Tuesday, March 17, 2009

A Nobel-prize winner adrift

I don’t know whether it’s my European blood raging or my dismay with Paul Krugman’s degeneration from an academic I admired to a dogmatic commentator who banks on his economist’s reputation to promote a narrow political ideology.

Krugman’s latest “prey” are European policymakers, in an op-ed piece that is so shallow and uncorroborated in its assertions, and so one-size-fits-all in its prescriptions, that it might have well been written by an American freshman student of European studies in a rush to finish his midterm exam.

Accordingly, European leaders are claimed to have been “slow” and spineless in their reaction to the financial crisis, “poor” in their leadership and full of “know-nothing diatribes” comparable only to those of “well, Republicans.” In fact they have apparently been so slow, poor and know-nothing that the very integration of Europe (and even the euro itself) is at stake.

Let’s start with monetary policy and the ECB, who “completely missed the depth of the crisis”, is still "complacent" and (always per Krugman) basically lacks the balls and/or the government backing to follow the Fed in its bold, resolute steps.

Perhaps a few facts might help here, in lieu of the colorful charges above.

Complacent? The ECB was the first to act back in August 2007 upon the first signs of funding pressures and liquidity hoarding by banks. It did so by providing banks with ample amounts of liquidity at longer maturities. A year later, when the (real) fireworks began, the ECB expanded its support measures by providing unlimited liquidity with maturities of up to six months, and by expanding considerably the list of eligible assets that banks could pledge as collateral.

As a result of these measures, the ECB’s balance sheet increased by 600 billion euros compared to its pre-crisis level. This is about 6% of eurozone GDP, which, actually, is almost the same as the Fed’s own balance-sheet expansion in GDP terms! Critically, Trichet has by no means signaled the end here. Au contraire!

“Shied away from any strong measures to unfreeze credit markets”? Given the above, I take it that by “strong measures” Krugman refers to the likes of the TALF or the MBS purchase program—i.e. measures taken by the Fed to bypass the banking system and support targeted dysfunctional credit markets directly (e.g. housing or credit card loans, auto loans, etc).

The ECB has yet to go that far and for a good reason. Bank-based lending is far more predominant in Europe than in the US, where capital markets play a substantial role in allocating credit. Addressing any dysfunctions in the banking sector in order to jumpstart bank lending is therefore of utmost importance in Europe, with TALF-like measures only secondary.

In fact, I would go as far as to suggest that restoring bank health is as important in the US (see here why) and any thought that the TALF could help revive credit by bypassing the US banking system is wishful thinking.

Slow (in cutting rates)? Possibly, but the facts don’t really prove the superiority of the Fed’s bolder approach either. For all its whopping rate cuts, the Fed has not succeeded in loosening financial conditions in the US in a meaningful way. (See here again).

Three-month Libor rates in Europe are only 0.30% higher than in the US, despite the ECB’s policy rate being 1.25% higher than the Fed’s. US yields on long-term corporate debt came off their October peaks but have subsequently resurged amidst the ongoing uncertainty in financial markets. The Fed’s announcement that it would start purchasing Agency mortgage-backed securities (MBS) brought MBS yields sharply down in late November. But mortgage yields have edged up again since mid-January, partly on concerns that the US Treasury’s fiscal “adventures” might lead to inflation in the future.

Completely missed the depth of the crisis? Perhaps. But it looks like the ECB was in good company. Here is a quote from Ben in the FOMC statement of August 7, 2007—the very onset of the crisis (sorry Ben!):

“Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses, and the housing correction is ongoing. Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.” (My emphasis).

And on June 25, 2008: “Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased.”

Coming on to fiscal policy, the “know-nothing” diatribes of the German finance minister, and Europe’s “striking” hesitance to match America’s audacity. I’ll leave aside the “know-nothing” criticism, although I can’t help noting that I have yet to hear any words of wisdom from our own Treasury Secretary. I’ll also refrain from debating the desirability of a stimulus package of the size and shape approved by the US Congress. *The* point here is that it’s ludicrous to claim that European governments should follow the US Treasury’s footsteps, without stopping to think whether they can afford to.

Unlike the US Treasury, which can (still) issue 10-year notes at a 3% yield, long-term yields are materially higher in some European countries, reflecting fiscal vulnerabilities that could only be exacerbated by further debt burdens. As to Germany, which could arguably “afford to” increase its stimulus, it has potentially a lot on its plate. Germany would be one of the few European countries that could muster sufficient resources to provide emergency bilateral support to a fellow EU country experiencing a sudden loss of investor confidence (The IMF could be another source of support, provided its resources are replenished fast).

Would the likes of Germany do it? Anyone who doubts any eurozone member’s commitment to integration and the euro itself has zero understanding of the interconnectedness that has made European integration a necessity.

From the perspective of weaker countries, the currency stability and relatively low yields (even during this crisis) are just one demonstration of the immense benefits of such integration. The fact that some Eastern European members are now knocking on the door for a faster eurozone membership is a further confirmation. As to Germany, the bulk of its trade surplus remains with Europe and the currency devaluations that would likely follow a euro break-up would destroy the growth model it has been benefiting from for years.

Talking about boldness, the euro has been one of the boldest policy measures in recent economic history. And if Krugman wants to talk seriously about currency crises, he’d better go back to the drawing board and write a paper of the caliber that showed his genius back in 1979. Otherwise I recommend a year off in Brussels. They have good beer!


Anonymous said...

well done! I am tired of hearing self proclaimed experts on this side of the Atlantic making bets about the break up of the euro! Mr Krugman should spend a bit more time in Spain, where he seems to be these days, and spare us all from his own I-think-I-know-it-all diatribes!

Festinalente said...

The article was witty, wise,informed and to the point.
Thumbs up from Ireland!

Anonymous said...

"I don’t know whether it’s my European blood raging or my dismay with Paul Krugman’s degeneration from an academic I admired to a dogmatic commentator who banks on his economist’s reputation to promote a narrow political ideology." Well said!

Like an aging rock star, Krugman's best stuff happened long ago.

M.G. said...

From Lorenzo Bini Smaghi
Member of the Executive Board of the European Central Bank
To Prf. Krugman.
(at http://blogs.wsj.com/economics/2009/03/19/ecb-official-responds-to-krugman-criticism/ )
In a recent article in the International Herald Tribune, Professor Paul Krugman states that Europe may have made a mistake in adopting the euro ten years ago. His point, he claims, is corroborated by the euro area’s apparent institutional inability to react to the severe crisis we are facing at present, an inability which, he claims, may have disastrous results.

The claims made in the article are in no way supported by empirical evidence. I don’t want to bother the readers with too many figures and statistics, but we should also avoid gross inaccuracies.

Let’s get the facts straight, starting with the question of fiscal policy, an area in which – according to Krugman – Europe has failed, more so than the United States, to enact an effective recovery policy. This conflicts with recent IMF calculations, which show that the fiscal stimulus in European countries is wholly comparable to that seen in the United States, particularly when taking into account measures to cushion the effect of automatic stabilisers, which, by contrast with the United States, are a major factor in Europe. For instance, for the period 2009-10, discretionary measures adopted in Germany total 3.5% of GDP, compared with 3.8%in the United States. In some European countries, such as Italy, the size of such stimulus measures is relatively limited owing to the high levels of debt, but in other countries the total fiscal stimulus is larger than in the United States.

The perception that more has been done in the United States probably stems from the extensive financial measures adopted in support of the US banking system. It should be pointed out, however, that the US banking system was in greater need of such measures than the European banking system. When overall stimulus measures are considered in relation to the situation, the differences are indeed fairly limited.

As regards monetary policy, the degree of stimulus can be better measured by comparing market interest rates, rather than official interest rates. Such a comparison shows that European rates are more or less in line with those observed in the United States, and are even lower in some cases. For example, 6 and 12-month interbank interest rates in Europe are slightly lower than their US equivalents. Furthermore, real interest rates – i.e. net of inflation – are markedly lower in Europe than in the United States, and retail interest rates on mortgage lending and lending to non-financial corporations are of a comparable magnitude, if not somewhat lower in Europe.

As regards action taken by the central bank, following the initial liquidity injection of in excess of €90 billion in August 2007, the ECB’s balance sheet has steadily grown, increasing by approximately €600 billion to reach a level of 16% of GDP (compared with 13% of GDP for the US Federal Reserve). There is a major difference, however: the ECB lends to the banking system against collateral, thereby reducing the risks for European taxpayers.

According to Krugman, the fact that the ECB does not have a government behind it which can cover any losses accounts for its being overly cautious. However, this assumption implies that the taxpayer should bear the burden – through inflation – of the difficulties experienced by the banking system. I’m not so sure that this is what US citizens want, and it is certainly not what people in Europe want.

To sum up, Krugman’s argument is that it is better to have only one decision-maker in a crisis, rather than 16 governments which need to coordinate their actions, as is the case in the euro area. In theory, this seems reasonable. But it doesn’t explain how the most fateful decision of all – the decision to allow a systemically important bank to fail in the midst of a financial crisis – was taken by a single decision-maker, while the 16 euro area governments have managed to avoid making such a large mistake. Neither does it explain how euro area governments have managed to agree on measures aimed at bank recapitalization, at guarantees to bank liabilities and on principles for removing toxic assets from banks’ balance sheets, decisions which have become a point of reference for all the countries of the G20.

Krugman concludes that countries such as Spain would have been better off without the euro. Again, in theory he has a point, since devaluing one’s currency might seem attractive in the current circumstances. In practice, however, when global trade grinds to a halt and the financial market is in distress, the depreciation of a currency can trigger a loss of market confidence in the country, which can further aggravate the economic and financial crisis. This is what happened in Italy in 1992-93, for example. Krugman should travel to those European countries which do not yet have the euro and would really like to introduce it as soon as possible; he would not fail to notice that the reality is very different from textbooks economic theory.

Nobody can claim that Europe is perfect; quite the opposite. We should continue to strengthen economic integration and the coordination of financial and economic policies. We just need to build on what we already have, in particular the euro.

Lorenzo Bini Smaghi
Member of the Executive Board of the European Central Bank

M.G. said...

No doubt that European integration must improve!
On the other hand, a single government to make decisions, like in US, per se is no guarantee of better results and performance. The management of the financial crisis and cases like Lehman, AIG, Madoff etc. are just examples were governance of a single administration is not really better than that of 27 countries or even 16 (eurozone).

M.G. said...

I think that Prof. Krugman Op-Ed would not deserve any comment if what he wrote would not come from a Nobel Prize. Yet I think he needs at least to update some of his arguments. He also deserves to study more International Economic Diplomacy instead of writing that “maybe European integration and the creation of a common currency was a mistake”. Europe does not “need to prove the skeptics wrong”, or “its politicians start showing more leadership” (than US????). Europe must just learn not to follow US bad exemples (in finance for exemple) and US economists bad advises…

David Murphy said...

There is a significant weight of American opinion, on both the left and the right, that does not want to see the EU succeed. They seize every opportunity to do down the Europeans and all their works (notably the Euro). It is, I agree, depressing to see Krugman join this circus. But perhaps more interesting is why this particular show plays so well in Washington.

(This isn't to say of course that the Commission, the Council and the ECB are perfect. Just that, as you suggest, they are doing rather better a job than some give them credit for.)