we may by default find Europe hurtling inexorably into "solution" number 3 -- sovereign defaults:

The accepted view is that, in the final analysis, Germany will embrace fiscal integration or allow printing money. This assumes that a cost-benefit analysis indicate that this would be less costly than a disorderly break-up of the Euro-zone and an integrated European monetary system. This ignores a deep-seated German mistrust of modern finance as well as a strong belief in a hard currency and stable money. Based on their own history, Germans believe that this is essential to economic and social stability. It would be unsurprising to see Germany refuse the type of monetary accommodation and open-ended commitment necessary to resolve the crisis by either fiscal union or debt monetisation.

Unless restructuring of the Euro, fiscal union or debt monetisation can be considered, sovereign defaults may be the only option available.

Perhaps it betrays a little bit of anarchy in my own soul, but I'm rooting quite hard for sovereign defaults. I wish the Greeks had gone ahead with their referendum. For all the complaining about the slack morals of the Greek taxpayer, every debt-creating transaction has two sides -- and the creditors (French and German banks) bear as much responsibility as the debtors.

Then again, the end is likely to bring some severe social misery, not to mention riots (the UK is already advising its European embassies on the likelihood). A third article by Simon Johnson and Peter Boone points ominously in this direction, essentially echoing Davies' analysis in bleaker language:

The path of the euro zone is becoming clear. As conditions in Europe worsen, there will be fewer euro-denominated assets that investors can safely buy. Bank runs and large-scale capital flight out of Europe are likely.

Devaluation can help growth but the associated inflation hurts many people and the debt restructurings, if not handled properly, could be immensely disruptive. Some nations will need to leave the euro zone. There is no painless solution.

Ultimately, an integrated currency area may remain in Europe, albeit with fewer countries and more fiscal centralization. The Germans will force the weaker countries out of the euro area or, more likely, Germany and some others will leave the euro to form their own currency. The euro zone could be expanded again later, but only after much deeper political, economic and fiscal integration.

Tragedy awaits. European politicians are likely to stall until markets force a chaotic end upon them. Let’s hope they are planning quietly to keep disorder from turning into chaos.

European Central Bank's Trechet on post-crisis economics

Italian physicist Luciano Pietronero recently pointed me to an address given by Jean Claude Trichet, president of the European Central Bank. It was titled Reflections on the nature of monetary policy: non-standard measures and finance theory and given at the ECB's 2010 Central Banking Conference which brings together central bankers from around the world.

In the speech, Trechet aimed to identify "some main lessons to be learned from the crisis regarding economic analysis." After talking a little about monetary policy and inflation targets, Trichet got to his main points about the shortcomings of current finance theory.

When the crisis came, the serious limitations of existing economic and financial models immediately became apparent. Arbitrage broke down in many market segments, as markets froze and market participants were gripped by panic. Macro models failed to predict the crisis and seemed incapable of explaining what was happening to the economy in a convincing manner. As a policy-maker during the crisis, I found the available models of limited help. In fact, I would go further: in the face of the crisis, we felt abandoned by conventional tools.

In the absence of clear guidance from existing analytical frameworks, policy-makers had to place particular reliance on our experience. Judgement and experience inevitably played a key role... In exercising judgement, we were helped by one area of the economic literature: historical analysis. Historical studies of specific crisis episodes highlighted potential problems which could be expected. And they pointed to possible solutions. Most importantly, the historical record told us what mistakes to avoid.

But relying on judgement inevitably involves risks. We need macroeconomic and financial models to discipline and structure our judgemental analysis. How should such models evolve? The key lesson I would draw from our experience is the danger of relying on a single tool, methodology or paradigm. Policy-makers need to have input from various theoretical perspectives and from a range of empirical approaches. Open debate and a diversity of views must be cultivated – admittedly not always an easy task in an institution such as a central bank. We do not need to throw out our DSGE and asset-pricing models: rather we need to develop complementary tools to improve the robustness of our overall framework.

This is a somewhat formal and wordy expression of a sentiment expressed quite beautifully two years ago by journalist Will Hutton of The Observer in London:

Economics is a discipline for quiet times. The profession, it turns out, ...has no grip on understanding how the abnormal grows out of the normal and what happens next, its practitioners like weather forecasters who don't understand storms.

In other words, when markets are relatively stable, unstressed and calm, the basic equilibrium framework of economic theory gives a not-too-misleading picture. But in any episode of slightly unusual dynamics the standard theories give very little insight. The trouble is, of course, that unusual episodes are actually not so unusual. I haven't yet tried to count of the number of financial and economic crises described in Charles Kindleberger's masterpiece Manias, Panis and Crashes: A History of Financial Crises, but it is surely a few hundred over the past two centuries (and this doesn't even touch on the short term tumults that frequently hit markets on short time scales).

Trichet went on to describe the kinds of ideas he thinks finance theory needs to turn to if it is going to improve:

First, we have to think about how to characterise the homo economicus at the heart of any model. The atomistic, optimising agents underlying existing models do not capture behaviour during a crisis period. We need to deal better with heterogeneity across agents and the interaction among those heterogeneous agents. We need to entertain alternative motivations for economic choices. Behavioural economics draws on psychology to explain decisions made in crisis circumstances. Agent-based modelling dispenses with the optimisation assumption and allows for more complex interactions between agents. Such approaches are worthy of our attention.

Second, we may need to consider a richer characterisation of expectation formation. Rational expectations theory has brought macroeconomic analysis a long way over the past four decades. But there is a clear need to re-examine this assumption. Very encouraging work is under way on new concepts, such as learning and rational inattention.

Third, we need to better integrate the crucial role played by the financial system into our macroeconomic models. One approach appends a financial sector to the existing framework, but more far-reaching amendments may be required. In particular, dealing with the non-linear behaviour of the financial system will be important, so as to account for the pro-cyclical build up of leverage and vulnerabilities.

In this context, I would very much welcome inspiration from other disciplines: physics, engineering, psychology, biology. Bringing experts from these fields together with economists and central bankers is potentially very creative and valuable. Scientists have developed sophisticated tools for analysing complex dynamic systems in a rigorous way. These models have proved helpful in understanding many important but complex phenomena: epidemics, weather patterns, crowd psychology, magnetic fields. Such tools have been applied by market practitioners to portfolio management decisions, on occasion with some success. I am hopeful that central banks can also benefit from these insights in developing tools to analyse financial markets and monetary policy transmission.

So, four things: get past the idea that economic agents must be rational and optimising, take note of human learning, include financial markets in the models used by central banks, and bring economic theories up to date with advanced ideas coming from physics and other sciences linked to the study of complex systems. This quite an extraordinary statement made by the president of the European Central Bank to central bankers from around the world. Were they listening?

On Trechet's speech, physicist Jean-Philippe Bouchaud had the following interesting comment:

Those not steeped in economic theory may not realize how revolutionary Mr. Trichet’s challenge is. Economics has traditionally been closely focused on developing a core set of ideas that are very different from those that Mr. Trichet champions above. It is truly remarkable for the president of the ECB to suggest such a radical departure from the traditional canon of economics, and it is a reflection of the seriousness of the crisis and the magnitude of the loss of confidence in existing tools. And it is not just Mr. Trichet who is asking these questions -- senior policymakers in finance and economic ministries, central banks, and regulatory agencies across the EU, as well as in the US and other countries are asking similar questions.