The value of the yen has fallen sharply since November, owing to the monetary component of Japan’s efforts to jump-start its economy (”Abenomics”).  Thus the issue of currency wars is expected to feature on the agenda at the G-8’s upcoming summit in Enniskillen, UK, June 17-18.

The phrase “currency wars” is catchy.  But does it have genuine analytical content?   It is another way of saying “competitive devaluation.”  To use the language of IMF Article IV(1) iii, it is what happens when countries are “manipulating exchange rates…to gain an unfair competitive advantage over other members…” To use the language of the 1930s, this manipulation would be a kind of beggar-thy-neighbor policy, with each country seeking to shift net exports toward its own goods at the expense of its neighbors.

Although the phrase “currency wars” has over the last couple of years been applied to expansionary monetary policy by the Fed, Bank of Japan, and other central banks, the concept does not in truth fit very well.  A key point is often missed:   Even the direction of the effect (let alone the magnitude) of one country’s monetary stimulus on its trade balance and hence on the demand for its trading partners’ goods is ambiguous: the expenditure-switching effect when the exchange rate responds is counteracted by the expenditure-increasing effect when the expanding country expands.  Higher income leads to higher imports.  (Chinn, 2013, surveys the effects in the wake of recent QE experience.)

The phrase fits a bit better countries that deliberately intervene in foreign exchange markets to push down the value of their currencies in order to help their trade balances. 

National authorities will and should pursue economic policies that are primarily in their own countries’ interests.There are times when cooperation is fruitful, whether by norms, decisions in multilateral meetings like the G-8 or G-20, or formal institutions like the WTO and IMF.  Indeed, the latter two institutions were conceived by the Allied countries at Bretton Woods NH in July 1944, in an effort to avoid a future repeat of trade wars and currency wars.  This was one month before the same countries met at Dumbarton Oaks in Washington to formulate the United Nations, in an effort to avoid a future repeat of real wars.

But there is little point in even attempting international cooperation if the nature of the spillover effects is not relatively clear and agreed upon.  Everybody agrees for example that pollution spillovers are negative externalities, not positive externalities.   So cooperation means reining in pollution.  Most would probably agree the same about tariffs, the original “beggar-thy-neighbor” policy. But the case is not as clear when it comes to monetary policy.

In the example of fiscal expansion, there may be times when countries can agree that the spillover effects are positive - the locomotive theory, supporting the case for jointly agreed expansion by the largest economies during a time of recession, as at the G7’s Bonn Summit of 1978.  And there may be times when they can agree that the spillover effects are negative - moral hazard among members of a currency area like the eurozone, supporting the case for jointly agreed fiscal deficit rules.   In the case of monetary expansion the nature of the externality is less often clear.

If unemployment is high and inflation low in the United States, it is natural that the Fed will choose an easy monetary policy, particularly via low interest rates.   If the situation is the reverse in Brazil, with the macro-economy overheating (as it was not long ago), it is natural that its central bank will choose a tight monetary policy, particularly via high interest rates.   It is also natural that capital will flow from north to south as a result, that it will in turn appreciate the Brazilian real, and that this will have real effects. 

But that is the beauty of floating exchange rates. Such an exchange rate movement is a sign that the international economic system is working as it should, not the reverse - once one takes as given the difference in cyclical positions of the two countries.  It allows both countries to choose their own appropriate policy settings appropriate to their own circumstances.

Of course the exchange rate movement will help US exporters and hurt those in Brazil, other things equal.   But such “casualties of war” are not even unintended collateral damage.  They are the point of the monetary policies chosen by each of the two countries.  If the goal is to stimulate demand for goods produced in the US and cool off demand for goods produced in Brazil, why shouldn’t the exporters in both countries share in that process, alongside construction and the other sectors that are sensitive to the interest rate via domestic demand in the two respective economies?   (Frankel, 1988.)

More of a dilemma arises if one of the countries had previously been targeting or even fixing the exchange rate.  It could have lots of reasons for having chosen such a regime.  For example, many governments in Latin America finally succeeded in killing off very high inflation rates in the late 1980s and early 1990s only by means of targeted or fixed exchange rates.   Such a country won’t necessarily want to abandon a proven exchange rate regime at the first sign of trouble.

Capital controls and sterilization of reserve flows might help delay the adjustment.  Fiscal policy is another relevant tool.  (Brazil could have reacted to its fears of overheating by reducing its budget deficit, rather than just by controls on capital inflows and appreciation or sterilization.)  But a persistent uni-directional capital flow will eventually force the country with the fixed exchange rate either to allow its exchange rate to adjust or its money supply. 

In the case of China during 2004-2011, this meant a choice between allowing some appreciation of the RMB and allowing an increase in the money supply.   The Chinese did some of both — but more of the latter than the former: the monetary inflow eventually turned inflationary, as expected.

It is true that in recent years an impressively wide array of countries have indicated in some way that they would prefer weaker currencies to stronger ones, as a means to improve their trade balances.  Opinion is often divided internally, however, e.g., within the eurozone or within the US.   The Fed has been attacked domestically for supposedly trying to debase the dollar.  Within the eurozone, Germans tend to want a stronger euro than most other members do.   

It is also true, by definition, that not every country can depreciate at once, nor improve their trade balance at the same time.  This does not necessarily mean that they are guilty of violating any agreements or norms, especially if they have not devalued but merely stuck with a pre-existing exchange rate regime (float, fixed, or band). 

Uncoordinated monetary expansion does not even necessarily leave the world in a worse equilibrium.  It might just give theworld what it world needs.  Barry Eichengreen and Jeffrey Sachs (1985, 1986) persuasively argued this for the 1930s, the opposite of the conventional wisdom regarding beggar-thy-neighbor competitive devaluations.  To the extent that every country devalued against gold, although they could by definition not all succeed in improving their trade balance, they could and did succeed in raising the price of gold and thereby increasing the real value of the global money supply, which is what a world in Depression needed. The same applies today (Eichengreen, 2013): US monetary expansion has contributed to global monetary expansion at a time when it was needed on average.

The specific merits of the “currency war” interpretation vary from country to country.

The US was the target of the man who originally launched the missile, Brazilian Minister Guido Mantega, in September 2010.    The currency wars language initially came as Brazil’s response to American efforts to enlist it and other trade competitors of China in a campaign for a stronger RMB.  (As side-kick Tonto famously said to the Lone Ranger, “What do you mean we, white man?”)   But the accusation is especially misplaced against a country like the United States:  the US authorities have not intervened in the foreign exchange market nor talked down the dollar. Depreciation of the dollar is probably not even toward the top of the list of the effects that the Fed had in mind when deciding to undertake Quantitative Easing, though mind-reading is difficult and the right answer must vary across members of the FOMC. 

True, the usual channel of monetary stimulus, via the fed funds rate and other short-term interest rates, is all-but-ended by the Zero Lower Bound.  But that still leaves effects on longer term and riskier securities, the credit channel, expectations regarding inflation, equity prices, real estate prices, and so on. It doesn’t have to be the currency depreciation channel.  

Japan comes a little closer than the United States to meriting the status of currency warrior, in that members of the new Abe government were initially foolish enough as to mention yen depreciation as an explicit goal.

China qualifies in one important respect: the RMB was undervalued by most measures from 2004 to 2009 (less so, by now).   But countries have a right to opt for a fixed exchange rate regime.  China was continuing a regime that had previously been in place, which does not sound like “manipulation.”   True, appreciation was probably in China’s interest.  It would have been reasonable, beginning in 2004, for those worried about current account imbalances to propose that China voluntarily allow some appreciation as part of a deal voluntarily agreed among sovereign states — in exchange, for example, for the US putting its fiscal house in order.  But this is different from charging Beijing with having violated international norms or rules and from threatening retaliation (e.g., by tariffs, which are a violation of WTO rules).

Indeed, very few of the countries accused of participating in the currency wars have undertaken discrete devaluations in recent years or otherwise acted to weaken their currencies by switching exchange rate regimes.    These are the sort of deliberate policy changes connoted by a phrase like “manipulation,” whether judged “unfair” or otherwise.

Switzerland perhaps comes the closest to meeting the definition.  But the Swiss franc is strong, even at the rate that was newly set September 2011.  It is hard to prove the case for unfair undervaluation.

Countries have enough serious disputes as it is, without creating unnecessary ones.

[Comments can be posted at the Project Syndicate blog site.  The blog is an expanded version of a Project Syndicate op-ed.   See also video or slides of a panel on "Printing pressure: Global currency war," held at the American Enterprise Institute, March 18, 2013: Jeff Frankel, Anne Krueger, Rakesh Mohan, and John Makin, organized by Desmond Lachman. ]

References

    Chinn, Menzie, 2013, “Global Spillovers and Domestic Monetary Policy: The Impacts on Exchange Rates and Other Asset Prices,” prepared for the 12th BIS annual conference, 20-21 June, Luzerne.         
     Eichengreen, Barry, 2013, “Currency War or International Policy Coordination,” forthcoming in Journal of Policy Modeling. Bellagio Group, Tokyo, January.
    Eichengreen, Barry and Jeffrey Sachs, 1985, “Exchange Rates and Economic Recovery in the 1930s,” Journal of Economic History 49, pp. 924-946.
    Eichengreen, Barry and Jeffrey Sachs, 1986, “Competitive Devaluation and the Great Depression: A Theoretical Reassessment,” Economics Letters 22, pp. 67-72.
    Frankel, Jeffrey, 1988, “The Desirability of Currency Appreciation Given a Contractionary Monetary Policy and Concave Supply Relationships,” Journal of International Economic Integration 3, no.1, spring, pp.32-52.  NBER WP No.1110.
    Frankel, Jeffrey, 2006,  “On the Yuan: The Choice Between Adjustment Under a Fixed Exchange Rate and Adjustment under a Flexible Rate,” in Understanding the Chinese Economy, edited by Gerhard Illing (CESifo Economic Studies, Munich). 
     Frankel, Jeffrey, 2010, “The Renminbi Since 2005,” in The US-Sino Currency Dispute: New Insights from Economics, Politics and Law, edited by Simon Evenett (Centre for Economic Policy Research: London), April, pp.51-60.
     Frankel, Jeffrey, and Katharine Rockett, 1988,”International Macroeconomic Policy Coordination When Policy-Makers Do Not Agree On the Model,” American Economic Review 78, no. 3, June, pp. 318-340. NBER WP 2059.

     Europe’s fiscal compact went into effect January 1, as a result of its ratification December 21 by the 12^th country, Finland, a year after German Chancellor Angela Merkel prodded eurozone leaders into agreement.   The compact (technically called the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union) requires  member countries to introduce laws limiting their structural government budget deficits to less than ½ % of GDP.  A limit on the “structural deficit” means that a country can run a deficit above the limit to the extent — and only to the extent — that the gap is cyclical, i.e., that its economy is operating below potential due to temporary negative shocks.   In other words, the target is cyclically adjusted.  The budget balance rule must be adopted in each country, preferably in their national constitutions, by the end of 2013.

    Will the new approach help?   The aim is to fix Europe’s long-term fiscal problem, which since the date of the euro’s inception has been evident in the failure of the Stability and Growth Pact (SGP), the crisis in Greece and other periphery countries that surfaced in 2010, and the various ways in which these countries were subsequently bailed out.  

     There is no reason to doubt that the eurozone countries will follow through to the extent of adopting the national rules by the end of the year.  ["The granting of new financial assistance under the European Stability Mechanism is conditional on ratification of the fiscal compact and transposition of the balanced budget rule into national legislation in due time."]  But after that the fiscal compact will probably founder on precisely the same shoals as the SGP.

    Since the inception of the euro, its members have made official fiscal forecasts that are systematically biased in the optimistic direction.   Other countries do this too, but the bias among eurozone countries is, if anything, even worse than that elsewhere.  During a period of economic expansion, such as 2002-07, governments are tempted to forecast that the boom will continue indefinitely.  Forecasts for tax revenue and budget surpluses are correspondingly optimistic and so hide the need for adjustment of fiscal policies.  During a period of recession, such as 2008-2012, governments are tempted to forecast that their economies and budgets will soon rebound.  Since forecasting is subject to so much genuine uncertainty, nobody can prove that the forecasts are biased when they are made.

     Fiscal rules such as the SGP ceilings won’t constrain budget deficits, if forecasts are biased.  The reason is that governments can in any given year forecast that their growth rates, tax revenues, and budget balances will improve in the subsequent years, and then next year say that the shortfalls were unexpected.   Indeed, it turns out that the eurozone bias in official forecasts during 1999-2011 can be neatly characterized as responding to the SGP’s 3% limit on budget deficits by offering over-optimistic forecasts each time governments exceed the limit.  In other words, they adjust their forecasts rather than their policies.   (The results described here come from a new paper, coauthored with Jesse Schreger: “Over-optimistic Official Forecasts and Fiscal Rules in the Eurozone,” forthcoming 2013 in the Review of World Economy, vol.149, no.2, from Germany’s Kiel Institute.)

    Phrasing the budget rules in cyclical terms, while highly desirable in terms of macroeconomic impact, does not help solve the problem of forecast bias.  It can even make it worse.  In a year when a forecast for the actual budget deficit turns out to have been over-optimistic, the government has to admit that it made a mistake, which can carry some embarrassment.  In a year when a forecast for the structural budget deficit turns out to have been over-optimistic, the government can still claim that its own calculations show the shortfall to have been cyclical rather than structural.   After all, estimation of potential output and hence the cyclical versus structural decomposition is notoriously, even after the fact.

   Will it help that under the fiscal compact the rules are to be adopted at the national level, as opposed to the supranational level on which the SGP operated?  A look at the various rules and institutions that have already been tried by European countries shows that some work and others don’t.  Creating an independent fiscal institution that provides its own independent budget forecasts works, in that it reduces the bias in projections.  Euro area governments with an independent budget forecasting institution have a mean bias when making forecasts while in violation of the Excessive Deficit Procedure (EDP) that is smaller by 2.7% of GDP [at the one-year horizon], compared to euro area countries that are in violation of the EDP without such an independent fiscal institution.

    It would be better still if the governments were legally bound to use these independent forecasts in their budget plans (thereby borrowing an innovation from Chile).  

   Regardless how well-designed the rules are, clever and determined politicians can find ways around them.  One of the tricks is the privatization of government enterprises which reduces the budget deficit this year on a one-time non-repeatable basis, but might raise it in the long-term if the enterprise had been earning profits.  Another trick is phony legislated sunsets on tax cuts, in order to make future revenues look larger despite the political intention later to make the tax cuts permanent. 

   Still, other things equal, the right institutions can reduce the procyclicality of fiscal policy in the short run and help deliver debt sustainability in the long run.    Examples of the right institutions are cyclically adjusted budget targets combined with independent agencies that make independent fiscal forecasts.  Things can still go wrong even if such mechanisms are in place; but, as the history of the SGP illustrates, the risk is higher if they are not.

     [The original of this post appears at Project Syndicate.  Comments may be posted there.]

         A survey of economists is published in the November 2012 issue of Foreign Policy.  One question was whether we thought that the US unemployment rate would dip below 8.0% before the election.   When the FP conducted the poll at the end of the summer, unemployment was 8.1-8.2%.  Now it’s 7.8%.  Only 8% of the respondents said “yes.”   (I was one.  I basically just extrapolated the trend of the last two years.)   

My fellow economists choose defense spending and agricultural subsidies as the two categories of US federal budget that they think the best to cut.  They rate the euro crisis as the greatest threat to the world economy now and are particularly worried about Spain.   

For a slideshow presentation of the results, see “The FP Survey: The Economy.”   Or in a magazine format:  “If we’re ever going to get out of this slump, what will it take?  We asked more than 60 leading economists to tell us.”   

        Also, here is a recent poll from The Economist, asking similar questions of NBER and NABE economists:   “Asking the Experts,” Oct. 6.

     I have argued that the best way to think of “black swan” events is as developments that, even though low-probability, can in fact be contemplated ahead of time.  Even if they are the sort of thing that has never happened before within an analyst’s memory, similar things may have happened before in the distant past or in other countries.   

     What current possible shocks have probabilities that, even if fairly low, are high enough to warrant thinking about now?  Some have been discussed ad infinitum, others hardly at all.

• Most widely discussed is the danger of a break-up of the euro. Considered unthinkable a short time ago, the probability that one or more euro members will drop out is now well above 50%. Currency unions have disintegrated before.
• Another is the possibility of a hard landing in China, analogous to the crisis that hit Korea and other East Asian markets in 1997.
• An oil crisis in the Mideast is the classic black swan event. Each one catches us by surprise: 1956, 1973, 1979, and 1990 (among others). Oil prices can rise for lots of reasons, not just crises in the Mideast, and have done so in recent years. But the most likely crisis scenarios currently stem from either military conflict with Iran or instability in some Arab government. The threatened loss of supply to world markets typically shows up as a sharp increase in demand for oil inventories and thus in prices.
• The most worrisome financial threat is a crash of currently over-priced bond markets. In theory such a crash could be precipitated by inflation (particularly commodity-induced inflation as in 1973 or 1979). But this seems unlikely. More likely triggers are (i) a breakdown in the eurozone or (ii) political dysfunction in Washington. A default in Greece or some other Mediterranean country could trigger a global debt crisis any time. The evidence of extreme dysfunction in US politics is already there for all to see, in the attempts by some politicians to repeat the macroeconomic policy mistakes of 1937 and in the debt-ceiling show-down of August 2011 (which led S&P to downgrade US government credit rating from AAA to AA). The obvious crunch date comes after the American election, as the “fiscal cliff” approaches in the last two months of this year. In theory, fears of what will happen January 1 should lead investors to start dumping bonds now. But it is still considered a sign of sophistication in financial markets to opine that, precisely because the consequences of going over the cliff would be so bad, the politicians will again find a last-minute way to avoid it. In truth, the fact that we haven’t gone over the cliff before does not necessarily mean we won’t this time. Perhaps observers think that a clear result in the election, one way or the other, would help settle things. A true black swan in the mix would be a repeat in November of the disputed 2000 presidential election; there has been no reform in the meantime to assure people that their votes will be counted or that a disputed outcome would be resolved by independent institutions rather than by interested political appointees.
• Scariest on the list is a terrorist attack with weapons of mass destruction. When politicians have used the specter of a September 11 repeat to scare the American public into supporting unhelpful policy responses, the mistake has been in the unhelpful policy responses, not in the “scare” part. There is long-standing gap between the probability of a nuclear event as perceived by terrorism experts and the probability as perceived by the public. Admittedly the probability is lower now that Osama bin Laden is dead.
• Last on this list is an unprecedented climate disaster. Environmentalists sometimes underestimate the benefits of technological and economic progress when they reason that a finite supply of resources must of necessity be exhausted eventually. But the disbelievers are just as faulty in their reasoning that because a global climate disaster has not happened in the past it can’t happen in the future.

       Throughout history, big economic and political shocks have often occurred in August, when leaders had gone on vacation in the belief that world affairs were quiet.   Examples of geopolitical jolts that came in August include the outbreak of World War I, the Nazi-Soviet pact of 1939 and the Berlin Wall in 1961.  Subsequent examples of economic and other surprises in August have included the Nixon shock of 1971 (when the American president enacted wage-price controls, took the dollar off gold, and imposed trade controls), 1982 eruption in Mexico of the international debt crisis, Iraq’s invasion of Kuwait in 1990, the 1991 Soviet coup, 1992 crisis in the European Exchange Rate Mechanism, Hurricane Katrina in 2005, and US subprime mortgage crisis of 2007.   Many of these shocks constituted events that had previously not even appeared on most radar screens. They were considered unthinkable. 

The phrase “black swans” has come to be used to mean a very unlikely event of this sort.  Managers of Long Term Capital Management in 1998 or of most major banks in 2008 have suggested that they could not be expected to have allowed for a financial collapse such as the one that followed the default of Russia or the one that followed the bursting of the US housing bubble, because it was a “7-standard deviation event,” that is, an event of inconceivably tiny probability…in the realm of the probability that two major meteors hit the earth at the same time.   This is nonsense.  If the statistical model says the probability of a financial crisis is that low, it is the model that is wrong.  This is like the case when “hundred-year floods” turn up every few years.

A bit more enlightened are people who talk about Knightian uncertainty or “unknown unknowns.” Ignorance with humility is better than ignorance without it.    A still better interpretation is that statistical distributions have “fat tails,” in technical terms.  But it would be nice to get beyond the Jurassic Park lesson (”don’t be surprised if things go wrong”), to be able to say intelligent things about what causes tail events. 

       What does “black swan” really mean?   In my view, it should refer to an event that is considered virtually impossible by those whose frame of reference is limited in time span and geographical area, but that is well within the probability distribution for those whose data set includes other countries besides their own and other decades or centuries. 

      Consider five examples of mistakes made by those whose memory did not extend beyond a few years or decades of personal experience in a small number of countries.

1. “All swans are white.”  The origin of the black swan metaphor was the belief that all swans were white, a conclusion that might have been reached by a 19^th century Englishman based on a lifetime of personal observation and David Hume’s principle of induction.   But ornithologists already knew that there in fact existed black swans in Australia, having discovered them in 1697.  A 19^th-century Englishman encountering a black swan for the first time might have considered it an event of unthinkably low probability, even though the relevant information to the contrary had already been available in ornithology books.  It seems a waste of an excellent metaphor to use the term just to mean a highly unexpected event.  A better use of “black swan” would be to mean an event that would not have been quite so unexpected ex ante if forecasters had cast their data net over a broader set of countries and a longer time perspective.

 2. “Terrorists don’t blow up big office buildings.”   Before September 11, 2001, some terrorist experts warned that foreign terrorists might try to blow up tall American office buildings.   These warnings were not taken seriously by those in power at the time.   Many Americans did not know the history of terrorist events taking place in other countries and in other decades.  

 3. “Housing prices don’t fall.” Many Americans up to 2006 based their behavior on the assumption that nominal housing prices, even if they slowed down, would not fall.   After all, “they never had before,” which meant that they had not fallen in living memory in the United States.   They may not have been aware that housing prices had often fallen in other countries, and in the US before the 1940s.  Needless to say, many a decision would have been made very differently, whether by indebted homeowners or leveraged bank executives, if they had thought there was a non-negligible chance of an outright decline in prices.

 4. “Volatilities are low.”   During the years 2004-06, financial markets perceived market risk as very low.  This was most nakedly visible in the implicit volatilities in options prices such as the VIX.  But it was also manifest in junk bond spreads, sovereign spreads, and many other financial prices.  One of the reasons for this historic mis-pricing of risk is that traders were plugging into their Black-Scholes formulas estimates of variances that went back only a few years, or at most a few decades (the period of the late “Great Moderation”).  They should have gone back much farther - or better yet, formed judgments based on a more comprehensive assessment of what risks might lie in wait for the world economy.

 5. “Big banks don’t fail.”   ”Governments of advanced countries don’t default.”   ”European governments don’t default.”  Enough said.  Greece’s debt troubles, in particular, should not have caught anyone by surprise, least of all northern Europeans.   The perception was that euro countries were fundamentally different from emerging markets, that like Germany they were free of default risk.  Suddenly, in 2010, the Greek sovereign spread shot up, exceeding 800% by June. But even when the Greek crisis erupted, leaders in Brussels and Frankfurt seemed to view it as a black swan, instead of recognizing it as a close cousin of the Argentine crisis of ten years earlier, the Mexican crisis of 1994, and many others in history, including among European countries.

      My next blog post will list some of the shocks that, even though low-probability, have high enough probability that they should be treated as thinkable rather than unthinkable, they would have great consequences, and they therefore warrant some advance preparation.

     My preceding post bemoaned the tendency for many US politicians to exhibit a procyclicalist pattern:    supporting tax cuts and spending increases when the economy is booming, which should be the time to save money for a rainy day, and then re-discovering the evils of budget deficits only in times of recession, thus supporting fiscal contraction at precisely the wrong time.  Procyclicalists exacerbate the magnitude of the swings in the business cycle.        This is not just an American problem.  A similar unfortunate cycle — large fiscal deficits when the economy is already expanding anyway, followed by fiscal contraction in response to a recession — has also been visible in the United Kingdom and euroland in recent years.   Greece and Portugal are the two most infamous examples. But the larger European countries, as well, failed to take advantage of the expansionary period 2003-07 to strengthen their public finances, and instead ran budget deficits in excess of the limits (3% of GDP) that they were supposed to obey under the Stability and Growth Pact. Then, over the last few years, politicians in both the UK and the continent have made their recessions worse by imposing aggressive fiscal austerity at precisely the wrong time.      Historically, developing countries used to be the ones where dysfunctional political systems produced procyclical fiscal policies.  Almost all of them showed a positive correlation between government spending and the business cycle during the period 1960-1999.  But things have changed.   Remarkably, during the decade 2000-2010, about a third of emerging market governments - in countries such as China, Chile, Malaysia, Korea, Botswana, and Indonesia - managed to reverse the historical correlation.  They took advantage of the boom years 2003-2007 to strengthen their budget positions, saving up for a rainy day.  They were thus in a good position to ease up when the global recession hit them in 2008-09.        In fact a majority of the governments that have followed countercyclical spending policies since 2000 are in emerging market or developing countries.   They figured out how to achieve countercyclicality during the last decade, precisely the decade when so many politicians in “advanced countries” forgot how to.

Any solution to the euro crisis must meet two objectives.  One is short run and the other is long run.  Unfortunately they tend to conflict.

The first necessary objective is to put Greece, Portugal, and other troubled countries back on a sustainable debt path, defined as a long-term trajectory where the ratio of debt to GDP is declining rather than rising.  Austerity won’t restore debt sustainability.  It has raised debt/GDP ratios, not lowered them.   A write-down would do it.  New bigger bail-outs might too, or might not.  But either write-downs or bailouts would then create moral hazard and thus make even it even harder to satisfy the second necessary objective.

That second objective is to reform the system so as to make it less likely that similar debt crises will recur anew in the future.   Fiscal rectitude in the long run is indeed the way to accomplish this.  But it is hard to commit today to fiscal rectitude in the future.  Rules to cap debt such as the Maastricht fiscal criteria, “no bailout” clause and Stability and Growth Pact (SGP) didn’t work because they were not enforceable.

Eurobonds could be part of the solution, if designed properly to take into account fiscal fundamentals, both short term and long term.  These are defined as government bonds that would be the liability of euroland in the aggregate.

The creation of a standardized Eurobond market would bring a boost to help a reform plan come together, badly needed in light of the damage that years of failed European summits have done to official credibility.  That boost is the latent global portfolio demand for a good eurobond. 

Even when the euro was at the height of its success five years ago, its international currency status suffered from lack of a counterpart to the US Treasury bill market, a deep, liquid, standardized market in low-risk bonds.  Bonds are issued by the 17 member governments.  This fragmentation has hindered European financial integration and impeded any bid by the euro to rival the US dollar as international reserve currency.  Central banks in China and other big developing countries are still desperate for an alternative form in which to hold their foreign exchange reserves – an alternative to holding US government securities, that is.   US Treasury bills pay extremely low interest rates, and the value of the dollar has been on a negative downward trend for 40 years (ever since President Richard Nixon took the dollar off gold and devalued in 1971).   Despite all of Europe’s problems, a Eurobond would be attractive to central bankers and other portfolio investors around the world, both to achieve higher expected returns than on US treasury bills and to diversify risk.

But that latent global demand for Eurobonds will not come to the table unless they are by design backed up with solid economic and political fundamentals.

Germany opposes Eurobonds on the sensible grounds that if individual national governments were allowed to issue them freely, the knowledge that somebody else was paying the bill would make the incentive for member countries to spend beyond their means worse than ever.  This version of Eurobonds would be bound to fail, both economically and politically.   This seems to be the version that some opponents of austerity have in mind, such as the new French president, François Hollande, though it is hard to tell.

A different version of the Eurobond proposal has recently begun to gain traction in Germany.  The German Council of Economic Experts - usually called “wisemen,” although the council includes a woman — proposed last year a European Redemption Fund (hence yet another new acronym, ERF).   The plan would convert into defacto Eurobonds the existing debt of (approved) member nations in excess of 60% of GDP, the supposed threshold specified in the Maastricht and SGP criteria.  The ERF bonds would then be paid off over 25 years.   Steps toward this proposed solution to the short-term debt problem would be paired - politically and logically - with approval of the Fiscal Compact, Angela Merkel’s proposed solution to the long-term problem.

But this seems upside down.  Yes, any solution to save the euro will have to ask German taxpayers to put still more money on the line.   But to use Eurobonds as the mechanism for eliminating the big debt overhang looks like the nail in the coffin of the longer term moral hazard objective.  It offers absolution precisely on the margin where countries in the future will in any case have the most trouble resisting the temptation to sin again, the margin where they cross the 60% threshold.

If the Fiscal Compact or proposed “debt brakes” could be relied on as a firm constraint on future behavior, then fine.  But there is little reason to believe that they could, especially after confirmation of the precedent that individual spendthrifts are relieved of their excess debt burdens.

The new Fiscal Compact is unlikely to succeed where the Maastricht criteria failed, the “no bailout” clause failed, and the SGP failed.  It is less credible that excessive deficits will be punished than it was three years ago - and it wasn’t credible even then.   Rules don’t work without some enforcement mechanism.   The problem with the SGP wasn’t that it wasn’t written strictly enough or even that it wasn’t incorporated into the constitutions of the member countries as the Fiscal Compact would have it.  The problem with the SGP was that no matter how many times a member government’s deficit or debt exceeded the specified limit, the country’s officials could say (often sincerely) that the gap was the fault of unexpected circumstances such as slow growth and low tax receipts and that they expected to do better next time.  Even if some court in Brussels or Frankfurt were given life-and-death power to enforce the rules, exactly which officials would it punish for violations, and how?  No version of the SGP or Fiscal Compact or debt brake proposals has ever provided a satisfactory answer to that question.

Hope by some Europeans that the Fiscal Compact would finally make enforcement credible by writing the constraints into the constitutions of member states might be based on misunderstanding of the US system.   One can see the logic:   The US federal government has never bailed out one of the 50 states and nobody expects it to do so in the future.  How has the US solved the problem of moral hazard that so plagues euroland?  The states have rules to limit deficit spending.  That must be the answer !  (Well, 49 of the states have rules; these laws are voluntary on the part of the states, and Vermont does not have one).  State laws are not the primary explanation for the absence of US moral hazard.  The primary explanation is that the right precedent was set in 1841 when the federal government declined the opportunity to bail out 8 troubled states and let them default.  Euro leaders should have done the same with Greece a year or two ago. A second (related) explanation for absence of moral hazard in the US federal system is that, ever since the 1840s, when American states start to run up questionable levels of debt the private market demands an interest rate premium to compensate for the default risk.   The premium acts as an automatic disincentive to further profligacy.  This mechanism should have operated after the euro was created in 1999, but it never did:  Greece and the other high-borrowers were able to borrow at interest rates that — disturbingly – had fallen virtually to the same levels as German bunds.  

The final explanation is that when citizens started to ask more from their public sectors governments in
the 20^th century (defense, entitlement spending, etc.), the expansion in the case of the United States took place at the federal level, not the state level.  For this reason even the fiscally most dysfunctional of the American states, which is probably California, does not operate on a scale remotely like European national governments.   US federal spending is 24% of GDP versus an EU budget of 1.2% of GDP.  Europeans are not ready to transfer most spending and taxation from the national to the federal level.   And even if they decide some day that they are ready, if the bailout precedent still stands then this federalization will not solve the moral hazard problem regarding the spending that remains at the national level.

The version of Eurobonds that might work is almost the reverse of the Germans’ Redemption Fund proposal.  It goes under the more colorful name of “blue bonds,” originally proposed two years ago by Jacques Delpla and Jakob von Weizäcker at the think tank Bruegel.   Under this plan, only debt issued by national authorities below the 60% criteria could receive eurozone backing, be declared senior, and effectively become Eurobonds.  These are the “blue bonds” that would be viewed as safe by investors.  When a country issued debt above the 60% threshold, the resulting junior “red bonds” would lose eurozone backing.   The individual member state would be liable for them.  This proposal structures the incentives “right side up.”

The blue bonds proposal has been extensively debated in Europe.  As usual in such controversies, many participants in the euro debate fixate on one evil or the other –moral hazard or austerity — and fail to grapple with practical proposals to balance the two.

As I see the plan, the private markets could make the judgment as to whether a country was in the process of crossing the threshold, even before the final statistics were available, and therefore assess whether default risk on the new red bonds required an interest rate premium.  If private investors judged that the new debt had genuinely been incurred in temporary circumstances beyond the government’s control (say a weather disaster), then they would not impose a large interest rate penalty.  Otherwise, the sovereign risk premium mechanism would operate on the red bonds, much as it does among American states, and much as it did in Italy, Greece and the others before they joined the euro.   Similarly, if the ECB after 2000 had operated under a rule prohibiting it from accepting as collateral the debt of SGP-noncompliant countries, the resulting default risk premum might possibly have headed off the entire euro sovereign debt problem early in the decade.

The point is that the red-bond mechanism would be truly automatic, as desired.  Perhaps in ambiguous borderline cases the judgment whether a country had truly exceeded the limit, or whether it was still in good standing so that its debt qualified for eurobond status, would ultimately have to be made by a eurozone agency or court, with an inevitable lag.  But, in the meantime, private investors could apply informed views about the merits from moment to moment.  The resulting market interest rates would provide the missing discipline. Compliance would not rely on discretionary letters from Brussels bureaucrats, which have proven toothless no matter how many exclamation points are put at the end of their penalty threats.  Nor would it require unenforceable debt ceilings legislated at the national level.  The U.S. has one of those too.  It has never had any effect, except on a very few occasions, when Congress has actively used the debt ceiling law to make everything worse.

Of course the euro countries cannot jump to a blue bond regime without first solving the problems of debt overhang and troubled banks that are front and center.   Otherwise, in today’s world, the plan by itself would be destabilizing since it would put almost all countries immediately into the red.   The debt paths that are currently unsustainable in many countries result from the combination of debt/GDP ratios that are already far in excess of 60%, combined with very high sovereign spreads and recessions.    Relieving them of responsibility for debt up to 60% would be substantial assistance, but would not in itself restore sustainability to all members.

Thus Eurobonds are emphatically not the complete solution to these vexing problems.  It is hard to say, at this late date, what the right short-term solutions are.   In Greece’s case, it may be forced to default and to drop out of the euro.  The banks and sovereigns in other countries will then have to be insulated from the conflagration through a combination of acronymic “bailout” money (EFSF, ESM, ECB…) and serious policy conditionality, as always.  Creating this fire break between Greece and the heart of Europe would have been far easier two years ago, before debt/GDP levels and sovereign spreads climbed so high and before the credibility of the euro leaders sank so low, or even one year ago.  Now the fire has spread over a much larger area and there are no natural gaps in sight for creating firebreaks.

But one thing seems clear.  German taxpayers, whose longstanding fears that they would be asked to bail out profligate Mediterranean euro members have been proven correct, will not be happy when asked to put up still more money in the cause of European integration by the same elites whose assurances of the last 20 years have proven false.   They will at a minimum need some credible reason to believe that future repetitions have been rendered unlikely, that the bailout is “just this once.”   Official assurances do not constitute that credible reason.    Nor does the Fiscal Compact, in itself.   The red bonds / blue bonds scheme just might.

[A much condensed version of this posting appears in Project Syndicate, June 14, 2012.  This fuller version also appears on Vox, June 28, 2012.]

The Hour of the Technocrats has arrived.   In desperation from debt crises that their gridlocked political systems have created, Italy and Greece both in November chose new Prime Ministers who are technocratic economists rather than politicians:   Mario Monti and Lucas Papademos, respectively.  One can even describe them as professors:  Monti has been president of the prestigious Bocconi University when not a European Commissioner in Brussels, and Papademos has been my colleague at Harvard Kennedy School in the year since he finished his term as Deputy Governor of the European Central Bank (even teaching a class I usually teach).

No doubt, whatever happens, pundits who evaluate their performance will soon be writing: “Professors Earn ‘A’ in Economics, but Flunk Politics.”   This will be unfair.   It is not lack of political ability that will stymie them, but lack of political power in the mandates they have been given.    Mario Monti, despite very strong popular support among Italians for his technocratic government, does not have a parliamentary majority that he can rely on.   Berlusconi, in boasting that he can pull the plug on Monti anytime he wants, has made it clear that he still will not lay aside his personal political interests for the good of the country even when everyone understands what he is doing.   

Lucas Papademos in Greece has been dealt an even weaker hand.  Despite his best efforts to insist on a term longer than three months and the ability to appoint some members of his cabinet, as requirements for accepting the Prime Ministership, in the end he could not get even these minimum conditions.

The elevation of these two outstanding civil servants comes after a period when some other professors have been squeezed out by the political process.   Several good technocratic economists from emerging market countries were passed over in June, when choosing the successor to Dominique Strauss-Kahn as Managing Director of the International Monetary Fund.

Next, an example from Germany. Axel Weber in January 2011 resigned as President of the Deutsche Bundesbank and member of the Governing Council of the European Central Bank.  The interpretation in the press was that his statements opposing ECB purchases of bonds issued by troubled periphery countries had been evidence of political naivety on his part.   The press could not imagine that a technocrat might voluntarily relinquish a sure shot at a position of great power — successor to Jean Claude Trichet as ECB President — on a matter of principle.    But that is precisely what Weber was doing.  The willingness to give up power if necessary is one of the advantages of professors for such positions.  (It is a different matter that the ECB presidency then went to Mario Draghi, who is also an economist and technocrat, and in fact the perfect man for the job.)

It is a mistake to conflate technocrat elites (they are the ones with the PhDs or other advanced economics degrees) with other kinds of elites (the ones with money or power, especially if they got them from their parents).   Most economists understood very well the possible downside of European monetary union.  In the late 1980s, when Jacques Delors asked major European leaders what the next step should be in the European integration project, they underestimated the technical difficulties when they opted for monetary integration.

Technocrats can play a useful role.  One of their advantages is acting as an honest broker when traditional politicians have become discredited or parties are deadlocked.  Another is the credibility that comes when they are not motivated by getting re-elected, either because their term in office has been limited in advance or because it is know that they in fact prefer the quiet life back at the university.  The most obvious advantage to technocrats comes when the biggest problems facing the country are in large part technical such as proposing economic reforms or negotiating loan terms.  A good precedent in Italy is Carlo Ciampi, who took the governing reins in 1993 after Italy was forced to drop out of the European Exchange Rate Mechanism, but managed to repeal the scala mobile (the wage indexation system), beat down inflation, and re-board the train of European monetary integration. 

Obvious disadvantages of some technocrats include lack of managerial experience, lack of perceived legitimacy, and lack of a domestic political powerbase.   Monti and Papademos both have managerial experience and, for now, perceived legitimacy.   The last of the three factors will be the limiting factor for them.

Among current heads of state who could be considered technocrats are President Felipe Calderón of Mexico, President Sebastián Piñera of Chile, and President Ellen Johnson Sirleaf of Liberia.  Nobody could accuse these three of having led sheltered lives or being unaccustomed to making difficult decisions.   But it happens that all three received their ivory tower training at the Harvard.  Calderón took a record three courses from me.   Unfortunately, dealing with violent drug lords was not on my syllabus. 

Having shiny international credentials is not always an advantage.  When Sirleaf received the Nobel Peace Prize in 2011, the speculation was that this evidence of her good image abroad could hurt her with the voters at home in her campaign for re-election.   Analogously, Prime Ministers Monti and Papademos hold gold card memberships in the clubs of EU and euro elites that will help them obtain support for their countries abroad but leave them vulnerable domestically to charges that they are lackeys of foreign powers.

It is good that Rome and Athens, the two seats of classical western civilization, have turned to these two civilized men for leadership. I hope the politicians realize that Monti and Papademos cannot work miracles if they are not given the political tools to get their policies enacted.   

[A version of this column appeared Nov. 25 on Project Syndicate.  Comments can be posted there]

A subsequent blog post will extend the discussion of technocrats to some recent examples from the United States of highly qualified academics who have been blocked from office for political reasons.

US News and World Report asks, “Who is handling its debt crisis better: Europe or the United States?”   My answer follows.

  In both Europe and the United States, the current public debt woes are attributable to mistakes made by political leaders going back more than a decade.  In both cases the tremendous magnitude of the long-term debt problems has only become evident for all to see recently, by which time it was too late for the straightforward policy solutions that were viable options previously. 

  It is hard to judge whether it is Europe or the United States that has screwed up worse.     On the one hand, Europe is now much closer to full-fledged crisis: the debt problems in Mediterranean members are virtually insoluble at current interest rates, are probably pushing Europe back into recession, and could well result in one or more countries forced to leave the euro.  By contrast, there is no true fiscal crisis here yet; the world’s investors are still buying large quantities of US bonds at low interest rates.

  On the other hand, the mistakes by US politicians are more gratuitously self-inflicted than on the other side of the Atlantic.   In 2001, all we had to do was continue the fiscal progress that had been made during the 1990s: preserve the budget surplus and move on to address the longer term problems of social security and Medicare in a deliberate and balanced manner.  Instead we recklessly enacted massive tax cuts and tripled the rate of growth of federal spending, in ways guaranteed to generate serious fiscal troubles in the decade of the 2010s and beyond.  The debt-ceiling standoff last summer was but the latest self-inflicted wound, new evidence that the US political system is not functioning.  

  To be sure, euroland too has made serious policy mistakes.  But one can sympathize with the difficulty of agreeing policy across 17 sovereign governments.   The political fissures have been inevitable ever since 1999, when the euro members (then 11) adopted a single currency without a single fiscal authority, in what was nevertheless a historic and laudable enterprise.  As they say, “why should anyone be surprised at the difficulty of getting 17 national legislatures to agree, when the United States cannot even do it with one?”

  It is not too late for American politicians to enact the economically sensible policy:  current short-term fiscal stimulus simultaneous with steps to lock in a long-run return to fiscal responsibility (which cannot possibly be accomplished solely by discretionary spending cuts, entitlement reform, or tax revenues, but rather should include all three).   For euroland, unfortunately, even if the politicians could come together, there no longer exists an option for preserving the monetary union in quite the form originally envisioned.

** This column (along with others’ answers to the question) first appeared in the Debate Club of U.S. News & World Report , Nov. 7, 2011, which has the copyright. **

[My reactions to developments in the euro crisis can be seen in four clips from CNBC's Kudlow Report in October and one on BNN in November.] 

My preceding blogpost identified three mistakes made by leaders of the European Economic and Monetary Union in dealing with Greece.   But what is done is done.  The mistakes now lie in the past.  How can Europe’s fiscal regime be reformed to avoid future repeats of this crisis?  

The reforms that are now underway are not credible.  (”We are going to make the fiscal rules more explicit and make sure to monitor them more tightly next time.”)    Similarly, most proposals for how to put teeth into the rules are not credible — penalties such as monetary fines or loss of voting privileges. 

It is too late for Greece. But it is not too late for a euroland reform that would help avoid the re-emergence of unsustainable sovereign debt levels next time around by applying the lesson of mistake number two: to adjust the ECB policy of accepting the debt of all member states as collateral.  This is the policy that short-circuited warning signals that the private markets would otherwise have sent via interest rates during 2002-2007.  

My proposal:   The eurozone should in the future adopt a rule that whenever a country violates the fiscal criterion of the Stability and Growth Pact (say, a budget deficit in excess of 3% of GDP, structurally adjusted), the ECB must stop accepting that government’s debt as collateral.  This system would achieve the elusive objective of true automaticity.   If a country exceeded the threshold for justifiable reasons, such as natural disaster, the private markets could perceive that and impose little or no default risk premium.   No judgment of the merits by bureaucrats or politicians would be required.   More likely, for periphery countries, the result of such a re-classification would be the re-emergence of sovereign spreads of moderate magnitudes, in between the extremes of the 2002-07 lows and the 2009-11 highs (see chart).  The interest rate premium would send a message far more credibly, forcefully, and promptly than any warning that any Brussels bureaucracy will ever turn out.  

This is how it works among the U.S. states and municipalities.  Despite the absence of their own currencies, the recurrence of dysfunctional local politics and excessive deficits, and even a history of state defaults in the 19^th century, federal bailouts are not delivered and are not expected.   Without some such device, the new European Stability Mechanism is in danger of becoming a mechanism for instability.

[Niels Thygesen made the case in favor of the current reform track in "Governance in the Euro Area" at the Challenge of Europe session of INET's Annual Conference, Bretton Woods, NH, April 10, 2011. I gave my comment there as well. (Video)]

[Comments can be posted on the Vox.eu site (which has the copyright.)]