Several of my colleagues on the Harvard faculty have recently been casualties in the cross-fire between fiscal austerians and stimulators.   Economists Carmen Reinhart and Ken Rogoff have received an unbelievable amount of press attention, ever since they were discovered by three researchers at the University of Massachusetts to have made a spreadsheet error in the first of two papers that examined the statistical relationship between debt and growth.   They quickly conceded their mistake.

Then historian Niall Ferguson, also of Harvard, received much flack when — asked to comment on Keynes’ famous phrase  ”In the long run we are all dead” — he “suggested that Keynes was perhaps indifferent to the long run because he had no children, and that he had no children because he was gay.”  

There is a lot more to be said about each of the two cases.  (i) Reinhart and Rogoff’s 2010 estimates had already been superseded by a subsequent 2012 paper of theirs written along with Carmen’s husband, Vincent, which used a more extensive data set where the error does not appear.  (ii) The debt-growth causality is debated.  (iii) “Some of Ferguson’s best friends are gay.”   (iv) Keynes was actually bi-sexual.  (v) He tried to have children.  And so forth.  Most of this has already been said many times by now.  Apparently people are even more fascinated by Harvard than they are by macroeconomic theory.

But what does it all have to do with the debate between austerians and stimulators?   Not much.  But the battle lines of the austerians have been wavering lately under the continuing onslaught of facts (most notably the recessions in Europe and Japan’s recent conversion to stimulus), and the stimulators find the missteps of Reinhart-Rogoff and Ferguson to be convenient stones to throw into the attack as well.   But they are barking up the wrong tree.  Sorry;  they are throwing the wrong stones.

The Reinhart-Rogoff controversy is not in fact relevant to the question whether governments should expand or contract at a given point in time.  The basic finding in their papers continues to hold up, that subsequent growth tends to be lower among countries with debt/GDP ratios above 90% than below 90%; but neither that finding nor their policy advice was designed so as to support the proposition that a recession is a good time to undertake fiscal contraction. 

The Ferguson controversy is even less relevant, because the phrase “in the long run we are all dead” was neither about fiscal policy when Keynes wrote it nor an argument against deferred gratification.   Nor was Keynes in favor of uninhibited fiscal stimulus regardless of economic conditions;  he argued, rather, “the boom, not the slump, is the right time for austerity at the Treasury.”     Fix the hole in the roof when the sun is shining, not when it is raining.

Neither of the controversies bears on the policy proposition that is important at the moment, which is the Keynesian claim that under conditions of high unemployment, low inflation, and low interest rates (the conditions that hold in rich countries today, as in the 1930s), fiscal expansion is expansionary and fiscal contraction is contractionary.

Some research by yet another highly valued colleague at Harvard does bear much more directly on this important proposition.   Alberto Alesina has not been receiving his “fair share of abuse.”  His influential papers with Roberto Perotti  (1995, 1997) and Silvia Ardagna (1998, 2010) found that cutting government spending is not contractionary and that it may even be expansionary.  

It is true that sometimes a country may have no alternative to fiscal “consolidation,” if its creditors insist on it, as has been the case with Greece and some other euro members.  But that does not mean austerity is expansionary, especially if the currency cannot depreciate to stimulate exports.

As with Reinhart and Rogoff, the Alesina papers themselves are much more measured in their conclusions than one would think from the claims of some conservative politicians that academic research finds fiscal austerity to be expansionary in general.  Nevertheless, the conclusions are clear:  “Even major successful adjustments do not seem to have recessionary consequences, on average” (1997).  And “several fiscal adjustments have been associated with expansions even in the short run” (1998).   And “spending cuts are much more effective than tax increases in stabilizing the debt and avoiding economic downturns. In fact, we uncover several episodes in which spending cuts adopted to reduce deficits have been associated with economic expansions rather than recessions” (2010, p.3).   Most recently, a May 2013 paper with Carlo Favero and Francesco Giavazzi finds “that spending-based adjustments have been associated, on average, with mild and short-lived recessions, in many cases with no recession.”  

Alesina’s recent policy advice is that the US should cut spending “right away.”  By contrast, the advice of Reinhart and Rogoff seems to favor inflation and financial repression and, if anything, postponing fiscal adjustment (trim entitlements in the future, but increase infrastructure spending today).  In more far-gone cases like Greece, they favor restructuring the debt.   If the thunderstorm is too severe and the roof is too far-gone to be fixed, it may be necessary to rebuild from scratch.

A new attack on Professor Alesina’s econometric findings comes from an unlikely source:   Perotti, the co-author of the first two of the five articles, has now recanted (2013a, b).    He points out some problems with the methodology (including the papers that Alesina wrote with Ardagna).  Under the dating scheme, the same year can count as a consolidation year, a pre-consolidation year, and a post-consolidation year.   It turns out that some of what have been treated as large spending-based consolidations, though announced by the governments, were in fact never implemented.  Currency devaluation, reduced labor costs, and export stimulus played an important part in any instances of growth, for example, the touted stabilizations of Denmark and Ireland in the 1980s.  His conclusions:  “the notion of ‘expansionary fiscal austerity’ in the short run is probably an illusion: a trade-off does seem to exist between fiscal austerity and short-run growth” and so “the fiscal consolidations implemented by several European countries could well aggravate the recession” (2013b, p.10).   To me, this is a more powerful indictment of the reasoning behind recent attempts at fiscal discipline during recession than is a spreadsheet error or a too-flippant line about Keynes’ sexuality.

References
    Alberto Alesina, and Silvia Ardagna, 1998, “Tales of Fiscal Adjustment,” Economic Policy Vol.13, no, 27, October, 487-545.
     Alberto Alesina, and Silvia Ardagna, 2010,  ”Large Changes in Fiscal Policy: Taxes versus Spending,” in Tax Policy and the Economy, Volume 24 (University of Chicago Press).
     Alberto Alesina, Carlo Favero and Francesco Giavazzi, 2013, “The Output Effect of Fiscal Consolidations,” IGIER, May.
     Alberto Alesina and Roberto Perotti. 1995, “Fiscal Expansions and Adjustments in OECD Countries,” Economic Policy, October.  NBER WP 5214.
   Alberto Alesina and Roberto Perotti, 1997, “Fiscal Adjustments In OECD Countries: Composition and Macroeconomic Effects,”  International Monetary Fund Staff Papers, vol.44, no.2, June, 210-248.
     Francesco Giavazzi and Marco Pagano, 1990, “Can Severe Fiscal Contractions be Expansionary?” NBER Macroeconomics Annual 1990, Vol.5, Olivier Blanchard and Stanley Fischer, editors (MIT Press) p. 75 - 122.
    Thomas Herndon, Michael Ash, and Robert Pollin, 2013, “Does High Public Debt Consistently Stifle Economic Growth? A Critique of Reinhart and Rogoff,” Political Economy Research Institute WP Series 322,University of Massachusetts Amherst, April.
     Roberto Perotti, 2013a,”The ‘Austerity Myth’: Gains Without Pain?” A. Alesina and F. Giavazzi, eds.: Fiscal Policy After the Financial Crisis (University of Chicago Press). BIS WP 362.  NBER WP no 17571.
     Roberto Perotti, 2013b, “The Sovereign Debt Crisis in Europe: Lessons from the Past, Questions for the Future,” Academic Consultants Meeting , Federal Reserve Board , Washington DC , May 6 , 2013.  Bocconi University.
     Carmen Reinhart and Ken Rogoff, 2010, “Growth in a Time of Debt,” AER, 100, May, 573-578.
     Carmen Reinhart, Vincent Reinhart, and Kenneth Rogoff, 2012, “Public Debt Overhangs: Advanced-Economy Episodes Since 1800,” Journal of Economic Perspectives, Vol.26, No.3-Summer, 69-86.

 [Comments can be posted at On Deck of Project Syndicate or on the site of the shortened op-ed version.]

Some prominent institutional bond investors are shifting their focus away from traditional benchmark indices that weight countries’ debt issues by market capitalization, toward GDP-weighted indices.   PIMCO (Pacific Investment Management Company, LLC, the world’s largest fixed-income investment firm) and the Government Pension Fund of Norway (one of the world’s largest Sovereign Wealth Funds), have both recently made moves in this direction.  

There is a danger that some investors will lose sight of the purpose of a benchmark index.   The benchmark exists to represent the views of the median investor dollar.  For many investors, going with the benchmark is a good guideline - especially those who recognize themselves to be relatively unsophisticated and also those who think they are sophisticated but really aren’t.   This is the implication of the Efficient Markets Hypothesis (EMH), for example.  

On the one hand, EMH theorists are often too quick to discount the possibility of ways to beat the benchmark.   To take an example, it should not have been so hard to figure out during the 2003-07 credit-fed boom that countries with high foreign-exchange-denominated debt, particularly in Europe, were not paying a sufficiently high return to compensate for risk.  That mistake described Eastern European countries with low ratios of reserves to short-term debt as well as periphery euro members that lacked their own currency.  It probably resulted from easy money, reach for yield, and pervasive underestimation of risk.  Or, to take another example (admittedly, a tougher call), some of these countries’ deeply discounted bonds would have been good buys in early 2012, after heavy mark-downs.   

On the other hand, most investors would do better if they went with a more passive investment strategy - especially due to high management fees among actively managed funds, exacerbated by excessive turnover.   At a minimum, if one is pursuing an activist strategy such as investing more in low-debt countries, it is helpful to frame it explicitly as a departure from the view of the median investor in order to be clear in your mind as to the nature of the bet you are making.

I can think of four functions of a benchmark index.    First, investors who do not figure that they can systematically beat the median investor need to be able to hold passively a portfolio designed to track a benchmark index consisting median investor holdings.   (See Vanguard.)   The second function is to provide an objective standard by which investors can judge the performance of active portfolio-managers who claim to be able to beat the median investor, within a specific asset class like sovereign debt.  (See Morningstar.)   Third, the same weights that are used in the index can be used to compute an average interest rate or sovereign spread in the market, which can serve as an indicator as to where the median investor is currently, in the risk-on, risk-off spectrum. (See J.P.Morgan’s EMBI — Emerging Market Bond Index.)    

The fourth function of a benchmark index is to help active investors to devise a deliberate strategy to depart from the views of the median investor when they think that the latter is erring in a particular direction.  They may think that the median investor is under-estimating risk in general (spreads too low) or under-estimating the downside in countries with some particular characteristic.   Examples of such characteristics include insufficient currency flexibility, inadequate reserves, too much short-term debt, too much foreign-currency debt, too much bank debt, insufficient openness to FDI, insufficient cost competitiveness, excessive budget deficits, insufficient national saving, political risk, and so forth.

For each of these four functions of a benchmark, the correct way of weighting different countries is by market capitalization.  True, the keeper of the index will need to judge what countries and what bonds are in “the market,” i.e., are fully investable.   But this is true for any index.

The logic behind the movement away from traditional bond market indices is that by construction they give a lot of weight to countries with high debt, some of which may be over-indebted and at risk of default.  At first the logic seems unassailable.  But in theory, if the market is functioning well, it should already have factored in high debt levels:  such countries should pay higher interest rates to compensate for the risk, unless there is some special reason to think they can service their debts easily.

It is important to emphasize that many investors will want to depart from the benchmark in various directions, as indicated under the fourth motive for having a benchmark.  An investor’s belief that countries with high debt/GDP ratios are riskier than the median investor realizes would call for a strategy equivalent to moving from the market-cap benchmark in the direction of the GDP-weighted benchmark.  But one is more likely to think about the strategy clearly if it is explicitly phrased in terms of factoring in debt/GDP ratios, rather than phrased as following a new GDP-weighted index.  Furthermore the phrasing may help an investor realize that he or she might want to modify the strategy if, for example, the country in question can borrow readily in terms of its own currency (think of American exorbitant privilege or Japan’s high domestic holdings of own debt) or if, on the other hand, its debt has a particularly vulnerable maturity or currency structure (think of Hungary).

Investors are reacting to what has turned out to be default risk that was higher than they had expected, among some high-debt countries.  Taking greater note of high debt levels last decade would have warned investors away from countries like Greece and Hungary.   But there is always a danger of fighting the last war.   Middle-income countries have paid down much of their debts over the last decade, attaining debt/GDP ratios far below those of advanced economies.    As the chart shows, major emerging markets have relatively low debts [first bars, for each country] compared to GDP [second bar].  That is, their debt/GDP ratios [third bar] are now much lower than in advanced countries.  (Russia’s sovereign debt is now below 7 per cent of GDP.)  As a result, there is only a limited supply of their bonds left to hold.  If the global investor community switches from market-cap-weighted to GDP-weighted investing, the high demand and low supply of bonds from low debt/GDP countries may drive their interest rates to unnaturally low levels, setting off new credit-fed boom-bust cycles in their economies.  

Of course, as a country’s international debt approaches zero, the keepers of the index might drop it altogether.  But the fall in demand for that country’s remaining international bonds from the investment funds that are following the benchmark could then produce an undesirable discontinuous jump in the interest rate.

Many emerging market countries have paid down debt denominated in dollars or other foreign currencies, while continuing to borrow in their local currencies.  (See the table at bottom.)  Such relatively large countries as Thailand, Malaysia, Indonesia, South Africa and Russia, for example, have little dollar-denominated debt left - 3% of GDP or less (shown in the chart as the dark bottom of each first bar).   If an international bond benchmark is to be limited to dollar-denominated debt, then GDP weights could imply a severe imbalance between international investor demand for these countries’ bonds and the small supplies available. 

Accordingly, local currency denominated debt must be included in the most useful benchmarks.  But then a portfolio reallocation away from traditional benchmark indices such as the EMBI would imply a big shift in allocations away from simple credit risk toward currency risk.   True, the ability of emerging market economies to attract foreign investment in their local currencies represents an important strengthening of the global financial system, relative to the currency mismatch and balance sheet vulnerabilities of the 1990s.  Nevertheless, an investor switching from one “benchmark” to the other needs to be aware of the extent to which the reduction in default risk comes at the expense of heighted exposure to currency risk.

In short, it is not crazy for an investor to depart from the market-cap-weighted benchmark in the direction of putting more weight on debt/GDP countries and less weight on high debt/GDP countries.   But the GDP-weighted index should not be mistaken for a neutral benchmark.

[A version of this post originally appeared at Project Syndicate, Feb. 11, 2013.  Comments can be posted there, or at Seeking Alpha.]

Table:  Sovereign debts as a percentage of GDP

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.]

           After a month of high drama the Senate at high noon today voted to pass a bill to raise the debt ceiling.    How to evaluate this outcome?    If I must give a one-word verdict, it would be “good.”   If I can expand to two words, it would be “not good.”   If I can elaborate to 20 words: “The legislation confirms the sorry state of our public deliberations, but it is probably the best that could be hoped for,” given where the negotiations were as the big hand on the clock approached twelve.

            In what sense was the outcome to the debt ceiling standoff good?   It was much better than a number of alternatives that could have easily happened.  After the pin had been pulled out of the hand grenade, Washington managed to put it back in.   Specifically, it is good that:

• 1. Those who favored a US default — in some cases deliberately, not just as a bargaining tactic — did not prevail.
• 2. Those who sought to force the Congress and White House to go through the madness of voting on the debt ceiling every few months between now and the next presidential election did not prevail.
• 3. The bill’s 10 years of spending cuts are not front-loaded. Frontloading would have substantially raised the chances of going back into a new recession. (So would have default or an uncertainty-maximizing short-term fix.)
• 4. The bill has a mechanism that just might in November demonstrate to the arithmetically innumerate that it is literally impossible to eliminate the budget deficit if the cuts are to come primarily in discretionary non-security spending.  Instead, military spending, entitlements, and tax revenues will have to be part of the eventual solution — as also favored by the American people in polls, even a majority of Republicans. This epiphany on the part of the people who are described as die-hard fiscal conservatives is needed before we can break the political log-jam.  A solution is not possible so long as the extremists are under the mistaken belief that the deficit can be eliminated with cuts concentrated in domestic discretionary spending and so long as they have veto power in the eyes of the Republican leaders.

            The mechanism is to force Congress to confront an unpleasant but clear choice between (i) on the one hand, deep automatic cuts that hit defense, which are anathema to most Republicans, and Medicare, which are anathema to Democrats, and (ii) on the other hand, the more thoughtful recommendations of a bi-partisan Joint Select Committee on Deficit Reduction, which would certainly spread out the pain more to include increased tax revenues, anathema to Republicans, and other entitlement cuts, anathema to Democrats.  The 12-member panel is to report its recommendations in late November, and the Congress is to vote on them in December.  This mechanism is of course crude, but may be just the sort of thing we need to force individual congressmen to confront arithmetic.     
            Some have asked how this panel will differ from the ill-fated Simpson-Bowles commission.   A critical difference is the requirement that the Congress must vote up-or-down on the recommendations.   (This was also a feature of the original version of what became the National Commission on Fiscal Responsibility and Reform; but the provision was voted down by Senate Republicans, including some who had sponsored the proposal until President Obama came out in favor of it in January 2010.)

            In what sense was today’s outcome to the debt ceiling stand-off “not good?”   It would have been better if:

• 1. The Republicans had agreed to some of President Obama’s various compromise proposals over the last year and a half; or
• 2. The showdown had at the last minute forced a “$4 trillion” Grand Bargain in which all sides had ceded ground in order to adopt a workable and credible plan to get back to fiscal responsibility gradually over the coming decade, rather than subsisting on political rhetoric.
• 3. The outcome had included something to help the current faltering recovery.
• 4. President Obama had come off looking like Gary Cooper.

           [Comments can be posted at SeekingAlpha.]

In the 1955 movie Rebel Without a Cause, James Dean and a teenage rival race two cars to the edge of a cliff in a game of chicken.  Both intend to jump out at the last moment.  But the other guy miscalculates, and goes over the cliff with the car.

This is the game that is being played out in Washington this month over the debt ceiling.  The chance is at least 1/4 that the result will be similarly disastrous.    

It is amazing that the financial markets continue to view the standoff with equanimity.   Interest rates on US treasury bonds remain very low, 3% at the ten-year maturity.   Evidently it is still considered a sign of sophistication to say “This is just politics as usual.  They will come to an agreement in the end.”  Probably they will.  But maybe not.   (I’d put a ½ probability on an agreement that raises the debt limit, but just muddles through in terms of the genuine long term fiscal problem.  That leaves at most a ¼ probability of a genuine long-term solution of the sort that President Obama apparently proposed last week - described as worth $4 trillion over ten years.)

My advice to investors is to shift immediately out of US treasuries and into high-rated corporate bonds.  If the worst happens, you will probably save yourself from a big capital loss within the next month.  If not, there is no harm done.

The game is not symmetric.  The Republicans are the ones who are miscalculating.   Evidently they are confident of prevailing:  they rejected the President’s offer, even though he was willing to cut entitlement programs.

The situation is complicated because there are a number of different people crammed into the Republican car.    There is one guy who is obsessed with the theory that, come August 3, the federal government could retain its top credit rating if it continued to service its debt by ceasing payment on its other bills.  But this would mean failing to honor legal obligations that have already been incurred (paying suppliers for paper clips that have already been bought, paying soldiers their wages for last month’s service, sending social security recipients their checks, etc.).  This is like observing that the cliff is not a 90 degree drop-off, but only 110 degrees.   It doesn’t matter: the car would still go crashing into the ocean far below.   The government’s credit would still be downgraded and global investors would still demand higher interest rates to hold US treasuries, probably on a long-term basis. 

There are other guys (and gals) in the car who are even more delusional.   They are dead set on a policy of immediately eliminating the budget deficit (e.g., those opposed to raising the debt ceiling no matter what, or those campaigning for a balanced budget amendment), and doing it primarily by cutting nondefense discretionary spending.  This is literally impossible, arithmetically.  But they honestly don’t know this.   It is as if they were insisting that the car can fly.   Sometimes it can be a good bargaining position to adopt a very extreme position.  But if you are demanding that the car flies, you are not going to get your way no matter how determined you are. 

It seems likely that the man in the driver’s seat - House Speaker John Boehner - does realize that his fellow passengers don’t have the facts quite right.   But there is also a game of chicken going on within the Republican car.  The crazies have said they will oppose in the next Republican primary election any congressman who votes to raise the debt ceiling or to raise tax revenues.   (Yes, they think they would support someone who would eliminate the budget deficit primarily by cutting non-defense discretionary spending; but remember, this is arithmetically impossible.)   The guy who is riding shot-gun in the car - the one who believes the car can fly — is trying to put his foot on top of Boehner’s on the accelerator pedal.   

It seems to me that Boehner, too, is miscalculating.  Given that the car can’t fly, the crazy guy is probably going to oppose him in the primaries no matter what he does.   So I don’t see what his plan is.   But whatever it is, he has made it clear that he doesn’t plan to agree to any increase in tax revenues.   

As a result the Republican leadership is in the remarkable situation of refusing to agree to Obama’s offer to solve the problem so long as the solution includes raising tax revenue, even if it is via such measures as ending distortionary subsidies for ethanol, oil companies, and corporate jets.

If I had to guess:   The financial markets will wake up just before August 3.   US bond prices will finally fall.  The market reaction will shock the Republican leadership into action.  (Precedents include the delayed congressional passage of the unpopular TARP legislation in the fall of 2008 and the delayed passage of an unpopular IMF quota increase 10 years earlier.)   They will finally make the small but necessary concessions on tax revenues.   But by then it might be too late.

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.)]

By now just about everybody agrees that the European bailout of Greece has failed:  The debt will have to be restructured.    As has been evident for well over a year, it is not possible to think of a plausible combination of Greek budget balance, sovereign risk premium, and economic growth rates that imply anything other than an explosive path for the future ratio of debt to GDP.

There is plenty of blame to go around.  But three big mistakes can be attributed to the European leadership.  This includes the European Central Bank - surprisingly, in that the ECB has otherwise been the most competent and successful of Europe-wide institutions.

Mistake number 1 was the decision in 2000 to admit Greece in the first place.   The country was an outlier, geographically and economically.  It did not come close to meeting the Maastricht Criteria, particularly the 3 % ceiling on the budget deficit as a share of GDP.  No doubt most Greeks would agree with the judgment that they would be much better off today if they were outside the euro, free to devalue and restore their lost competitiveness.

The second mistake was to allow the interest rate spreads on sovereign bonds issued by Greece (and other periphery countries) to fall almost to zero during the period 2002-2007.   Despite budget deficits and debt levels that far exceeded the limits of the Stability and Growth Pact, Greece was able to borrow almost as easily as Germany.  Part of the blame belongs to international investors who grossly underestimated risk on all sorts of assets during this period.  And part of the blame belongs to the rating agencies who, as usual, have been lagging indicators of European debt troubles, rather than leading indicators.  But in this case, both groups might justify their attitudes by pointing out that the ECB accepted Greek debt as collateral, on a par with German debt.

The third mistake was the failure to send Greece to the IMF early in the crisis, before Greek interest rates went to 600 basis points (see graph).  By January 2010 the need to go to the Fund should have been clear.  Rather than going into shock, leaders in Frankfurt and Brussels could have welcomed the Greek crisis as a useful opportunity to establish a precedent for the long-term life of the euro.   The idea that a debt problem of this sort would eventually arise somewhere in euroland cannot have come as a surprise.  After all, why had the architects of the Maastricht fiscal criteria and the No Bailout Clause (1991) and the Stability & Growth Pact (1997) written them in the first place?   Skeptical German taxpayers believed that, before the project was done, they would be asked to bail out some spendthrift Mediterranean country.  European elites adopted the fiscal rules precisely to combat these fears.   

When the rules failed and the crisis came, the leaders should have thanked their lucky stars that the first test case had arisen in a country that met two characteristics admirably:   
(i) The Greek government had broken the rules so egregiously and so frequently that one could with a clear conscience judge that a firm stand was merited.  The only alternative was to risk establishing the precedent that even profligate governments can expect ultimately to be bailed out, with all the moral hazard headaches that precedent implies.    (ii) The Greek economy was small enough to make it feasible for Europe to come up with the funds necessary to insulate others who were vulnerable to contagion but not as blameworthy:  banks that hold Greek debt and governments such as Ireland that had tried to follow responsible policies in the period before the global financial crisis.

European leaders also should have thanked their stars that the IMF exists.   Instead of acting as if such a crisis had never been seen before, they should have realized that imposing policy conditionality in rescue loan packages is precisely the IMF’s job.  International politics is less likely to prevent the Fund from enforcing painful fiscal retrenchment and other difficult conditions than it is among regional neighbors or other political allies.   Europe is no different in this respect than Latin America or Asia.  

But the reaction of leaders in both Frankfurt and Brussels was that going to the Fund was unthinkable, that this was a problem to be settled within Europe.   They chose to play for time instead, to treat insolvency as illiquidity.  Against all evidence — despite a decade of SGP violations — they still wish to believe that they can impose fiscal discipline on member states.  Despite two decades in which citizens of Germany and other European countries have expressed clearly that they do not share their leaders’ enthusiasm for Economic and Monetary Union, the latter apparently still wish to believe that further progress to political and fiscal union is possible.  The emu has long since become an ostrich, burying its head in the sand.

It turned out that the German taxpayers had been right all along.   How, in light of that democratic deficit, can anyone think that Europe is ready for a transfer union? 

Next week’s post:   A proposal to avoid future repeats of Europe’s sovereign debt crisis.

These matters were discussed in a session on the Challenge of Europe at the Annual Conference of George Soros’ INET, April 10, 2011.  Video & slides are available, including my own comment.

[Comments can be posted on the Vox.eu site.]

The current economic question is what to do about budget deficits.   The Greek crisis has made sovereign debt a genuine concern even among advanced countries.  (I should say “especially among advanced countries,” because developing countries now have stronger fiscal positions, in a historic reversal of roles.)   At this weekend’s G-20 Summit, Germany and the UK are defending strong fiscal austerity, with language that doesn’t even allow for the idea that short-term spending might be expansionary under severe recessionary conditions such as 2008-09.   In the US, Peter Orszag is reported this week to have resigned as OMB Director, not just to get married, but supposedly in part out of frustration about the fiscal outlook and President Obama’s refusal, as part of any comprehensive deficit correction program, to reverse his campaign pledge against raising taxes on those earning less than $250,000.

American economists have no shortage of ideas for cutting the US budget deficit in the long run, in economically efficient ways.   (Among other steps: limit tax expenditures.)   There are two big obstacles.  (more…)

“Is the recent Return to Saving temporary or permanent?” asks the National Journal .

The famous Paradox of Thrift holds now more than ever: what is good for the individual, and for the economy in the long run — high saving — is bad for the economy in the short run.  During the current worst-post-30s recession we need a boost to demand.   In the longer run we need more saving.

Americans could not have gotten the timing worse. During the three expansions of 1983-2007 the economy grew well, and by the end of the period the first baby boomers had reached their peak earning years. Yet households’ saving rates declined, falling almost to zero in 2005-07.  Meanwhile, the government ran record deficits, reducing national saving even more (in the 1980s and 2000s; the late 1990s saw surpluses). It is ironic that the pro-capital orientation to the Reagan tax cuts of 1981-83 and the Bush tax cuts of 2001-03 was largely sold as an incentive to increase saving and investment, and yet household saving fell sharply subsequent to both policy changes — to say nothing of national saving. The increase in the after-tax return to saving did not lead to a “return to saving.”

The saving rate was so low before the financial crisis that it had nowhere to go but up, even if the timing has been awful. Incidentally, that the first substantial increase in American saving rates in 30 years has come in response to the worst recession in 70 years should put a nail in the coffin of macroeconomists’ practice of lavishing attention in their models on the mathematics of intertemporal optimization.   (But it probably won’t.)

Presumably the magnitude of the current economic dislocation is teaching many blind-sided individuals the value of precautionary saving. We certainly will need further increases in saving as soon as the recession is over. But have we seen a major permanent change in Americans’ anti-saving culture? I fear not. Even now, it does not occur to people that it is desirable to pay cash for auto purchases or other consumer durables, or eventually to pay off their mortgage when possible. Even now, it does not occur to politicians to change the pro-housing bias in the tax law, by eliminating the tax-deductibility of mortgage interest for example.

Moreover, the very first baby-boomers have now started to retire. Increasingly, the higher saving rate of those who see retirement looming ahead (some of whom now “have religion”) will be counteracted by the dis-saving of those who do retire.

The same thing will probably happen in other countries.  Indeed, in Japan, which reached the retirement bulge first, the saving rate fell correspondingly. Europe and China will probably follow. I declare the end of the “global savings glut.”  Real interest rates will have to rise.

[Readers wishing to post a comment are encouraged to go to the versions on the RGE Monitor site or the Seeking Alpha site. ]