Is Europe on the Verge of a Depression, or a Great Inflation?

Simon Johnson, the former chief economist at the International Monetary Fund, is the co-author of “13 Bankers.”

The news from Europe, particularly from within the euro zone, seems all bad.

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Perspectives from expert contributors.

Interest rates on Italian government debt continue to rise. Attempts to put together a “rescue package” at the pan-European level repeatedly fall behind events. And the lack of leadership from Germany and France is palpable – where is the vision or the clarity of thought we would have had from Charles de Gaulle or Konrad Adenauer?

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In addition, the pessimists argue, because the troubled countries are locked into the euro, no good options are available. Gentle or even dramatic depreciation of the exchange rate for Greece or Portugal or Italy is not in the cards. As a result, it is hard to lower real wages so as to restore competitiveness and boost trade. This means that the debt burdens for these countries are likely to seem insurmountable for a long time. Hence default and global financial chaos seem likely.

According to the September 2011 edition of the Fiscal Monitor of the International Monetary Fund, 44.4 percent of Italian general government debt is held by nonresidents, i.e., presumably foreigners (see Statistical Table 9), on Page 72). The equivalent number for Greece is 57.4 percent, while for Portugal it is 60.5 percent.

And if you want to get really negative and think the problems could spread from Italy to France, keep in mind that 62.5 percent of French government debt is held by nonresidents. If Europe has a serious meltdown of sovereign debt values, there is no way that the problems will be confined just to that continent.

All of this is a serious possibility – and the lack of understanding at top European levels is deeply worrisome. No one has listened to the warnings of the last three years. Almost all the time since the collapse of Lehman Brothers has been wasted, in the sense that nothing was done to put government finances on a more sustainable footing.

But perhaps the pendulum of sentiment has swung too far, for one simple and perhaps not very comfortable reason.

There is no way to have just a little debt restructuring for Italy. If Italian debt involves serious credit risk – an end to the view that government debt has “no credit risk” and is a “risk-free asset,” with zero probability of default – then all sovereign debt in Europe will need to be repriced downward.

Will Germany will remain a safe haven? Even that is far from clear. According to the I.M.F., gross government debt in Germany will be 82.6 percent of gross domestic product at the end of this year (Statistical Table 7 of the Fiscal Monitor, on Page 70; the net government debt number for 2011, in Statistical Table 8, on Page 71,is 57.2 percent). Reports of German fiscal prudence have been greatly exaggerated.

German policy makers and the German public will not do well in the event of a major sovereign-credit disaster. Credit would tighten across the board. German exports would plummet. The famed German social safety net would come under great pressure.

There is an alternative to a decade of difficult austerity. The Germans could agree to allow the European Central Bank to provide “liquidity” support across the board to the troubled governments.

Many things are wrong with this policy – and it is exactly the kind of moral hazard-reinforcing measure that brought us to the current overindebted moment. None of us should be happy that Europe – and the world – has reached this point.

Among others, the bankers who bet big on moral hazard – i.e., massive government-backed bailouts – are about to win again. Perhaps the Europeans will be tougher on executives, boards and shareholders than the Obama administration was in early 2009, but most likely all the truly rich and powerful will do very well.

But if the German choice is global calamity or, effectively, the printing of money, which will they choose?

The European Central Bank has established a great deal of credibility with regard to keeping inflation at or close to 2 percent. It could probably offer a great deal of additional support – through creating money – without immediately causing inflation. And if the bank is providing a complete backstop to Italian government debt, the panic phase would be over.

None of this is a lasting solution, of course. Europe needs a proper fiscal center – much as the United States needed in 1787 and got under Alexander Hamilton’s policies from 1789. When he became Treasury secretary, the United States was in default and the credit system was almost completely broken. Some centralized tax revenue and control over fiscal deficits are needed.

Silvio Berlusconi stood in the way of all this. Other European leaders would not trust him to tighten Italian fiscal policy. But if he is really gone from power – and we should believe that only when we see it – there is now time and space for Italy to stabilize and, with the right help, find its way back to growth.

Of course, if the European Central Bank provides unconditional financial support to Italian, or other, politicians who refuse to bring their deficits under control, we are heading for another Great Inflation.

Avoiding triggering Greek sovereign CDS is a mistake

Should policymakers attempt to prevent credit default swaps?

Credit default swaps (CDS) are supposed to serve as a form of insurance against default.  A sovereign CDS provides insurance against a country defaulting.  If such insurance is not available, then companies and investors, wishing to insure themselves against the possibility of a country defaulting, will either have to reduce their exposure to such an event (eg by selling their holdings of that country’s bonds) or hedge in some other way (eg by going short on that country’s bonds).

In the run-up to the 21 per cent Greek default announced on July 21st, Eurozone policymakers were quite explicit that they would try to design the default in such a way that credit default swaps would not be triggered.  They doubtless thought this a clever wheeze, imagining it would punish those who had used CDS to speculate upon the possibility that Greece would default (how wicked of them!) and might deter others from using CDS to speculate upon Portugal or Italy defaulting.

Of course, one immediate consequence of this was that investors sold their Greek CDS.  But once the July 21st deal was announced, there were consequences for Italy, also.  Italian bond yields spiked.  Partly this was because selling Italian bonds became the key way of speculating upon total collapse of the euro.  And partly it was because if firms and investors wanted to hedge against / speculate about Italian default, they could no longer trust Italian sovereign CDS.  Net Portuguese CDS positions have fallen more than 30 per cent in recent months, and Italian net positions more than 25 per cent, despite increased perceived risk that these countries will default.  As a predictable consequence, Italian bond yields went above 6 per cent.

Following last night’s quasi-deal, the whole concept of a sovereign CDS in the Eurozone appears to be finished.  If losing even 50 per cent of your money on Greek government bonds doesn’t trigger payout on the CDS insurance you purchased, what is the point of them?  Eurozone sovereign CDS are now virtually worthless.

The question now is, once the halo of the EFSF leverage is gone, what are the implications of the death of the sovereign CDS market for Italian bond yields?  Had the larger Greek default triggered CDS payouts, one might reasonably have expected Italian bond yields to fall (at least once the initial dust had cleared), because the credibility of insurance was greater.  But what now?  Had everyone already assumed that Italian and Portuguese sovereign CDS were worthless, or were there some poor souls still hoping they might provide some protection?  If the latter, then we should expect Italian and Portuguese yields to rise (eventually), as a consequence – at least until financial markets can produce some new credible mechanism for providing insurance.

We can observe a paradox here.  In this financial crisis, governments have insisted upon destroying the functioning of capitalism by providing implicit state insurance of banks, through bailouts and debt guarantees.  At the same time, governments have sought to destroy the system of market insurance of banks (and others) that existed through the private sector – through sovereign CDS.  Dumb?  You might very well say that…

When Times Get Tough, the Elderly Work

Casey B. Mulligan is an economics professor at the University of Chicago.

The elderly are one group whose work hours now exceed what they were before the recession began. This pattern is most evident in the most depressed regions of the United States.

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The recession has varied in different regions of the United States. In some areas – including Arizona, California, Florida, Hawaii, and Nevada – housing prices surged more dramatically in the early part of the 2000s than they did in the rest of America, and their economies fell hard when housing prices collapsed.

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One view is that such areas experienced a deeper recession because their banks became overwhelmed with defaults and were unable or unwilling to make new loans to consumers and businesses. Without those new loans, demand collapsed more than it did nationwide, and jobs were especially difficult to find, even while people living in the area were especially eager to work.

Absent demand, just about all workers will have a tough time retaining a job or finding a new one.

Another view is that old loans are the problem, not newer ones. A significant fraction of households and businesses are typically so burdened with the debts they accumulated during the housing surge that they have little incentive to produce and work, because their creditors would get most, if not all, of the fruits of their labor.

In contrast to the no-new-loans-and-no-demand theory, old loans do not affect all workers; some are less burdened by debt. The elderly may fall in this category, because they are more likely to have saved money over their lifetimes and to have paid off their mortgages. Although some elderly working for debt-burdened employers may have lost jobs, on average the elderly in these areas should be working more because they have better incentives to do so.

The chart below compares 2007-10 changes in work hours for two areas –- the regions where housing prices rose and fell the most, on the left side of the chart, and the rest of the United States on the right. For middle-aged and younger people (blue bars), hours worked fell 12 percent in the large cycle regions and about 9 percent in the rest of the United States.

Hours worked by elderly people increased in both regions.

As I noted a few weeks ago, the average American elderly person worked more in 2010 than did the average elderly person before the recession began, even while work hours were down sharply for middle-aged and young people. The chart above shows that this is true even in the states that generally experienced the largest collapse during this recession.

Demand is not the only factor driving employment patterns.

Argentina and a eurozone breakup

Sigh! Some readers, commenting on my column for this morning's Daily Telegraph on the eurozone crisis, say the arguments are right but I've reached the wrong conclusions in thinking that the best outcome for the UK is for Europe to move closer towards fiscal union.

Actually, I didn't really say that but what I did argue is that the consequences of a disorderly breakup or series of defaults would be economically catastrophic for both Europe and us here in Britain. There is good reason to doubt the legitimacy of the estimates recently produced by UBS. I too don't think the effect would be that large (up to 50pc of GDP for weaker countries. UBS says), but we are only arguing about differences of degree here.

Mass liquidation would be the order of the day, which might be OK if you don't work, own agricultural land and have all your savings under the bed in gold bars, but for everyone else would be an economic calamity to match that of the 1930s, and we all know what that led to.

As I say, once the omelette is made, it cannot be unscrambled without consequences. Comparisons with Argentina, which is now apparently booming again after abandoning its dollar peg, are invalid. For starters, the immediate consequences for Argentina were horrific – a collapse in GDP, the destruction of middle class savings and pensions, and so on.

But the real point is that Argentina was not in a currency union, which meant that the banking crisis associated with the collapse of the sovereign was largely confined to Argentina. So called "spill over" effects were limited. In Europe, the banking system is now so heavily integrated that for one part of it to go down imperils the rest. Credit across Europe would contract violently, causing a depression.

What is more, Argentina devalued and defaulted against a backdrop of relatively benign external conditions. The world economy was growing strongly, and a commodities boom came along to supercharge the recovery. None of that's likely to be true for the European periphery, which in any case, is in far worse shape in terms of the size of national debts and current account deficits than Argentina was back then.

I hope that answers some of my critics.

Debt Crises, Real and Fake

There are real debt crises — Greece is going through one — and there are fake ones, created by politicians playing chicken with the nation’s credit.

I expressed that sentiment in a column last week that ran in the Asian editions of The International Herald Tribune on Friday. The new Greek rescue caused me to write a different column for The Times, and the I.H.T. column never made it onto the Web. It follows.

FLOYD NORRIS

Notions on high and low finance.

In the world of government bond markets, never have the haves been treated so much better than the have-nots. The haves can borrow for virtually nothing. The have-nots, if they can borrow at all, must pay exorbitant rates.

Notions on high and low finance.

Yet politicians, even in the countries that investors seem to trust completely, talk of impending budget disaster if spending is not cut immediately.

This summer, as the markets offered a ‘‘no confidence’’ vote on Europe’s effort to rescue Greece — and grew notably more worried about Italy and Spain — they appeared to be highly confident about the debt of the United States government.

The yield on benchmark 10-year Treasury securities fell back below 3 percent this month, even as the Washington rhetoric about the debt ceiling heated up.

That was a sign that investors were not alarmed about a potential United States default, whether in the next few weeks or the next 10 years. If they were, rates would be soaring.

For much of the spring and summer, the proportion of people who believed that Congress would raise the debt ceiling seemed to vary based on the distance from Washington. The closer to Capitol Hill, the more doubt there was that rationality would prevail.

In politics, it appears, familiarity breeds contempt.

If rationality does prevail, the debt ceiling will be raised. For that matter, there is no good reason to have a debt ceiling other than to give politicians a chance to grandstand. The important decisions for Congress and the White House concern spending and taxing. Borrowing, or paying back debt as happened for a couple of years before the Bush tax cuts, is a result of the interplay of those decisions and the state of the economy.

Trying to control the result by putting limits on borrowing is a bit like trying to balance a household budget by waiting until the money has been spent and then deciding not to pay the bills.

To analyze the fiscal problems confronting the United States now, it is necessary not to confuse short-term and long-term problems. And it is crucial to pay attention to the state of the economy.

A weak economy will inevitably worsen the fiscal balance. Tax receipts fall because profits and incomes decline. Government spending increases on automatic stabilizers, like unemployment insurance payments.

To the extent high deficits are a result of a weak economy, a decision to react by cutting spending or raising taxes can lead to a vicious cycle. The solution, if possible, is to revive the economy even if that makes deficits temporarily worse.

One of the most important failures to analyze what was happening in the economy came in the late 1990s, when the United States government, to the surprise of almost everyone, began to run budget surpluses. Some of that was a result of tax increases and spending restraint, but a lot of it was caused by a completely unexpected and misunderstood surge in tax receipts.

That surge was the result of the bull market in stocks, and of the peculiar nature of it. Individual income tax payments soared both because of high capital gains and because profits from stock options are taxed at ordinary income rates, not the reduced rate charged on capital gains.

Most analyses ignored that. The conventional assumption was that the taxes on option profits were balanced by reduced taxes paid by companies. That would have been accurate if the companies were paying taxes and could use the additional deductions. But many of those companies — the heroes of the dot-com bubble — paid no taxes because they had no profits. So the extra deductions did them no good.

A proper analysis would have seen that the inevitable end of the bull market would reduce tax receipts, and a slowdown would increase government spending. In that sense, it is wrong to blame the Bush tax cuts for ending the surpluses of the Clinton years. They would have ended anyway. The deep tax cuts and the wars in Afghanistan and Iraq made the deficits that much larger.

There is a risk that many analysts now are making the opposite mistake. Deficits have skyrocketed in recent years for reasons that are clearly temporary, or that will be temporary if the economy recovers.
In some of the debate, the short-term problems are mixed up with longer-term demographic concerns caused by the aging and retirement of the baby boomers and the rising costs of Medicare, the health insurance program for Americans over the age of 65.

It is worth looking at what has happened to financial markets around the world since the financial crisis exploded. A mild slowdown turned into something much worse after the collapse of Bear Stearns in March 2008 showed the vulnerability of the financial system. Stock markets plunged around the world, credit dried up for many borrowers and there was a flight to safety. Central banks intervened with unprecedented measures and banks were bailed out. Deficits soared.

Now, more than two years later, the American stock market is about where it was in February 2008, just before the crisis hit. That may not sound impressive, but markets in nearly every other country are down sharply. The dollar has lost ground against the Swiss franc and the yen, but is up versus the euro and the pound.

The yields on government bonds — the price investors demand to lend money to the government — are down in countries with solid foundations, including the United States. They have soared in markets where default seems a real possibility, and are up in some European countries where investors are getting more nervous, including Italy and Spain.

That is a vote of confidence in Uncle Sam, at least relative to the alternatives.

Markets can be wrong, of course. But Europe is in far worse shape. Greece is insolvent. It must have its debt reduced, but a default could cause bank failures and substantial losses for the European Central Bank. Europe’s battles reflect the fact that there are no good alternatives. There is a crisis in Europe, where lenders now fear to tread. Would there be one in the United States if the politicians produced an unnecessary default? Let’s hope we will not find out.