What kind of crisis?

by John Quiggin on June 21, 2010

Some thoughts on the nature of the European crisis, which I’m writing up for an opinion piece. Comments much appreciated

Just when it seemed that the world was recovering from the global financial crisis, a new crisis has emerged in Europe. This crisis is being analyzed in terms quite different from, and even inconsistent with, the first round of crisis originating in US mortgage markets. Yet, in reality, this is simply a continuation of the same crisis, with the same essential cause. The only important difference is that there are fewer policy options to respond this time around.

Two main stories have been told about the European crisis to suggest that it is fundamentally different from the original crisis centred in the US. Both stories have an element of truth, but neither gets to the main point.

The first story is one of government profligacy and ‘sovereign risk’. The idea that the European crisis is the consequence of excessive public spending gains some credence from the fact that the crisis originated in Greece, where public debt, hidden by a variety of expedients, has been out of control for years.

This interpretation has been encouraged by ratings agencies, eager to resume their role as guardians of fiscal rectitude after the fiasco of AAA-rated CDOs based on subprime mortgages. It has also been welcomed by opponents of Keynesian fiscal policies, eager to restore the ideological dominance of free-market liberalism.

But Greece is not typical. Most of the countries now threatened by the crisis were, or appeared to be, in reasonably good fiscal shape before the global financial crisis. The Maastricht criteria for admission to the euro required member countries to reduce public debt to 60 per cent of GDP, and budget deficits to 3 per cent of GDP. While these criteria were breached in the aftermath of the the 2000-01 recession, they ensured a degree of fiscal discipline in most eurozone countries that seemed adequate to maintain solvency in the face of plausible shocks.

Greece and to some extent Italy were exceptions. But even in the Greek case, the ability to dodge the Maastricht rules was largely due to creative financing options provided by institutions such as Goldman Sachs. The fact that Goldman Sachs was simultaneously creating ways to bet that Greece would be unable to repay the debt should come as no surprise.

The second story about the crisis is favored by critics of the euro, notably including Paul Krugman. In this story, the central problem is a current-account crisis, for which the appropriate remedy is devaluation. But because they share a common currency, Spain and Greece cannot devalue against Germany and France. Hence, it is argued, they must either undergo a painful deflation or leave the eurozone. The underlying problem, in this analysis, is that Europe is not, in the jargon of international monetary economics, an optimal currency area.

But problems with non-optimal currency areas emerge primarily when one country would benefit from an expansionary monetary policy, while circumstances elsewhere require contraction. In the current crisis, the entire eurozone needs a more expansionary monetary policy and an end to the massive overvaluation of the euro relative to purchasing power parity. This has happened to some extent, but the European Central Bank is still more concerned with the shadow of inflation.

In fact, the central cause of the crisis this time is the same as in the earlier round of crisis. Banks and other financial institutions lent too much money without worrying about the capacity of the borrowers to pay it back. Some of this money went to profligate governments, but most, as in the first round of crisis, went to stimulate booming real estate markets in Spain, Ireland, Iceland and elsewhere.

The main problem for the governments in this countries have arisen because they have been forced to bail out their domestic banks. As the losses are too big to be managed by the governments in question, their own solvency is called into question. This in turn creates problems for the French and German banks which have lent heavily both to governments and to banks in the crisis countries. The French and German governments have therefore chosen to bail their banks out indirectly, by assisting the governments faced with immediate crisis. The alternative would be to force those governments to default, then undertake a direct bailout of the banking system.

It remains to be seen whether the eurozone governments can manage this crisis, or whether the whole euro project will collapse. Whatever the outcome, the main policy lesson is that light-handed regulation of a ‘too big to fail’ financial sector is a recipe for disaster.

{ 75 comments }

1

NomadUK 06.21.10 at 11:29 am

I can’t pretend that the hanging, drawing, and quartering of everyone in executive management of a financial institution would solve the crisis, or even improve the current situation, but I must say it would certainly make me feel a whole lot better as my world and that of my children goes into the shitter.

2

otto 06.21.10 at 11:36 am

“But problems with non-optimal currency areas emerge primarily when one country would benefit from an expansionary monetary policy, while circumstances elsewhere require contraction. In the current crisis, the entire eurozone needs a more expansionary monetary policy and an end to the massive overvaluation of the euro relative to purchasing power parity.”

There’s quite a lot of work being done here by a bit of sleight of hand in the way you reject the idea that within the Eurozone “circumstances elsewhere require contraction”. The political circumstances – the preferences of its permanent ruling coalition on monetary policy issues – of Germany require contraction, or at least much less expansion than the Greeks / Quiggin etc would like. That is the basis for Krugman’s argument, and the indictment of the Euro, not we cannot come up with a different view of that the Eurozone “needs” than the dining room tables of Frankfurt.

3

stostosto 06.21.10 at 12:09 pm

Shorter Krugman on the euro: Germany is irrationally addicted to austerity and blocks sensible euro-area wide expansionary policies. Given this, Greece, Spain and others would be better off outside the euro. (Also that the prior overheating of these economies was caused in large part by their status as euro members, thus attracting a lot of inflationary investment).

Nothing logically wrong with that argument, imo, but it’s a waste of time to argue against the euro as such, since it’s not going to be abandoned.

4

matt wilbert 06.21.10 at 12:47 pm

Although it is clear to me, if not to the Germans, that the ECB should be printing a lot more euros, to me the puzzle is why did the French and German banks lend so much money to Greece (and Greece-like countries) and Greek (and Greek-like) banks? And what kind of regulation would prevent this?

The underlying problem of grading and monitoring creditworthiness seems to be key in this financial crisis both in Europe and the US, but this doesn’t seem to be an area where there is agreement on a solution.

5

hix 06.21.10 at 12:47 pm

This rich Eurozone countries just bailed out their banks story makes no sense at all , a direct limited bank bailout would have been a lot cheaper. Or why even do that, the problem with the US real estate credits was intransparancy through many layers of derivatives, thats not the case here. Its a transfer payment, lots of foreign aid for the current account deficit Eurozone countries, thats it.

6

The Raven 06.21.10 at 12:47 pm

NomadUK: well, you’ve earned my “croak of the day” award.

Me, I’m trying to think about how to deal with living in The Big Minus Sign (which apparently is going to come after The Big Zero) and not doing well at all. Respected academic hosts, we need to get started on this. Our “representatives” aren’t representing. So what do we do now?

7

Henri Vieuxtemps 06.21.10 at 12:52 pm

“Germany require contraction”, “Germany is irrationally addicted to austerity”
“Nothing logically wrong with that argument” – nothing?

What does it mean exactly in the EU context? I mean, what makes an European private enterprise specifically German?

8

bert 06.21.10 at 1:02 pm

You need to tighten up the criticism of Goldman.
Something like: “The markets panicked not because Greece’s numbers were bad; they panicked because the numbers were bogus”, followed by whatever criticism you want to make of the role played by Goldman’s geniuses and financial “innovation”.
At the moment it reads somewhat like you’re taking a small detour from your argument to aim a crowdpleasing kick.

9

Tim Worstall 06.21.10 at 1:38 pm

“but most, as in the first round of crisis, went to stimulate booming real estate markets in Spain, Ireland, Iceland and elsewhere.”

Yeessss…but then there’s this:

“But problems with non-optimal currency areas emerge primarily when one country would benefit from an expansionary monetary policy, while circumstances elsewhere require contraction.”

Which is rather skating over the point that membership of the euro is what gave Ireland and Spain the inappropriately expansionary monetary policy and the real estate boom in the first place: membership of a non optimal currency area and the inevitable one base rate to accompany the one currency.

10

Hektor Bim 06.21.10 at 1:43 pm

It seems to me that the big problem for Spain is that they don’t collect enough taxes. Their government spending isn’t out of line with other European countries as a percentage, but their tax collections are. So what seems to be needed is a quadrupling of the tax inspectorate, and a huge and public crackdown on tax cheats, after a short grace period (1 month or so) when everyone is allowed to declare missing taxes without threat of legal action. Since this is also going to most heavily impact the rich, it seems likely this might also mollify some of the populist anger at the government.

I don’t know enough about Portugal or Ireland. Is tax avoidance a serious problem there as well?

11

Hektor Bim 06.21.10 at 1:44 pm

Arrgh, meant Greece not Spain.

12

hix 06.21.10 at 1:58 pm

“So what seems to be needed is a quadrupling of the tax inspectorate”

Right and the tax inspectors need to earn more not less than right now, much more in exchange for hard non corrupt work.

13

Earnest O'Nest 06.21.10 at 2:01 pm

The kind of crisis we have is the kind that can be expected when there is too much consolidation of capital in a few hands. Luckily the few hands can count on many helpers: the Krugmanites – to consolidate the countries as competitors model – & the Keynes-when-it-suits-them-ites – to give respectability to the credo that deficits can only be justified when it helps consolidated capital.

What we get will be the worst of both worlds: competition for the most austere, combined with a capital-friendly policy to avoid capital crossing the border to & next best capital-friendly policy.

14

Map Maker 06.21.10 at 2:03 pm

Which crisis are you writing about again? May be a bit of a quibble, but when you write:
“The main problem for the governments in this countries have arisen because they have been forced to bail out their domestic banks. As the losses are too big to be managed by the governments in question, their own solvency is called into question. This in turn creates problems for the French and German banks which have lent heavily both to governments and to banks in the crisis countries. “

This applies to Iceland, definitely. Lessor extent to Spain, even less to Ireland, and no way shape or form to Portugal, Italy or Greece. Considering Greece was the focal point of your Goldman Sachs kicks, you’d think it apply to your “main problem”.

Of course I will disagree with your conclusion, but it raises an interesting point – rating agencies served, and subsequently failed, to play an important role in financial markets. What is going to take their place? Less “light-handed regulation” Only with your benefit of hindsight – a regulator telling German or French banks to avoid Greek debt 2 years ago woud have been fired (and accelerated the crisis). Of course, with the CDS market, French and German banks can continue to lend and control their risk ;-)

15

bert 06.21.10 at 2:23 pm

At Wimbledon, Federer losing right now in the first round.
On CT, Worstall making good sense and an excellent point.

Fill your cellar with tinned food, and pray.

16

ejh 06.21.10 at 4:04 pm

The main problem for the governments in this (sic) countries have arisen because they have been forced to bail out their domestic banks

Is this really true of Spain? The main problem?

Arrgh, meant Greece not Spain.

You could have left it as it is, to be honest. Tax evasion in Spain is endemic. The black economy constitutes around 20% (in so far as it can be calculated) of the economy a a whole. People an lay into the functionarios all they want, and sometimes there’s a case for it: but if you’re paid a salary by the government, at least your taxes get deducted from it.

17

Current 06.21.10 at 4:36 pm

In this post and the previous post Quiggin seeks to blame commercial financial companies. I don’t really agree with this, though they are somewhat to blame.

But, finance is run from the top-down by the central bank. It is the central bank that determines the interest rate. With this in mind how can the commercial banks control absolutely the quality of the debt they hold? It’s impossible that the interest rate is exogeneous to commercial finance and at the same time debt quality is endogenous to commercial finance.

The governments wish to have the ability to push the interest rate below what would prevail on a free market. In order to do that the governments must provide central-banking services such as the discount window and things like deposit insurance and bailouts. They must protect banks from the full effects of their credit policies.

It’s a faustian bargain. In a debt-money system to control the interest rate and the monetary base the government must socialise the losses of banks that ensue.

18

Substance McGravitas 06.21.10 at 4:50 pm

But, finance is run from the top-down by the central bank. It is the central bank that determines the interest rate. With this in mind how can the commercial banks control absolutely the quality of the debt they hold?

You can’t have a Ponzi scheme without the central bank’s permission?

19

Mr_ Punch 06.21.10 at 5:13 pm

There are two crises here: an immediate financial crisis “originating in US mortgage markets” (or at least brought to a head there), and a long-term fiscal crisis in all or almost all developed countries largely because of unrealistic entitlements to social benefits. What has happened, I suggest, is that the financial crisis has interacted with the fiscal crisis in at least three ways: it has moved the fiscal crisis forward, it has made obvious the fact that we can’t grow our way out of the fiscal crisis, and it has reminded us that there’s a lot more risk out there (even in sovereign debt) than we had believed.

20

P O'Neill 06.21.10 at 5:20 pm

I don’t know enough about Portugal or Ireland. Is tax avoidance a serious problem there as well?

Well, there was the time that a large tax evasion scheme involving dodgy bank accounts was being run out of the offices of the country’s biggest construction materials company by the PM’s accountant.

But that was all sorted out years ago and never again has a collusion of construction, politicians, and banks been allowed to sully the country.

21

chris 06.21.10 at 5:26 pm

a long-term fiscal crisis in all or almost all developed countries largely because of unrealistic entitlements to social benefits.

This only makes sense if you count low taxes as a social benefit (which, I guess, some people do — at least, they react quite vehemently when their low taxes are threatened). Otherwise the fisc has two sides, neither of which is exogenous from the viewpoint of policymaking by the sovereign people, and you can’t term only one of them “unrealistic” while ignoring the other.

Or, IOW, you could equally well say “a long-term fiscal crisis largely because of unwillingness to raise the revenue actually needed to do the job of government” and it would be just as true, but with an opposite (and equally semi-misleading) spin.

Which jobs are necessary? Which expectations are realistic? The vague terms calling for judgment calls are doing all the work in both sentences.

22

Current 06.21.10 at 5:34 pm

You can’t have a Ponzi scheme without the central bank’s permission?

You can, but the other agents you are dealing with will have an interest in finding it out and closing it down.

With the central banking system the state must somehow provide insurance to the commercial banks. Otherwise they won’t always do the central banks bidding when the central bank tries to push the interest rate too low.

Suppose you’re a central banker and you want to reduce the rate of interest. If you were the governor of the Bank of England in the early 19th century this is something you may fail at. What the central bank did then was to issue more banknotes and correspondingly accept more debt (in those days they did that directly, like a commercial bank). The commercial banks may be of the opinion that the low rate of interest is unsustainable. In which case they may choose not to follow the central bank and reduce their interest rates. That forced the central bank to take on a much greater part of the debt market. To prevent this from happening the central banks did several things. Most important they offered lender-of-last-resort protection to the commercial banks. Once that was in place the costs of lowering the rate of interest were partially socialised by the bailouts offered to commercial banks from the central bank discount window. The government in some places made central bank notes legal tender that allowed commercial banks to use them as reserves. The governments also backed up the inter-bank payment systems, that prevented potentially wobbly banks from being kicked out of inter-bank clearing system by other banks. Later they went further and deposit insurance was created, that gave savers less incentive to invest in sound institutions.

Without all those elements making a Ponzi scheme would be much more difficult than it is. But, without them the government couldn’t control the interest rate or monetary base.

23

Substance McGravitas 06.21.10 at 5:36 pm

You can, but the other agents you are dealing with will have an interest in finding it out and closing it down.

How about schemes in which you put larger-than-sustainable leverage onto loans of dubious worth?

24

Current 06.21.10 at 7:01 pm

How about schemes in which you put larger-than-sustainable leverage onto loans of dubious worth?

Such schemes would certainly be possible. But, it would be in the interests of those within banking to discourage them.

As I understand it the reason CDOs and other similar investments became so popular was because of regulatory capital requirements. Banks needed to find ways of appearing to meet regulatory capital requirements.

This should provoke the question: why? Other businesses in other areas don’t have balance sheets that look anything like that of banks. If the CEO of a normal fortune 500 company were found to be finding dubious ways of claiming his assets were worth more then the shareholders of that company would not look kindly on it. Banking is different. The shareholders of banks know that the lender-of-last-resort facility is open to them. The current account holders know that they are protected by deposit insurance.

Let’s say I’m the owner of a bank worth with £5M assets and 100 people lend a total of £10M at a small interest rate to me, so I have £15M in funds. Let’s say I can lend it out on a high-risk loan that has a 70% chance of returning £20M and a 30% chance of no return causing my bankruptcy. Alternatively, I can lend on a lower risk loan that has a 98% chance of returning £16M. Now, my interests as the owner conflict with those of the lenders. I’m the one who makes a profit on high-risk investments, they just take risk and earn a smaller amount of interest. In a free-market the lenders would prevent me from making the high-risk loan by refusing me their £15M in funds. But, if the lenders are protected by deposit insurance (especially underpriced deposit insurance) they have no interest in doing that. The central bank similarly doesn’t have the same commercial interest as normal lenders if it is providing the loan.

That’s why things like capital adequacy regulations exist in the first place. The central banks realised that if they were to give privileges to commercial banks – which is what they do – then they must regulate them to make sure that they don’t abuse these privileges in a way that is costly to the state institutions involved.

I don’t think this sort of system can work in the long term even if the bureaucrats involved are honest and competent. There is no way they can realistically prevent the privileges given to commercial banks from leaking. They could do it better than they are now, but the system will always be prone to failure.

25

chris 06.21.10 at 7:40 pm

Later they went further and deposit insurance was created, that gave savers less incentive to invest in sound institutions.

This was, of course, *after* the realization that depositors couldn’t tell a sound institution from an unsound one by any means more reliable than casting horoscopes of the CEOs, and couldn’t reasonably be expected to ever discover such a method. They were, and are, always going to lose the information arms race to people wanting to make their unsound institutions or investments look sound.

Incentives only affect voluntary behavior. Investing in a Ponzi scheme is generally not. If someone is incapable of reliably distinguishing information from misinformation, there’s no incentive you can give them that will make them do so.

That’s why there are fraud-busting bureaucrats — not out of some desire for more government control in the abstract, but because amateurs weren’t and aren’t getting the job done on their own.

26

Current 06.21.10 at 8:13 pm

Chris,

To some extent I agree. It is difficult for the ordinary man in the street to understand the finances of a bank. However, it’s not as difficult as you suggest. Normal people may use the actions of others more informed agents as a proxy. That they may do the same thing that share investors do and rely on market prices. Doing that isn’t perfect but it’s reasonably accurate.

Those who really police the solvency of banks aren’t the normal man-in-the-street. They are the larger economic agents, such as businesses and other banks. This is why the government backed payments systems are important. If there is no government backed payment system the businesses and other banks will not deal with wobbly banks. In normal circumstances balances must pass through the hands of larger and more knowledgeable agents first before it can reach the ordinary person.

As Larry White and George Selgin have shown in their books the system of free banking that operated in Scotland worked well. There were many fewer bank failures than in nearby England and the account holders got their money back more often. Of course deposit insurance means that the account holders get their money back every time, but the costs of that are borne elsewhere often by taxpayers.

Anyway, the argument that depositors need protecting doesn’t justify the current system of protection. The current systems of deposit insurance generally do one of two things. They either under-price the insurance so the banks and customers don’t pay the full cost. Or, they accept no difference in risk classes. That is, all banks are considered the same and must contributed pari-passu with the amount of deposits they hold the high-risk banks pay the same as the low-risk ones.

And of course none of this affects the discount window loans, which are just as important if not more so.

27

chris 06.21.10 at 8:33 pm

Normal people may use the actions of others more informed agents as a proxy.

This only kicks the can down the road — how do you know which other agents are wrong or corrupt? Indeed, isn’t this exactly what the ratings agencies were for, to be used as proxies by investors who wouldn’t have to duplicate their whole investigatory process?

Also, the idea that individuals would be putting their money at risk by depositing it in banks would surely lead more of them to refrain from doing so. Keeping cash in a safe/under a mattress/etc. is practically a joke these days, but people used to think there was real risk in banks because there *was*.

Removing all that money from the liquidity intermediation market would have serious effects. Even the more moderate strategy of splitting your deposits among several banks in case one of them fails would impose higher administrative costs on everyone (and wouldn’t even necessarily work because of bank interconnectedness).

If there is no government backed payment system the businesses and other banks will not deal with wobbly banks.

Well, not knowingly. You seem eager to assume away information problems at the drop of a hat.

As Larry White and George Selgin have shown in their books the system of free banking that operated in Scotland worked well.

It was, of course, protected from being raided by corporate takeovers (indeed, I assume you’re talking about a historical period in which that concept was hardly even conceivable). How could such a low-margin business as boring banking possibly survive today without regulatory protection?

Anyway, the argument that depositors need protecting doesn’t justify the current system of protection.

And identifying a way that deposit insurance could be better than it is doesn’t justify eliminating it. If you want to make a technical argument that the FDIC or equivalent should improve their methodology in some particular way, then go ahead. Otherwise you’re just letting the perfect be the enemy of the better-than-nothing.

28

Barry 06.21.10 at 9:54 pm

Substance McGravitas: ” You can’t have a Ponzi scheme without the central bank’s permission?”

Current: ” You can, but the other agents you are dealing with will have an interest in finding it out and closing it down.”

Current, welcome back to consciousness; I hope the physical therapy goes well – 10 years of unconsciousness has got to be rough on the body!

I suggest that you have your friends and relatives catch you up gently on what’s happened while you’ve been dreaming.

There are some topics which might be touchy for your friends and relatives – ‘Dow 36,000’, Alan ‘Genius’ Greenspan, the reduced risks of the modern market, etc., and real estate as a safe investment.

You’ll find these out.

29

Current 06.21.10 at 10:20 pm

This only kicks the can down the road—how do you know which other agents are wrong or corrupt?

Of course we don’t, not for sure. But, it’s always like that with any sort of market transaction, but ways are found to make them work anyway.

Insurance is essentially similar, the person buying it can’t know for certain that the insurance company is solvent. Customers judge the companies by how long they have been around for and the reviews from others. Larger businesses that need insurance services, shareholders of insurance companies and reinsurance companies can examine the accounts of an insurer professionally.

Indeed, suggesting this for banking is just suggesting what already exists in many other businesses.

There are many other ways it can be done that have been used historically. Some banks have advertised their accounts to their customers for example.

Indeed, isn’t this exactly what the ratings agencies were for, to be used as proxies by investors who wouldn’t have to duplicate their whole investigatory process?

Yes. However, I don’t think that the highly politicised ratings agencies that exist in the US now are a useful point of comparison. For years the US government have restricted the entry into the ratings agency business in order to provide tame ratings agencies.

But, quite apart from that, the use to which the ratings agencies were put is different. If I have an interest in finding out what debt is likely to be good or bad I don’t have to go to a ratings agency, I could go other places too. The point of official ratings agencies is to provide a guide in situations where the debt buyer is dealing with other peoples money. That’s not the situation here.

Also, the idea that individuals would be putting their money at risk by depositing it in banks would surely lead more of them to refrain from doing so. Keeping cash in a safe/under a mattress/etc.

It may do. But, banks may offer useful services that cash cannot. With free market banking banks must offer services that are valuable enough to induce customers to take some extra risk.

History shows that banks can do this. In Scotland the free banks supplied banknotes as well as accounts and even private coinage. All of these were very popular, to the extent that in some places state coinage was rarely used.

Removing all that money from the liquidity intermediation market would have serious effects.

Any sort of transfer to a free banking system would have to be done very carefully. I agree with you that at the start holding cash would be very attractive. If there were a change then account would have to be taken of that.

but people used to think there was real risk in banks because there was.

Yes, but the reasons why there was are not what people think they were.

In the US much of the instability was caused by the branch banking laws. In small towns only one or two banks could function and laws against branch banking meant that they had to be separate businesses to other banks in other towns. That kept banks artificially small, making them more risky than they would have been otherwise. Laws against banking over state lines had similar effects.

In England and the US legal tender laws also helped to make banking unstable. In the days of the gold standard the central bank would redeem it’s banknotes into gold. However, legal tender laws were applied to the banknotes from central banks. So, commercial banks could offer the central banks notes instead of gold. That meant that commercial banks were relying on the resources of central banks to provide for their redemption. The state had unintentionally socialised the provision of redemption. So, from time to time the central bank had to take action to stop the commercial banks from creating too many notes. They would raise the interest rate sharply and doing that would bankrupt some commercial banks.

If there is no government backed payment system the businesses and other banks will not deal with wobbly banks.

Well, not knowingly. You seem eager to assume away information problems at the drop of a hat.

In any situation in a market economy when there is an information problem it’s in the interest of market participants to find a solution. The market process is a gradual process of integrating information.

Stiglitz sees the situation of perfect information as a perfect market and imperfect information as a deviation. This is confused, Hayeks point of view is better. He viewed all market interactions as always taking place under incomplete information, but subject to an evolutionary processes that eeks information out.

In this case such a process can be put in place by the market. The clearinghouses that manage payments between different banks can audit the books of the banks involved, and throw out bad banks. No such process would be perfect but it can be refined by the various market actors. This has been done many times and is being done continuously in other markets.

It was, of course, protected from being raided by corporate takeovers (indeed, I assume you’re talking about a historical period in which that concept was hardly even conceivable). How could such a low-margin business as boring banking possibly survive today without regulatory protection?

Yes, takeovers were not possible. But, how could that make very much difference? The existing managers of a bank were always able to take on more risky ventures.

Many boring low-margin businesses continue to exist in other fields. Making brick is boring and low margin, but that doesn’t mean that companies will stop making them.

And identifying a way that deposit insurance could be better than it is doesn’t justify eliminating it. If you want to make a technical argument that the FDIC or equivalent should improve their methodology in some particular way, then go ahead. Otherwise you’re just letting the perfect be the enemy of the better-than-nothing.

I don’t agree that it is better-than-nothing for society as a whole. Yes, it’s good for the individual depositor, but not for the taxpayer who must provide bailouts when the time comes.

I don’t wish to concentrate on deposit insurance for the normal person with a small deposit here. Really, that’s a small issue, and we could live with it continuing to exist. But, what about the other aspects of the system though the lender-of-last-resort facility and the discount window? What do you think of those?

30

piglet 06.21.10 at 10:34 pm

JQ: What actually is the crisis you are referring to? You are presenting several theories about the origin of “the European crisis”, but what exactly does “the European crisis” consist of? How does it manifest itself (other than Euro devaluation, which is no reason for crisis talk at all)?

31

Current 06.21.10 at 10:35 pm

Barry,

I don’t think you understand my points. I know very well about the recent crisis.

You quote me saying that when a dangerous financial situation develops then other market participants have an interest in closing it down. That’s the case *in a free market*. But, no western country has a free market in finance. The financial industry is corporatist, it’s a sort of public-private partnership. In that partnership system the costs of failure by financial institutions are partly socialised. In that kind of situation it’s quite clear that those in the industry will have an interest in taking on more risk than is socially optimal.

Hyman Minsky thought that capital markets are self-destabilising. He thought that in time all market actors would come to have unrealistic expectations of the future. I think that that argument may well be right at least partially. But, why should we reach for that explanation when in reality banks have good self-interested reasons to behave perversely.

32

Chris 06.22.10 at 12:12 am

In any situation in a market economy when there is an information problem it’s in the interest of market participants to find a solution.

No. It’s in the interest of *some* market participants to find a solution. It’s in the interests of other market participants (the ones with the information advantage) to exploit their information advantage while they have it, and possibly even to interfere with the solution-finding that would upset their applecart.

Heck, even principal/agent is a special case of information problems (you can hardly rip off your principal if you can’t conceal it from him); how has the market done at solving that one?

Hayek made insufficient allowance for the consequences of information asymmetry between parties with adverse interests. There’s no reason to believe the party wanting to reduce the asymmetry will win the resulting arms race (and in general they don’t in actual markets). Sometimes it’s more economically effective to rip people off.

33

lemuel pitkin 06.22.10 at 6:39 am

In the current crisis, the entire eurozone needs a more expansionary monetary policy and an end to the massive overvaluation of the euro relative to purchasing power parity.

The first half of this sentence, certainly, but the second half seems odd. The Euro area as a whole runs a rough current account balance, which seems like a more sensible (and I would have thought more conventional) test for over/undervaluation. I’m not even sure what claim you’re making here — that exchange rates normally move so as to maintain PPP, or that they ought to? Neither seems sustainable. Poor countries, certainly, with their inefficient nontradable sectors, would not be able to maintain tradable sectors at all if PPP held, while Europe would have a huge trade surplus. Why is that a natural or desirable state of the world?

The rest of the piece seems right, altho I might frame the conclusion a bit differently. The problem isn’t (just) that the private financial system was lightly regulated, but that it was responsible for cross-border financial flows in the first place. In a world where countries won’t accept deep deflations and depressions, you have to either adopt policies to ensure that current accounts remain roughly balanced, or else have some public agency to provide stable financial flows to cover them. Private flows are just to unstable to support an open trading system, in which large imbalances are inevitable.

34

lemuel pitkin 06.22.10 at 7:08 am

Yeah, the more I think about it, the weirder using PPP as a standard for overvaluation is. The whole reason PPP exists is that there are systematic differences in the ratio of tradable to nontradable prices between countries. So if exchange rates move so as to equalize the price of traded goods, as they are normally supposed to, then there will be differences between the prices of nontradables between countries. (E.g. personal services are very cheap in poor countries.) To say that exchange rates should move to equalize PPPs, on the other hand, implies there will be systematic national differences in the price of (the same) tradable goods, which implies persistent trade imbalances. I’m at a loss to understand how this could be the standard for correct valuation.

Maybe you meant to write something else?

35

stostosto 06.22.10 at 7:18 am

Vieuxtemps @ 7:

“Germany is irrationally addicted to austerity” “Nothing logically wrong with that argument” – nothing?

No, nothing.

What does it mean exactly in the EU context? I mean, what makes an European private enterprise specifically German?

In an EU context it means exactly that the Germans always obsess about deficits. Always, always, always. As in regardless of the situation, regardless of other considerations, regardless of the cost of contractionary policies in terms of growth, employment, investment. Therefore: Irrationally.

And who said anything about private enterprises? This is German politics.

36

Henri Vieuxtemps 06.22.10 at 8:42 am

But Europe is one economy, like the US. Common currency, no tariffs, free flow of capital and (theoretically) labor. I don’t see a mechanism for German local quirks (whatever they are) to have a significant effect on Greece, as in “Germany is irrationally addicted to austerity and blocks sensible euro-area wide expansionary policies.” No more than, say, California vis-a-vis Delaware.

37

John Quiggin 06.22.10 at 10:52 am

LP, your points are valid. In my defence, I was thinking mainly of exchange rates with the $US and other developed country currencies. There’s then no reason to expect systematic differences in the relative prices of traded and non-traded goods, and PPP seems as good a benchmark as any.

Henri, I think Stososto is simply saying that Germany (ie the German government, other German actors, concern about German public opinion etc) influences the European Central Bank and other EU institutions, in ways that favor austerity policies, in the way that Red states in the US influence the political process in ways that favor the rich. There’s nothing complicated about this.

38

James Wimberley 06.22.10 at 12:32 pm

Bert in #15: “Fill your cellar with tinned food, and pray.”
I think doomsday cellar optimisation requires allocating sufficient shelf space to gin to ensure that you can drink yourself to death just before the food runs out.

39

Bunbury 06.22.10 at 1:11 pm

How would monetary policy be more expansionist if not held back by the Germans? Isn’t the problem rather one of coordinated monetary policy without coordinated fiscal policy?

40

bert 06.22.10 at 1:54 pm

#39: Krugman recalls “how Rudi Dornbusch came down to breakfast one day and greeted a German central banker with a cheery ‘And stable prices to you, sir!'”.
There are some excitable types for whom it’s always Munich.
But for the guardians of sound money it’s always Weimar.

#38: Myself, I’m planning on being raptured.
But I notice that Federer did actually win in the end.
The bookmakers won’t even give odds on Worstall returning to drivel.
On mature reflection, keep calm and carry on.

41

piglet 06.22.10 at 2:04 pm

In addition to LP, I wonder whether “overvaluation of the euro relative to purchasing power parity” is true at all. Where does that claim come from?

Incidentally, nobody has answered my question in 30. Everybody talks of a European crisis, but what exactly are they referring to? Some European countries have varying degrees of fiscal difficulty, but what turns those into a “European crisis”? Here in the US, the deflation of the housing bubble has caused a crisis characterized by high unemployment, high levels of bankruptcy and foreclosure, drying up of local tax revenues and deterioration of the public infrastructure. What are the effects of the “European crisis”?

42

Current 06.22.10 at 4:17 pm

No. It’s in the interest of some market participants to find a solution. It’s in the interests of other market participants (the ones with the information advantage) to exploit their information advantage while they have it, and possibly even to interfere with the solution-finding that would upset their applecart.

Heck, even principal/agent is a special case of information problems (you can hardly rip off your principal if you can’t conceal it from him); how has the market done at solving that one?

Yes, it’s a constant cat-and-mouse game.

Let’s say I run a bank and I invent a new way to conceal the risks I’m taking from other interested parties. I may be found out, in which case those other parties will learn from that. Or, I may not be found out until the consequences of my risk taking become clear through losses. When that happens then the other parties will learn will learn from that through self-interest. Then, in the future steps will be taken to mitigate against that risk, so a new innovation in fraud would be needed next time.

It’s through these sort of processes that markets generally work. The rigid view of walrasians which Stiglitz criticizes doesn’t describe the situation. The same is true of innovation in the direction of making better products. When a innovating company provides a new product at the start the company has a monopoly in that product. But, if it proves to be useful then in time other companies will design competing products that are similar or superior.

Compare that to the existing situation. Bank account holders are protected by state sponsored insurance schemes. That protects those account holders that invest in bad banks from losing large sums. It does so by spreading the cost over the other account holders or to the taxpayer. The incentive to create the appearance of low risk investments continues to exist. But, the burden of tackling it moves from the market onto the administrators of the insurance scheme. This is why the FDIC audit banks in the US.

So, on the one hand if a new way of “appearing low risk” is found then the costs are spread across society not concentrated. But, the task of tackling the problem is handed to a government bureaucracy. Those who run it have “no skin in the game” as they say. And they face the other information problem, they aren’t party to the local circumstances of the contract. Suppose, as Stiglitz does, that we have two parties in a deal A and B, but A knows something B doesn’t. Stiglitz claims this can be solved if another party G enters into the picture who tells B what A knows, or otherwise rectifies the imbalance. But, in any real situation how is G to know what A & B know? If G means “God” then it’s possible and that’s how the analytical model of the situation is presented, it assumes an omniscient outsider intervenes. However, if G means “Government” the situation is different because government can’t know what A & B know, practically G can understand the overall picture of the marketplace but not the local details.

With these things in mind it’s no surprise that the system doesn’t work that well and that large problems with banking are exposed well after they’ve become damaging, as we’ve seen recently.

43

Ginger Yellow 06.22.10 at 4:54 pm

Which is rather skating over the point that membership of the euro is what gave Ireland and Spain the inappropriately expansionary monetary policy and the real estate boom in the first place: membership of a non optimal currency area and the inevitable one base rate to accompany the one currency

It was a contributing factor, but hardly the only one. Ireland in particular fostered the boom with absurdly lax tax and regulatory policies (not to mention corruption), while the Bank of Spain let its myriad tiny banks build up enormous concentrations of real estate development loans and, notoriously on the south coast, the government turned a blind eye to cowboy builders.

44

Current 06.22.10 at 6:12 pm

Ginger Yellow,

I think a major factor in the real estate boom is the different housing policies of the various governments. I live in Ireland. It’s an underpopulated country, planning permission is easy to obtain. It has a banking system quite like Britain, the banks often don’t require large downpayments. Unlike France there are no special laws against trading in houses.

The problem here is that the real price of capital isn’t the same across the eurozone. In the countries with heavy regulations on capital use it’s relatively more expensive than in the more neo-liberal countries. The interest rate was set for the benefit of the more tightly-regulated countries. But, loans naturally found their way to the more lightly regulated countries.

In my view that’s an argument for lighter regulation everywhere. Whatever you think though the difference is always bound to cause problems.

45

Map Maker 06.22.10 at 6:13 pm

Piglet:
“What are the effects of the “European crisis”?

How about high unemployment, high levels of bankruptcy and foreclosure, drying up of local tax revenues and deterioration of the public infrastructure?

Spain and Ireland for the first two, pan-european for the 3rd, and for #4, let’s just say fiscal consolidation or something more neutral. Given what I saw of public infrastructure spending among the Club Med, less is more …

46

chris 06.22.10 at 6:24 pm

Let’s say I run a bank and I invent a new way to conceal the risks I’m taking from other interested parties. I may be found out, in which case those other parties will learn from that. Or, I may not be found out until the consequences of my risk taking become clear through losses. When that happens then the other parties will learn will learn from that through self-interest. Then, in the future steps will be taken to mitigate against that risk, so a new innovation in fraud would be needed next time.

History proves you wrong. Madoff used the same trick as Ponzi and got away with it for quite a while, even though some people in the market were aware of the existence and nature of Ponzi schemes.

Self-interest can certainly provide the little guy with an incentive to uncover frauds, but it can’t provide him with the capability to do so. Fraud detection is a complex professional art and there’s no way that all market participants are going to be adept at it.

47

Current 06.22.10 at 6:45 pm

The problem is that the Eurozone has resurrected some of the worst problems of the international gold standard.

The national governments still determine tax policy, redistribution policy and regulatory policy. They still have their own debts. That gives them a lot of rope for them to hang themselves. But, when they do they have no separate monetary policy to deal with the situation with. Even in the gold standard the banks had some degree of flexibility through changing reserve ratios and suspension. But, the Euro doesn’t even provide that.

The situation looks very like the gold standard. If a country were to leave the euro it faces more problems in international trade, the same thing happened in the 19th century with leaving the gold standard. If a country were to leave the euro it would be seen as a sort of national disgrace, the same was true of leaving the gold standard. The gold standard made it difficult to run deficits because they couldn’t easily be inflated away. The same is true for the minor euro countries that have little influence with the ECB. I understand the tactic of “internal devaluation” was also used in gold-standard times for similar purposes to those being suggested now.

Now, I don’t really like fiat money based central banking or gold based central banking. But, I think the euro seems to have constructed the worst of both worlds. It allows the central bank to inflate in boom, but because economic problems can be local to the member states in those circumstances it doesn’t allow much to be done about the problem.

48

lemuel pitkin 06.22.10 at 6:46 pm

. In my defence, I was thinking mainly of exchange rates with the $US and other developed country currencies. There’s then no reason to expect systematic differences in the relative prices of traded and non-traded goods, and PPP seems as good a benchmark as any.

I admit, I’ve only really studied this stuff in a development context. But I’m still wondering, why is PPP a better standard than current account balance?

49

lemuel pitkin 06.22.10 at 7:11 pm

Thinking about this a bit more, a world where PPP held would be a world of stationary real exchange rates. Clearly, that’s not the world we live in, even just considering the rich countries.

So this must be a normative claim — not that the Euro is overvalued relative to its normal or expected level, but that it is overvalued relative to its preferred level. But a significantly lower Euro would presumably imply sustained Euro-area trade surpluses, unless incomes in the Euro area grew faster than in its trade partners. But given demographic (and other) trends, slower Euro-area income growth seems more likely. So the claim that the Euro is normatively overvalued amounts to a claim that the world would be better off with big Euro-area trade surpluses, than with balanced trade. How come?

50

Current 06.22.10 at 7:38 pm

Chris,

History proves you wrong. Madoff used the same trick as Ponzi and got away with it for quite a while, even though some people in the market were aware of the existence and nature of Ponzi schemes.

Yes. I should have said, that of course enforcement systems cannot be perfect whatever market or institution does the enforcement.

Self-interest can certainly provide the little guy with an incentive to uncover frauds, but it can’t provide him with the capability to do so. Fraud detection is a complex professional art and there’s no way that all market participants are going to be adept at it.

It wouldn’t simply be “the little guy” by himself. The little guy can do some things by himself, he can see how long a bank has been around for or how big it is. But, more importantly, as I said earlier, he can seek guidance from better informed market actors either directly or indirectly. If your employer told you that it’s bank wouldn’t let you setup a bank transfer with bank X then would you bank with bank X? If you hold a lot of money in a bank account wouldn’t it be worthwhile getting a report from an impartial specialist to check out the bank? This is exactly how things work in other fields, such as home-buying and insurance.

(BTW I’m not really talking about fraud here in the context of banking, I think that fraud should be a criminal offence. However, running a risky bank isn’t really fraud, it’s just taking risk.)

Also, as I said earlier there are the other aspects of government support. Why does the government have to support the inter-bank payment system for all transactions? Why does the central bank have to bail-out the most marginal banks with discount-window loans? Neither of these actions are to aide the common bank customer.

51

chris 06.22.10 at 7:53 pm

However, running a risky bank isn’t really fraud

It is if you don’t disclose the risk to your stockholders, and in a world without FDIC-equivalents, your depositors as well. But obviously nobody is going to do that, it would make them look bad.

52

Substance McGravitas 06.22.10 at 7:57 pm

The little guy can do some things by himself, he can see how long a bank has been around for or how big it is. But, more importantly, as I said earlier, he can seek guidance from better informed market actors either directly or indirectly.

One of the problems with this is that you wind up having to do a boatload of research for every transaction you make. It’s much easier for a small working group to hold a bank accountable than it is for absolutely every citizen to do so. Regulation is not just wise from the point of view of those who want a stable society, but it’s a convenience for the citizen who shouldn’t have to worry about losing their $10,000 to malfeasance or their lives to tainted meat.

53

Current 06.22.10 at 8:41 pm

It is if you don’t disclose the risk to your stockholders, and in a world without FDIC-equivalents, your depositors as well. But obviously nobody is going to do that, it would make them look bad.

That’s right if you don’t disclose the risk then it’s fraud.

I’d point out here that the current system is hamstrung by the very strict interpretation of insider trading laws.

One of the problems with this is that you wind up having to do a boatload of research for every transaction you make.

No you wouldn’t. When you do an inter-bank payment what’s happening is that your bank is exchanging debt with another bank. Both banks will only do this if they trust each other, or if they work through a clearinghouse then the clearinghouse would have to trust each bank. So, the normal man in the street doesn’t really have to know the details. This is what happened in Scotland during the period of free banking.

It’s much easier for a small working group to hold a bank accountable than it is for absolutely every citizen to do so.

But, as I said earlier, it’s not a matter of every citizen having to redo all the work. There are mechanisms whereby the ordinary citizen can tap the expertise of others.

Besides, consider the problems that “working group” face. If they are a government organization, which is what I think you mean, then the government may not care much about whether this problem is dealt with. (Consider what happens if a government knows it’s going to lose the next election). The government and the bureaucracy it delegates too don’t necessarily have the interest in solving the problem. But, even if they do then that doesn’t mean they have the information to do it. A governments information gathering must be controlled by quite strict rules, they can’t evolve in the same way that market information gathering can. Expecting a bureaucracy to do this task well is expecting too much.

losing their $10,000 to malfeasance or their lives to tainted meat.

As I said earlier then issue isn’t really malfeasance or law-breaking which is would be with fraud or tainted meat. What deposit insurance schemes attempt to do is to take the risk of a bank failure on behalf of the account holder. If they didn’t exist that wouldn’t make fraud legal.

What I’m suggesting here is getting rid of that insurance, not rid of fraud law. So, if a bank misrepresented the risk it has taken then that would still be a crime. However, a bank could take any level of risk as long as it were adequately declared, it would be up to the other parties to decide if they want to transact with the bank.

54

Current 06.22.10 at 8:47 pm

Substance McGravitas,

I just read some of your blog. I particularly liked the “boners all the way down”.

55

Substance McGravitas 06.22.10 at 8:52 pm

My silliness is a pale shadow of the silliness here.

56

Substance McGravitas 06.22.10 at 9:02 pm

Both banks will only do this if they trust each other, or if they work through a clearinghouse then the clearinghouse would have to trust each bank.

“Trust” in some of the workings that led to part of the current crisis was managed by private ratings agencies who seem to have known full well that they would rate anything highly that suited their interests, and obviously many large banks colluded to build magic money on top of bad loans. I don’t see why the Scottish example – about which I know nothing – shouldn’t be considered miraculous.

57

Current 06.22.10 at 10:21 pm

Substance McGravitas,

I agree that private ratings agencies have their problems. However, the banking case I’m describing is different.

Ratings agencies are in some ways like those parts of the FDIC that examine risk. They exist to provide data on risk in situations where those taking the risk can’t speak. Banks have capital requirements that often refer to ratings of risk. That regulation is put in place because many of those who lend to the bank have deposit insurance, and because the bank has lender-of-last-resort support from the central bank’s discount window.

Ratings agencies aren’t like property surveyors. When you get a surveyor to examine a house that you buy you have an interest in getting a thorough surveyor and your surveyor has an interest in developing a reputation for thorough work. Ratings agencies though are often used in situations where the opposite applies, and this was the case during the recent crisis. They are used where the bank has – normally because of government protections or a law – less interest in the quality of a loan than it should have. In this situation it’s not particularly in the interest of the bank to pick a good ratings agency. That’s why ratings agencies are so heavily regulated themselves.

What I’m suggesting is that the situation *should* be like that with property surveyors. In the Scottish situation I described (which went on for about a hundred years) banks threw risky banks out of the inter-bank/clearinghouse agreements because that was in their own interest. When bank account holders examined the banks they used (or got others to do it for them) they did it from their own interest.

In the current system we as taxpayers hire an agent – the government. Government then hires other agents – the state regulators. And government requires banks to hire other agents – private ratings agencies.

What I’m suggesting is that it would all be more effective if those who take the risk choose their own basis to pick their agents.

My silliness is a pale shadow of the silliness here.

Ah the internet. How about http://hotchickswithdouchebags.com/

58

Substance McGravitas 06.22.10 at 11:04 pm

In the Scottish situation I described (which went on for about a hundred years) banks threw risky banks out of the inter-bank/clearinghouse agreements because that was in their own interest.

What happened to the risky banks? In my dreams people didn’t lose their life savings and so forth. Again I don’t see why Scotland should be a model: if it worked as you say it did, then private companies were successful in protecting both themselves and the populace, something that seems like an absurdity in the face of modern financial practices, let alone modern business practices in which large firms are involved. Were these fine Scotsmen club members? Church-goers? Were they permitted to loot their firms to the modern extent? That was then but this is now, and Scotland had a populace of about 2.5 million by the time the glorious free period ended.

For what it’s worth, the Mises people I hate think Scottish free banking is a misnomer and that it was really built on the non-free central bank of England.

59

John Quiggin 06.23.10 at 9:59 am

LP, my thinking here is mainly in terms of short-term macroeconomics rather than long-term equilibrium. The eurozone is facing a domestic demand shock, and needs a devaluation as part of the policy response.

But it is, as I’ve pointed out in the past, something of a mystery that the eurozone maintained a big current account surplus with the US even when the euro was way above PPP (so far, that, in exchange rate terms, Europeans earned higher incomes than Americans while putting in 30 per cent fewer hours per year).

60

Earnest O'Nest 06.23.10 at 10:17 am

Not a mystery, John, we are just smarter about what we do and less focused on running about a lot proclaiming that ‘the end is nigh’.

61

piglet 06.23.10 at 2:13 pm

42: “Bank account holders are protected by state sponsored insurance schemes. That protects those account holders that invest in bad banks from losing large sums.”

Not quite true. FDIC and similar schemes were designed to protect small depositors. Those investing millions in a bad bank are supposed to be able to look after themselves and are not supposed to be protected. Of course, the protection limits were raised in the recent crisis but originally, FDIC only protected relatively small, unsophisticated savers from being wiped out.

62

piglet 06.23.10 at 2:44 pm

45: thanks for somebody finally attempting an answer.

How about high unemployment, high levels of bankruptcy and foreclosure, drying up of local tax revenues and deterioration of the public infrastructure? Spain and Ireland for the first two, pan-european for the 3rd, and for #4, let’s just say fiscal consolidation or something more neutral.

Two problems with that answer.

First, Spain and Ireland have high unemployment but they are not “Europe”. My question was, what makes their difficulties a “European crisis”.
Second, you remember there was a global crisis? Europe was affected by that crisis and suffered consequences; those have little to do with a “European crisis”. When people talk about a “European crisis”, they mean something distinct from the global crisis and I an curious what that is. Eurozone unemployment just hit a record 10% but much of that can be attributed to the global crisis. Unemployment was 7.3% in January 2008 and 8.2% in January 2009. In the US, unemployment rose from around 5% in early 2008 to 10%. Interestingly, Germany just posted a decrease in unemployment to 7.7%, which is among the lowest rate seen in 20 years. The data I am aware of just don’t support the meme of a “European crisis”. They show fallout from a global crisis that affected EU countries to varying degrees, adding to distinct homemade problems in some countries.

Crisis talk always has a political subtext. It is frustrating to see so many people who should know better regurgitate “conventional wisdom” that has been made up for transparent political purposes.

63

piglet 06.23.10 at 2:47 pm

“But it is, as I’ve pointed out in the past, something of a mystery that the eurozone maintained a big current account surplus with the US even when the euro was way above PPP”

JQ, why don’t you tell us what you think is the PPP rate, and what evidence you are relying on?

64

piglet 06.23.10 at 8:05 pm

Seems JQ isn’t in the mood to explain himself. Too bad.

65

John Quiggin 06.23.10 at 8:17 pm

Piglet, IIRC my PPP rate is estimate is 1 euro = $US1.10, which is, from memory estimated by the WOrld Bank. Of course (well, not of course, most people aren’t aware of this) there is no one PPP rate, but a range of possible estimates consistent with the underlying economic theory of index numbers. All are ultimately derived from the data of the International Comparisons Project, which estimates prices for comparable goods and services in different countries.

66

Current 06.23.10 at 9:44 pm

I think the other posters criticising JQ are right.

In my defence, I was thinking mainly of exchange rates with the $US and other developed country currencies. There’s then no reason to expect systematic differences in the relative prices of traded and non-traded goods, and PPP seems as good a benchmark as any.

Why is there no reasons to expect systematic differences in relative prices of traded and non-traded goods? That’s not immediately obvious. Also, foreign exchange isn’t only bought to purchase goods, it’s also bought to purchase assets.

67

lemuel pitkin 06.23.10 at 10:27 pm

my PPP rate is estimate is 1 euro = $US1.10

It’s been over seven years since the euro has been that weak. And yet the Euro area has run current account surpluses over almost that entire period. How do you explain that except by a systematic divergence in the ratio of tradable to nontradable prices between Europe and its trade partners?

I’m going to go out on a limb here and say that a large majority of international economists, orthodox and heterodox, use long-run current account balance as the standard for correct valuation. In positive terms, current account balance is a better measure than PPP, because a current account surplus will tend to lead to appreciation, and a c.a. deficit will tend to lead to depreciation; there’s nothing equivalent for PPPs. And in normative terms, it’s better, because it implies an absence of large sustained capital flows, which as we’ve seen over and over again are highly destabilizing. In multiple exchanges on this question, you have given no positive reason to prefer PPP over long-run trade balance.

And of course depreciation might be good for demand in the euro area, but only to the extent it’s badd for demand elsewhere. We don’t need that kind of zero-sum stimullus. If the ECB’s willingness to engage in expansionary monetary policy was being constrained by a positive desire to maintain the value of the euro (as in the gold standard days) you’d have a point. But it’s not.

There’s a natural tendency to dig in in arguments like this. But this PPP thing is silly. It’s not convincing, it’s not even conventional, and it’s not necessary to your larger argument, which is quite good. You should drop it.

68

piglet 06.23.10 at 10:54 pm

JQ: It is generally the case, and I think has always been the case, that people from rich countries can go to poorer countries for a cheap vacation. Isn’t that the same as saying that the rich country’s currency is overvalued wrt PPP? There’s nothing unusual about that, it’s the strength and competitiveness of the underlying economy that determines the exchange rate. Now, I don’t think it is true that Europeans, even when the Euro was at $1.50+, could go for a “cheap” vacation in the US. Prices in many categories are actually quite high. But anyway, the exchange rate would be expected to reflect economic competitiveness, not the differential in the price of a hotel stay, and in that respect the dollar devaluation of the past 10 years makes perfect sense. The US economy is in very bad shape and I don’t see any evidence of the Euro being overvalued.

69

piglet 06.23.10 at 10:56 pm

Btw, my question in 30 remains open.

70

Current 06.23.10 at 11:12 pm

What happened to the risky banks?

It’s a free market, so if they take risks that are too reckless then they go bust.

In my dreams people didn’t lose their life savings and so forth.

People did, but not very many or very often. It happened much more often in England, according to White there were twice as many bank failures.

In those days there was no deposit insurance in either country. The main thing that this shows is the perverse consequences of the central bank discount window provision though, not the consequences of deposit insurance. But, both are an example of subsidising of risk.

Again I don’t see why Scotland should be a model: if it worked as you say it did, then private companies were successful in protecting both themselves and the populace, something that seems like an absurdity in the face of modern financial practices,

Why do you think it’s absurd? When’s the last time that you’ve heard of a great many people losing their home insurance or car insurance from the failure of one of those businesses? Or losing satellite or cable TV without a refund?

Lot’s of people these days look at the complexity of modern day finance and think that that is the source of the problem. I don’t find that a persuasive argument because these things have always been quite complex. Government bonds, and derivatives such as futures & options are centuries old, and must have seemed very complex for the time. Besides, the complexity argument why people use complex investments if they don’t understand them.

let alone modern business practices in which large firms are involved. Were these fine Scotsmen club members? Church-goers?

Perhaps they were Church-goers. But, I don’t think the difference was down to more ethical personal or corporate behaviour. The two biggest banks, the “Bank of Scotland” and the “Royal Bank of Scotland” tried to bankrupt each other several times. (They didn’t succeed).

Douglass North said:

… if the institutional framework rewards piracy then piratical organizations will come into existence; and if the institutional framework rewards productive activities then organizations – firms – will come into existence to engage in productive activities

My argument is that this is the problem with finance, not the individual ethics of the directors or the complexity of modern business.

The various bailout systems, especially the permanent ones such as the discount window and deposit insurance encourage risk taking. The system relies on a small set of government regulators to prevent that getting out of hand. But, how can these regulators be expected to win against the “Masters of the Universe” in the long run? Failures to achieve this aren’t just recent phenomenon associated with the present crisis, they’ve happened often. Open market operations, required reserve ratios, and capital requirements were all invented in the process of central banks and governments trying to limit the effects of the privileges they give out.

Were they permitted to loot their firms to the modern extent?

That’s a good point, they weren’t. AFAIK all the banks except the two biggest I mention above were partnerships, not limited liability companies. In those days a royal warrant was needed to start a limited liability company. And in those days there were no insider trading laws.

If this sort of thing were to work today then there would have to be some means by which agencies that rate debt could get their hands on the relevant present information. That would have to mean changes to banking laws either weakening insider trading laws, or requiring banks to reveal much more as a matter of course.

For what it’s worth, the Mises people I hate think Scottish free banking is a misnomer and that it was really built on the non-free central bank of England.

Yes, some Austrian Economists think that it was free banking, and some don’t, especially most of the Mises institute group. Most of the arguments against the free banking view were dealt with in papers a long time ago, I could talk about them though if you really want.

But, those “100% reserve” guys don’t think that deposit insurance or these other things I mention are a good idea either. But, they also think that fractional-reserve banking is too much risk too. They believe that a free market would choose commodity currency such as gold, and that for notes or accounts a 100% reserve would have to be used.

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Current 06.24.10 at 12:05 am

Not quite true. FDIC and similar schemes were designed to protect small depositors. Those investing millions in a bad bank are supposed to be able to look after themselves and are not supposed to be protected. Of course, the protection limits were raised in the recent crisis but originally, FDIC only protected relatively small, unsophisticated savers from being wiped out.

Yes, the limit in Britain was 100% of the first £2K and then 95% of the remainder up to £35K. It didn’t apply to companies or other institutions. I understand FDIC is similar, or at least was

But, that doesn’t mean that it only has a small effect. The aggregate balance of small account holders as a group is large. Also, they have a marginal effect. The most risky banks can advertise to those protected by insurance and raise funds from them.

I think this went on in Britain during 2009. Many banks, especially small ones, started advertising high-interest savings accounts and bonds. The interest rates were much higher than the BoE interest rate and much higher than the rate on short-dated government bonds. The banks were relying on the fact that to an individual account holder the extra risk-premium the bank’s debt contained didn’t matter.

The same sort of thing is true of the lender-of-last resort support, or other bailouts, they affect the most marginal players so they’re quite important.

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chris 06.24.10 at 2:40 pm

Besides, the complexity argument why people use complex investments if they don’t understand them.

I assume there’s a “doesn’t explain” missing here. In that case, the answer is simple: because those instruments are “explained” to them in terms that make them appear more favorable than they in fact are. This is legally not fraud because the precise terms are right there in the fine print and it is their own fault for not reading and fully understanding them. It’s just good salesmanship to emphasize the positives of your product and skim over the downsides, and if the consumer misunderstands, well, that’s their problem. And you can take that argument to court and win with it and the full power of the state will back up whatever terms you hid in that fine print (absent a specific consumer-protection statute to the contrary, which some jurisdictions do have, but I’m sure your lawyer can tell you how to stay just on the right side of them).

I don’t think you are approaching the analysis with the proper mindset: information asymmetry is the norm (with the small depositor/investor/borrower systematically holding the short straw), and the parties to any financial transaction have largely adverse interests which they will take advantage of if they have an opportunity. Those are the real-world conditions. The assumptions that lead to the market Panglossianism of the invisible hand are unrealistic simplifications. Nobody would take seriously a spacecraft flight plan that began “Assume a spherical shuttlecraft of uniform density…” but you seem to be doing the economic equivalent: assume perfectly informed, perfectly rational market participants who never try to cheat each other… Of course your conclusions are going to be inapplicable to the real world.

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piglet 06.24.10 at 10:34 pm

“I think this went on in Britain during 2009. Many banks, especially small ones, started advertising high-interest savings accounts and bonds. The interest rates were much higher than the BoE interest rate and much higher than the rate on short-dated government bonds. The banks were relying on the fact that to an individual account holder the extra risk-premium the bank’s debt contained didn’t matter.”

The argument you are making here is a moral hazard argument. Moral hazard is unavoidable with almost any type of insurance protection (whether provided by public or private entities), and insurers usually know what steps to take to minimize it. Unless you are arguing against insurance as a matter of principle – and I don’t think you are willing to do that – your argument (if it has merit) doesn’t show that deposit insurance is flawed, it only shows that the regulators weren’t doing their job in certain particular instances.

Deposit insurance has been around for a long time. The instances you are citing are rather recent. If you want to argue that the world would be a better place without deposit insurance, you’d have to provide extensive evidence. I think the evidence is that FDIC has worked well as long as it was accompanied by strong regulation. I have heard (but can’t provide a link at the moment) that for a long time after depression-era financial regulation was enacted, bank failures were rare and far between, whereas they were rather common before that, and again became more frequent with deregulation starting in the 1980s. Also, the main purpose of FDIC was to prevent destabilizing bank runs, along with protecting small savers. In both respects it was clearly successful.

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George Berger 06.25.10 at 10:05 am

I’m not sure that this is an example of bad banking that helped cause this crisis, so take it for what it’s worth. In my previous EU Eurozone country of residence I invested about half my savings in a fund for State Bonds. They were used to finance loans to solid public service institutions throughout Northern Europe. That was around 1983.

When the present crisis began, I looked up the status of my investment fund and checked the organisations that got loans from this bank. Without ever having informed me, this sneaky bank had at some time started investing half of my money in private businesses. The other half’s status was unchanged. The next day I withdrew all my money from the fund and put it in a savings account in another bank. This might be an example of the “central cause” mentioned by John Quiggin. This bank no longer exists, and its misbehaviour was compensated with the taxes I and many others paid each year.

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Grant Musgrove 06.29.10 at 5:27 am

the euro project is in a half way house that seemingly cannot address the imbalances.

possible respones- if the will exists:

more direct fiscal union, or partial union (maybe of only the strong).

Some soveriegn debt restucturing/writeoffs,

removal off the weak from the eurozone to let their currencies float and;

WRT to to big to fail: govt underwrites or nationalises financial insitutions as required.

Although German manufacturers are doing very well just now because of depreciatating Euro , while the Swiss are getting hammered with apprectaion as a safe haven agianst Euro depreciation , so having the weak in the Euro is a stimulus to the strong, which will flow through to Debt/GDP ratios.

Re PPP, yes a real mystery

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