Who will pick up the bill? And when?

Some voices have prematurely claimed that the economy is on its way out of the crisis and getting back to normal. The recent speech of FED chief Ben Bernanke and newly emerging turmoil in European sovereign debt markets suggest that dark clouds might still persist on the horizon. Taking the sub-prime mortgage meltdown in mid 2007 as a starting point most of the industrialized world has been in economic troubles for almost three years now. What has been done to solve the crisis? A lot and nothing at the same time. To be fair to policy makers, it must be conceded that a Great Depression style abyss has been prevented. However, the debt problem has merely shifted from the private sector to the public sector and the mess has not been cleaned up.

One essential part of the current crisis is that many people thought they were richer than they actually are. The financial collapse has made this quite evident. Imagine an economy with a more or less fixed amount of wealth. Modern economies have become so complex that the actual ownership of this wealth is not immediately obvious to everyone. Individuals hold bonds, stocks, cash, derivatives, to name just some. If, as happened in the recent crisis, those claims where as a whole overvalued and people therefore thought they are richer than they actually are, some individuals will have to lose claims on real assets. The question is now which parts of the economy will pick up the mess and give up on their perceived wealth.

Next to the question who will lose is how fast the process will be carried out. This is the more essential challenge and to put it simple, the faster the better. Recent economic history has two prominent examples on the extreme ends of debt resolution. Sweden has chosen the fast way and Japan gone down a long and dragging path. While Japan's lost decade might soon amount to twenty years of foregone economic growth, Sweden has recovered quickly and gone back to business as usual. My guess is that both Europe and the U.S. will not end up quite as bad as Japan, but the tendency goes towards it at the moment. Policy makers will most likely choose too start loosening monetary policy in ways not seen before in order to prevent a Fisher-type deflation spiral at any cost. This will, if successful, not solve the initially mentioned problem that certain economic agents have to give up on some of their claims. Overly loose monetary policy will only create high inflation, possibly the lesser of the two (inflation/deflation) evils. Overall, this hardly allows for a positive outlook on the economy.

What is Europe’s role in a increasingly bipolar world shaped by the USA and China?

If it had not been clear before, the global catastrophe of World War II manifested that no single European nation would be a dominant global power in the decades to come. Although once mighty colonial England and the proud French had won the war, their global dominance was predestined to further wane not to mention the defeated block of Germans, Italians, and Austrians. The world has seen the rise and demise of the Soviet Union in the second half of the last century and recently the final “emerging” of developing nations with China in the vanguard. Europe has mended its wounds since and it has united – or at least tried to do so.

Having come a long way from a conflict torn continent, Europe’s top politicians were convinced their turn on the world stage would come. Now it seems they are running out of time. The most recent push in terms of the Lisbon treaty has been an uneasy compromise partly lacking democratic foundation. The exhausting process has revealed clearly what Europe’s top officials were so reluctant to acknowledge: Europe has been too slow, too occupied with itself and the vision of a single voiced Europe remains elusive. This understanding has been painful for Europe’s political elite. Where does Europe go from here? Where can it go?

Well, the question should rather be where does it want to go. While people identifying themselves as European are primarily found among the younger generations, the idea of Europe is hard to grasp. Nevertheless, there is one unifying element: The almost complete lack of imperial ambition in people’s ideas about Europe. Maybe this results from the virtual inexistence of European armed forces or the relatively early stage of forming a European identity. Supporting the view that geo-political influence is not a top-priority are the developments in important individual member states. Germany’s attitude towards the Afghanistan war and the ongoing discussion on whether its troops are on a combat mission or merely acting as peace keepers shows it has no intention of getting anywhere close to its troublesome past. Even in the formerly more war-prone UK the public has become increasingly wary of its nation's involvement in the both Iraq and Afghanistan. Intellectuals have always understood that political influence comes at a price they seldom had to pay themselves. With mass media covering every detail of armed conflicts the wider public is understanding this as well. The waning opportunity of installing Europe as a heavy-weight in global politics is difficult to accept for politicians seeking ever more power and influence. It might bother citizens much less if at all.

From a western European perspective security concerns in the eastern states of the Union are sometimes easily put aside. The persistent fears result from historical experiences and are mostly based on suspicion when it comes to Russian foreign politics. However, an imminent threat for any country being already a member of the EU seems insubstantial and can, in the worst case, be resolved within the NATO framework. The point is that both the willingness and the opportunity costs of not investing resources in expanding political influence are low. Even if the latter statement might not be left unchallenged, there is plenty of evidence that Europe will most likely fail in attempting to increase its geo-political clout. The conflict on the lack of fiscal discipline in some of Europe’s more peripheral economies and the resulting internal power struggles are just another indicator. In addition, it might be a futile attempt to deepen Europe’s integration without voters’ consent, making it quite likely that Europe will not manage to be on a par with the U.S. and China any time soon.

So the world is indeed steering towards something like the “G2” that is to speak a world dominated by the U.S. and China. This is bad news for Europe’s favored political approach of multilateralism. Fortunately, a bipolar world dominated by China and the U.S. will be much different from the one with the Soviet Union as an antagonist. The main actors will not be as powerful and the lines not be as clear cut, leaving plenty of space for multilateralism. Europe has mastered multilateralism unlike any other union of sovereign states in history. Imperfect and at times chaotic the European Union may be, yet its achievements in bringing together different values, cultures, and languages are unprecedented. Being the mediator and a buffer between different powers might be the most fitting role for Europe.

If Europeans choose to focus on applying such a soft power profile it might not be maximising economic growth expressed in the form of its traditional measure, the GDP. This is exactly where most critics of such a relative withdrawal from power politics will point at. Europe will lose some ground in securing natural resources and political leverage in trade matters. The old continent might be willing to pay that price and actually fare better by doing so. GDP as the long uncontested sole measure of prosperity is about to be seriously questioned. Recent comments by the French president, Nicolas Sarkozy, show that the ideas of measuring prosperity as Gross National Happiness (GNH) or similar are not merely intellectual constructs, but have made their way into the highest political circles. Applying such alternative measures of growth and development will give European-style soft power a further competitive edge and make it welfare maximizing. Moreover, shifting attention towards a broader measure of prosperity makes Europe’s decline in world politics one of choice not necessity.

Europe will in fact have little choice other than accepting its future regression of geo-political importance. It can try to prevent its faith as long as possible, but such efforts will most likely be in vain. Instead, the old continent can embrace its role as a bloc in relative decline and concentrate its resources on what it is best at. Europe will possibly be happier and more prosperous place in the days to come albeit a less powerful one.

Inflation on its way

I have been writing on the return of inflation politics before (last year when the FED resumed printing money I discussed the topic as well). Now the bail-out package of the European Union, admittedly a bold move that few expected to be as comprehensive and as large in scale, will bring us a step further (The New York Times compares the Euro with the Rubel in 1998). It is not only the bail-out money itself that is worth noting in that context. Much more important is a at first glance less spectacular detail of the deal: the ECB is bowing to political pressure and is going to start buying the junk bonds of states when investors turn their back on them. This might mark the end of central bank independence as foreseen in the Maastricht treaty and insisted on by Germans that were so reluctant to give up their beloved Deutsche Mark. It will also mark the end of stabilization politics as we have seen it before.

For different reasons inflation could be kept remarkably low for years now, but a decisive factor were the rather cautious and hawkish inflation fighting policies of most central banks. This is poised to change now. What the ECB is planning to do is in effect printing new money (as the Bank of England and the FED are already doing). You don't have to study Milton Friedman to guess what that will cause in the not to distant future.

Is the dream of Europe dead?

The times are undoubtedly difficult if not apocalyptic for Europe. The dream of a united Europe is falling apart more quickly than people realize. In the middle of the chaos stands the most controversial issue these days: the common European currency, the Euro (see also my comment on a bailout of Greece from February this year). There is no use of economists who have always seen it coming (and many indeed have) playing the “I told you so” card. We are in this mess and we need to find solutions.

So what is the actual problem? As I see it politicians have either been naïve or have knowingly kept a low profile on the fact that a common currency is much more than having the same coins and bank notes. It means a common faith in many more aspects. Citizens gradually start to realize just that and they don’t seem to like what they got themselves into. As they see it the Euro makes them pay for the mistakes (or profligacy for that matter) of others and they are not really prepared to do that. You may call this a lack of European solidarity, but that is only part of the truth. Some serious policy mistakes have led to a fundamentally wrong public picture of Europe. Disadvantages of European integration were virtually non-existent in people’s minds. The only critical voices were nationalist politicians who usually do not have any arguments other than the value of national sovereignty itself. Although it seems that Europeans turn out to be more inward looking and nationalistic than previously thought, I think that there is more to the apparent reluctance to step in for Greek (and potentially others soon to come) household debts. Citizens were never allowed to consciously choose on whether to be in a union with whole Europe for the good and for the bad. They were told integration will have exclusively positive consequences and were barely ever asked directly anyway. It feels a little bit like being surprised by the small print in a standard contract you never paid attention to. No wonder citizens of countries that are expected to pay for the mess are disinclined and angry to do so.

Feasible solutions are in principle simple because there are only two viable options: much stronger integration close to a political union or disintegration. To avoid the latter solution, Europe needs a much more open dialogue about Europe. Citizens need to understand the pros and cons of a politically and economically fully integrated Europe and then be allowed to make a conscious decision on it. Candy-coating reality will not work anymore or if it does, create future fury. Quite understandably, politicians are trying to fix economic woes right now, but all they do is buying time. Hopefully, they are going to use the time wisely to address those ideological questions on European integration. Only then will a permanent solution of Europe’s existential crisis be conceivable.

Why can climate researchers not stick to the truth?

I am not anywhere close to being able to know whether global warming is happening or not. Taking the weather in Lund of southern Sweden, it is definitely not (coldest winter in 23 years or so). One thing seems to be clear, however: Some scientists and researchers trying to find answers on how our climate changes, tend to exaggerate their results. Together with such in the end counter-productive behavior, news on evidence of accelerating global warming are usually followed by public outcry and met with apocalyptic fears. Those two developments go somewhat hand in hand. Why are we so afraid of a warmer planet? Why are some researchers nourishing those fears further?

A simple explanation of the latter question can be traced back to general human behavior. Scientists are just human beings that seek attention and recognition for their work. In few other areas of modern science there is a similar bias towards going in one direction. In climate questions, the more that’s supposed to change the more interesting the research becomes to the wider public. Naturally, some members of the discipline (just to stress this, not all) cannot resist the temptation to fiddle with some of their results. Those are often equally convinced their “small adjustment” is for the good of humanity as it sends a strong warning signal and will potentially prevent further environmental havoc. The reason why such dramatic predictions do not fall on deaf ears is people’s inherent fear of change. Climate has always been changing if admittedly usually at a very slow pace. It is hard to predict what will exactly happen if the planet becomes a hotter place, but it is certain that huge areas would be transformed in dramatic ways. People might have to migrate to formerly colder areas and their base of living be eroded. Such uncertainty creates fear and explains why this has become such a heated debate.

Don’t misunderstand the point I’m making. I do believe all efforts should be focused on reversing environmental destruction and stopping the depletion of our earth’s natural resources. There are enough clear cut arguments to do so, if it is just that our children need to live off something. Therefore, it should not be the focus of the debate to what extent climate change is precisely happening. Exaggerating the whole scenario of climate change will only backfire, as it has of lately.

A short Note on the long Run

Last year I was questioning the potential of the world economy to come out of the financial crisis induced recession any time soon. Today, most countries are technically not in a recession anymore. Rubini and others have been warning of a “double-dip” recession and some countries show first signs that this might indeed be the direction we are headed.

The costs of getting out of this recession have been tremendously high. A relative stabilization has been achieved by unprecedented monetary (close to zero interest rates and quantitative easing – the modern form of printing money) and fiscal stimulus. The loose monetary policy can be upheld basically forever (see e.g. Japan over the last two decades), if inflation tendencies are neglected (see also the new IMF proposal of raising the central bank target rate to 4 %). Fiscal policy instruments have been overstretched and if anything budget cuts lie ahead at least in the middle run. The markets have started focusing their attention on sovereign debt and will monitor every step of troubled states closely. Even supposedly strong countries such as Germany are actually in fiscal troubles, it is just forgotten over others being in far worse crisis modes. As a result, fiscal stimuli will be withdrawn and probably reversed sooner or later (especially due to the increasing headwind when it comes to further lavish fiscal expansion). Forget about returning to normal times in terms of monetary policy, monetary policy will have to remain as loose for quite a while simply to prevent a further slump.

Europe and the U.S. have only started to deleverage and mostly redistributed the debt from the private sector to the public sector. While private households can simply decide to save and in that way reduce demand in the economy, debt-financed government spending increases demand instantly. This has bought some time, that is all. Deleveraging means saving and that for an extended period of time and it will need to be done sooner or later. It might take a decade or longer and no democratically elected politician hoping for re-election will admit that. There is no free lunch and an extended period of economic weakness lies ahead. How long it takes depends on how fast deleveraging will proceed and it seems likely that it will be slow. The U.S., although current problems seem slightly bigger, might grow out of it somewhat quicker than the less dynamic European economies.

The Return of Inflation Politics

Oliver Blanchard, chief economist of the IMF, has made the suggestion to raise the central bank’s target rate of inflation to 4 % arguing this would give central banks more flexibility. He claims the current crisis shows that this has become necessary and points out deflation plagued Japan as a negative example. The IMF has started rethinking some of its long held stances in the wake of the crisis. It went that far as to release a report promoting capital controls to prevent the influx of speculative capital. This time, Mr. Blanchard is either quite on the wrong track or hiding his true motives.

I started studying with Blanchard’s introductory macroeconomics textbook and one topic covered is called the liquidity trap. It describes a situation where the central bank cannot stimulate the economy further by lowering the interest rate, that is to say a situation that exactly describes current economic reality. Saying times have changed and we need to raise the “normal” level of inflation to avoid getting into that trap again is quite shortsighted and is certainly not a lesson of this crisis. Say we hit the inflation target every year we have accumulated inflation of well above 100 % over the course of the next twenty years. That is hardly price stability. The reasons why we are in this crisis are much too complex and a repetition can be prevented in other ways such as by reforming financial systems and public spending policies. Quite likely a target inflation of 4 % would have left us in the same situation and being caught in the liquidity trap would have been, if anything, merely delayed. Somehow it seems people always start forgetting the effects of one economic evil if it hasn’t occurred in a long time. Inflation has enough negative effects to justify a goal of stricter price stability than 4 %.

If, however, the IMF is barely hiding an uneasy truth, it might do a good job convincing citizens of giving up price stability. The truth is that we have little other choice than getting prepared for much higher inflation. In the very short run overcapacities are still putting pressure on prices and create deflationary tendencies. Famously coined by Milton Freedman, inflation is always and everywhere a monetary phenomenon and in the middle run the excessive liquidity pumped into crisis-ridden economies will push inflation. A bit longer down the road is a much worse problem: governments will need inflation. It is impossible to repay national debts that are, as it is becoming increasingly evident, much higher than previously claimed. Inflating away some of the obligations will be inevitable to prevent total fiscal collapse. Inflation of 2 % will not do the trick. It is questionable whether 4 % will do.

More on the euro

Just an additional note on the ongoing discussion about the euro and potential bail outs. Paul Krugman writes in his New York Times op-ed on the same topic. He is as always somewhat more critical and deems the whole common currency project as being built on "hubris" and "arrogance".

Bailing out or not? Greece and other Disasters

I do not want to claim that the whole world is about economics, but sometimes economic theory provides important insights. There are many controversial topics in economics, but I have not yet heard of a theory telling us that it is a good idea to give a single currency to a group of totally inhomogeneous countries. And so a lot of economists were warning of a situation like this. It is still surprising how fast and to what extent events are unfolding now. Greece is teetering on the brink of fiscal collapse and Spain and Portugal are not following far behind.

There are many advantages of the euro such as providing stability, avoiding costly cash exchanges, and not least creating a sense of unity among its participants. None of the critics has doubted this. Seeing Greece, Spain, Portugal now struggle with the very consequences of the common currency gives rise to the question whether those positive effects outweigh the negative ones. It has become evident that the eurozone (countries that have introduced the euro) is just too heterogeneous and in a sense to big. Size as such is not the problem, but the decomposition of economically strong countries and weak ones builds a dangerous mix. Certain countries might be better off without the euro while the remaining members might be do better without them. While from an economic point of view this statement seems quite obvious, political considerations do not allow Europe’s wealthy economies to merely drop poorer ones and force them out of the common currency.

So bailing out or not? Of course, Greece and other countries tumbling towards default cannot be left to themselves. The question is rather how to shape a bail out in order to avoid moral-hazard issues as effectively as possible. German and French government officials had maintained a low profile as long as possible in order to force Greece to make painful budget cuts and introduce essential reforms. Anyone knowing the least bit about the Greek political landscape can probably tell you that fiscal tightening is a Hercules task there. If Greece, Spain, and Portugal cannot solve their problems by means of their own efforts and only rely on external help, the difficulties for the eurozone are both delayed and in the long run severed. Bringing the IMF into the picture and letting it provide the funds for a bailout and supervise the reform process might be a good solution. However, taking IMF money would severely damage the euro’s reputation and is thus probably not a viable option.

The most likely solution at this point, a Franco-German led bail out, should be conditioned on as strict obligations and requirements as politically feasible. I do acknowledge the argument often brought forward against an IMF-style strait jacket. However, for countries that are member of the eurozone this is additionally a question of solidarity and mutual respect. If a non-eurozone country does not manage its budget properly and gets into fiscal troubles it affects other nations to a limited extent. If a eurozone country does not act fiscally responsible, other members have to foot the bill. This cannot be a permanent condition at least as long as the European Union is not politically united (even then it should not). Solidarity is certainly due in a severe crisis like this, but benefiting economies should not be given the possibility to maneuver themselves directly into the next fiscal disaster.

Europe – Quo Vadis?

I am not a particular fan of the Wall Street Journal, although I must admit they are sometimes quite inventive when coming up with arguments why Mr. Obama’s politics are a complete disaster and will completely ruin the United States. Nevertheless, I enjoy reading their view on international politics and in particular Europe (I do not often agree with them there, either). So is Europe’s dream of power waning with the rise of the so called “G2” (that is China and the U.S.)? To give a quick answer: probably yes. There are two main reasons why I think this is the case. On the one hand, Europe is not able to unite fast enough and speak with one voice. On the other hand, I believe Europe does neither really want nor need to aim for increased political influence.

First, those who were dreaming of a united Europe as a political counterpart to the U.S. have always been somewhat naive. While Europe’s economic weight is undoubtedly still considerably heavy, although in relative decline as well, its political power has always been based on individual member states. Without a fully integrated political union it is not going to be taken seriously on the world stage. And such a union, if possible at all, will take probably another half century or more. Moreover, economic and cultural nationalism is again on the rise in many European countries. Take France’s or Germany’s industrial policies (particularly in the automobile sector) or the view towards Europe of the likely new government in the U.K, just to mention some examples. The Lisbon treaty made evident what many in Brussels did not want to see: Europe needs to rest and digest. Deepening political ties and expanding its geographical borders have taken their toll. This is only natural considering where Europe has came from after the catastrophe of World War II. It has come a long way and it should be proud of it. We should not forget that Europe started as a peace project and has more than fulfilled its promises in that respect.

Second is the question whether it is necessary to be a global heavyweight in the political sphere. That depends largely on people’s priorities and an imminent threat of any kind of military hostility towards Europe seems more than unlikely (at least for European countries already member of the bloc). Political influence always comes at a cost and I am not sure whether Europeans are willing to shoulder such expenses. I believe Europeans, in particular the young generations, do not care much for political importance of Europe and have other priorities. They believe in the unique process of different cultures and values growing together. Europe has learnt its lessons. Just look at e.g. the attitude of Germans towards war in general and the one Afghanistan in particular; it is completely unpopular there.

Europe will be occupied with managing itself for some time to come. I feel quite comfortable with that thought. Of course, our politicians who strive for ever more power and influence will keep trying to convince us otherwise.

Bankers are not that stupid

Paul Krugman's latest op-ed comment on bankers is quite dead-on. I have been arguing in the same direction. However, I think he is quite modest this time. Saying that bankers are clueless is most certainly right when it comes to knowledge about their risk-taking and how to control it. What those bankers do exactly know is that they take on those risks and the potential consequences (their memory cannot possibly that short). They also know how much money they personally make in the current, under-regulated system. Therefore, and for no other reason they want to keep the system going (even though they come up with all kinds of other arguments such as limited growth potentials owing to stricter regulation).

I can also fully agree with Mr. Krugman that without tighter regulation and supervision a future credit crisis is almost inevitable.