When Friedman and Krugman agree

Lots of people now understand that the euro was a very serious mistake.  But most still don’t understand just how badly the project was botched. Let’s start with the obvious.  If you are going to launch a grand experiment in monetary policy (like NGDP targeting for instance) you need a back up plan if it fails.  My back up plan would be to return to the previous policy.

But the EU did not provide for any backup plan.  There is no procedure to unwind the eurosystem if it failed.  They simply assumed it would work. They acted like they were 100% certain it would work.  That’s not really a good idea, even if the experts were unanimous that the project would succeed. Experts might be wrong. But in this case it was far worse. Many of the world’s leading experts thought it was a horrible idea, and predicted exactly the sort of disaster that has arisen.

There are probably a few times in my life where I’ve felt that both Paul Krugman and Milton Friedman were wrong about some issue, and that I was right. Maybe I’ve even said I was “sure” they were wrong.  But suppose God put a gun to my head and threatened to fire if Friedman and Krugman were right. Would I still say I was “sure” they were wrong?  The point is so obvious that it really shouldn’t even need making; if leading intellectuals on both sides on the ideological spectrum think an idea is crazy, then policymakers must at least entertain the idea that there is at least a small probability that the idea is indeed crazy. They need a backup plan. The Eurocrats (with the French in the lead) were not willing to entertain this sort of uncertainty.

Would a backup plan have been difficult to devise?  I can’t imagine why; we already know how easy it was for countries like the US to devalue during the Great Depression.  They would simply have needed to allow for a similar fallback plan.  This would have involved holding onto the old currency when it was withdrawn from circulation, and printing new currency at the normal pace, and putting it into storage for an emergency.  Then there would be a provision that if the country reverted to the old currency, the bonds and bank accounts would automatically be converted over as well.  In that case Greek bonds and bank accounts would have continued to price in devaluation risk, as they did before 2000.  If the euro were a success, then the risk premium would gradually fade away over time.

This sort of fallback plan would have allowed the euro to be unwound in a crisis, in much the same way that Britain and Sweden left the EMS in 1992.  A bit messy, but nothing like the crisis we are now facing.  But the Eurocrats who dreamed up their perfect monetary system were too arrogant to even entertain the prospect of failure.  And now we pay the price for that . . . what’s the Greek word?

Hubris.

Update:  One commenter suggested that my previous post left the impression that I don’t like Greek culture.  Not true.  Although I’ve only visited Greece once, based on my impressions I prefer Greek culture to American culture (yes, that’s a low bar.)  I prefer American attitudes toward capitalism, but overall I prefer Greek culture.  It’s a wonderful country.  Apologies to any Greek readers if my post left a bad impression.

Independence Day for Greece!

Instant reactions to complex economic shocks are almost always wrong, but that’s never stopped me before.  Much to my surprise, it has been reported that the No votes won by an overwhelming majority.  This means:

1.  The Greek government obviously cannot accept the EU deal, even with minor tweaks.

2.  It’s hard to imagine the EU offering dramatically better terms, although I suppose anything is possible.  The fate of Podemos in Spain depends on whether the EU caves.  If they do, Podemos is the next government of Spain.  If they don’t, Podemos is in deep trouble.  Keep in mind that Eurozone governments are among the major financiers of ISIS.  If they are willing to finance terrorists, is it really so hard to believe they’d cave in and finance communists?

3.  Does the Greek government secretly want to leave the eurozone?  That seems like the most plausible explanation for their erratic behavior, although I can’t be certain.

4.  Even if Syriza secretly wants to leave the eurozone, they clearly prefer to stage-manage things so that it looks like they were pushed out.  And if the Germans secretly want Greece out, they’d prefer to stage-manage things so that it looks like Syriza is to blame.  This may take a while to play out.

5.  Is it possible that Greece will remain in the euro, despite all of this?  In Europe, anything in possible.  Keep in mind that in macroeconomic terms “leaving the euro” means changing to a different medium of account.  As long as the euro is Greece’s medium of account, it’s still in the eurozone in a macroeconomic sense.  It doesn’t really matter whether the Bank of Greece no longer has a seat at the table.  Thus issuing “script” won’t do much to help their labor market recover, unless it takes the form of disguised wage cuts.  (Greece may join its neighbor to the north Montenegro in being a de facto euro member, but not a de jure member.)

6.  Although I would have voted yes no, I certainly wish them well.  Leaving the euro would certainly produce one undeniable benefit—more NGDP! The truly nightmare scenario is that Greece stays in the euro and becomes increasingly statist—a failed state.  In my view leaving the euro with Syriza in charge is worse in the short run, better in the medium run, and worse in the long run (as in Argentina), as compared to a yes vote.

7.  This slightly increases the risk of Brexit, as the eurozone will increasingly resemble a failed project.

8.  European leaders have been saying a no vote means Grexit.  If on Monday they are saying something different, they will look like complete fools.

This is the best one paragraph explanation of what this is all about that I’ve seen so far:

And for those in the euro, exit may not be a palliative. Spain has already improved its competitiveness through wage and price cuts. A euro exit could bring with it populist polices that hurt long-term growth. “You do not leave the euro to become a market-friendly Switzerland. You leave the euro to become Argentina,” says Jesús Fernández-Villaverde of the University of Pennsylvania.

If this spreads across Europe, you could eventually end up with a sort of (non-violent) civil war.  Neoliberal northern Europe against statist southern Europe.  The best way to predict global events over the past 20 years is to assume that countries will have governments that increasingly reflect their cultural characteristics.  Thus as China and Denmark becomes more capitalist, Argentina and Greece becomes more statist.

Don’t bet against the Danes

One of the important tenets of market monetarism is that countries with their own currency can can control their nominal exchange rate.  This means there is no such things as a “liquidity trap”; a country can simply depreciate its currency if it wishes to create inflation.  Switzerland did this in 2011 and held the exchange rate at a depressed level for more than three years.  But then the Swiss National Bank let the currency float higher, for reasons that still are not entirely clear.  Some argued that they didn’t want to buy up so much foreign exchange, and that this somehow discredited the claim that a central bank could always depress its currency.

I doubted that explanation; the financial markets certainly didn’t see any reason why the Swiss would need to abandon the euro peg. Fortunately, another test case occurred at about the same time, in Denmark.  Speculators bought lots of Danish krone and the central back was forced to buy lots of foreign assets to defend the currency.  Here’s the FT from 5 months ago.

Denmark’s central bank governor pledged to face down speculators testing its currency peg to the euro, saying he would do “whatever it takes” to defend it.

Lars Rohde told the Financial Times that Nationalbank could “go on forever” defending the peg, after lowering interest rates four times in three weeks to a global record low of minus 0.75 per cent. It has also swelled its balance sheet to a record size by printing krone in an attempt to weaken the Danish currency.

“The main message is that we are ready to do whatever it takes to defend the peg. We have unlimited access to Danish krone and we have no restrictions on our balance sheet,” he said, in his first public comments since the recent quadruple rate cuts.

Tyler Cowen claimed this would provide a test of the claim that the Swiss were not forced to devalue:

I would bet against them, in any case this will be a neat test case for our judgments of Switzerland.

It’s not 100% clear what the test actually was.  No one expected the Swiss to maintain their euro peg forever; it was always viewed as a temporary expedient. More likely, the test was whether the currency peg would be abandoned because of a wave of speculation anticipating a currency appreciation.  If that’s the test, the Danes seemed to have passed:

It looks like the pressure is off, for now at least.

At the start of this year, it looked a bit like Denmark could be the new Switzerland, with some observers wondering whether the tiny Nordic nation could scrap its currency peg to the slumping euro.

Pressure ramped up quickly after the Swiss central bank nixed its cap on the franc, prompting a series of Danish interest rate cuts, writes Katie Martin.

In its latest monetary review, Denmark’s central bank acknowledges that the market’s krone buying was enthusiastic in the opening months of the year.

The central bank is still intervening to lean against krone-positive flows. But it’s all on a much smaller scale.

It’s still not clear exactly why the SNB abandoned the peg (they gave mixed signals.) But if they left under “pressure” from speculators, it now looks like they made a serious mistake.  It’s smooth sailing in Denmark:

Screen Shot 2015-07-04 at 9.01.03 AMScreen Shot 2015-07-04 at 9.01.17 AM

And I might add that they defended their currency peg with strongly negative interest rates on reserves, an idea that was dismissed as impractical when I proposed it in early 2009.  Some even claimed the policy would be contractionary. OK, so how has the krone not appreciated if negative IOR is contractionary?  And why did the Swedish currency recently depreciate on news that IOR was being made even more negative?

The new jobs report (plus computer bleg)

Today’s job report was more interesting than the headline number suggested. There were 223,000 new jobs, and unemployment fell to 5.3%.  Yawn.  But beyond the headline:

1.  U-6 unemployment plunged to 10.5%

2.  Hourly wage growth slowed to 2.0% over the past 12 months

Unemployment fell very rapidly for about 2 years, but has been falling at 0.1% every 2 months for the past 8 months.  This is normal as we approach the natural rate.  However people then say, “What about U-6?”  The decline from 10.8% to 10.5% shows that U-6 is still falling rapidly, and will soon arrive in the 8% to 10% range considered normal for U-6.  (It was 10% in 1996, a normal year for the labor market.)

The LFPR rate is still weak, showing that it’s not just a cyclical problem.  Those workers are gone forever.

In the early part of 2015 there were signs of accelerating wage growth.  Hawks at the Fed worried about an upswing in inflation.  Liberals welcomed the news as representing long overdo gains for labor.  They are both wrong—there is no upswing in wages. The steady 2% wage gains we’ve seen for 6 years continues on. The Fed will not achieve its 2% inflation target on any sustained basis (other than oil price blips.)  The normal wage growth rate is about 3.5%.

Over at Econlog I explain how the Fed is putting too much weight on discredited Phillips Curve models.

PS.  Chris Giles and Alex Tabarrok each have excellent posts on Greece.  BTW, three days ago I assumed that a yes vote meant Syriza is gone, and a no vote meant Grexit.  Now people are saying that neither assumption is true.  Perhaps soon I’ll just tune out this issue, as I did the Israel/Palestinian issue 20 years ago, when I realized that every single press report about “important new developments” was a lie.  Nothing important has happened in Israel for many decades, and I have no intention of wasting time reading news reports on that country.  If Greece becomes like Israel, I’ll just stop caring.

PPS.  Anyone except Ray have any tips for a slow computer?  It’s an iMac, maybe 3 years old.  Should I take it in to get fixed, or is there a technique a computer novice like me can use at home.  (I tried reset on Chrome, and I deleted most of my files in downloads.)

Confirmation bias and bubbles

I’ve done a number of posts pointing out that people are hard-wired to find patterns where they don’t exist.  Studies have shown that people will see “bubbles”, even in data that is generated to follow a random walk.

Now of course just because most people would believe in bubbles even if they did not exist, does not in any way prove that they don’t exist.  Maybe they do.  But we always have to be on guard against cognitive bias.

Bob Murphy had some fun earlier today commenting on a post I did on China.  His post is entitled Chinese Stock Market Crashing”:

Details here. It’s down about 25% in the last two weeks, and 11% in the last two days.

Meanwhile, Scott Sumner is running victory laps, over those broken records who called it a “bubble” but didn’t give the precise timing.

So it sounds like I did a post mocking Chinese stock market bubble theories, and then the market crashed right after my post.  That wouldn’t really prove anything, but even I have to admit it would be pretty funny.  Chalk one up for Bob.

The only problem is it never happened.  My post was put up on June 27th, and when Bob did his post the Chinese market was actually higher than it was when I did my post.

Does this prove anything about the Chinese market?  No, for all I know it might collapse 20% tonight.  Who knows? It’s certainly been extremely volatile in recent weeks.

What it does show is that people are very receptive to data that supports their preconceived bubble theories.  And this is a part of my anti-bubble theory.  I’ve done posts on how the Economist magazine once bragged that it correctly predicted a bunch of housing bubbles, whereas the article it cited was actually totally, spectacularly WRONG about the future course of house prices in a number of countries.  Prices actually rose in markets where they predicted declines.  And yet the Economist put their “successful” prediction into an ad for the magazine. Someday China will have a big crash, and the people who have been predicting it for a long time will say, “I told you so.”  And I’ll say, “Market prices rise and fall, that’s what markets do.”

Economies have booms and recessions.  If talking about bubbles makes you feel good, go for it.  But don’t think it’s telling us anything useful about the world. When prices are high they might crash, or they might go higher.  That’s what history shows.