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.]

       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.)]

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.]

         December 31 is technically the end of the first decade of the 21^st century.  It is perhaps an appropriate time to review one’s predictions.    It seems to me that I got some things right over the last decade.  Indulge me while I review the predictions that came true, before turning to those that did not work out as well.

Stock market peak     At the end of the 1990s, I felt that the dizzying ascent of equity prices could not continue into the new decade, that there was “…a bubble component in the stock market”  (Nov. 20, 1999).   This was four months before the bubble burst in 2000.  So far so good.

The Euro        Also at the start of the decade, I thought the european currency was undervalued.   My prophesy: “… there will be a major appreciation of the euro against the dollar” (June 21, 2000).  Over the next eight years the euro in fact rose 60% in value.    (But ”I don’t mean to express an optimistic forecast regarding European economics or governance…. Europeans have made many mistakes, the leaders and public alike.” 2006.)

TIPS           I recommended Treasury Inflation-Protected Securities to my blog readers, early in what turned out to be a period of steep rise in their value.  (Feb. 2009.)

            The big economic story  of the decade of course was its second recession, the worst in 70 years, and the severe financial crisis that caused it.    A number of economists got important parts of the 2007-09 crisis right ahead of time (although nobody got all of it right).   I give credit in particular to Krugman, Shiller, Gramlich, Rajan, Borio and White at the BIS, Rogoff, and Roubini.  A 2009 paper identifies 12 commentators as having warned that the US housing market would end in a serious recession.

What parts of the crisis did I get right?

Severity of recession             After the tax cuts of 2001 and 2003, I predicted that spending growth and deficits would rise rather than fall, and that the legacy of high debt would mean that the next recession would be longer and more severe than past recessions:

 ”Good economic logic does not support the idea that Bush fiscal policies caused the weak economy of the last three years. Good economic logic supports, rather, a causal link between Bush fiscal policies and the next recession. The future downturn is likely to be far worse than the recent one…They also created long-range uncertainty that makes planning difficult (nobody from either party expects the relevant tax law to remain as it is currently written)… It is impossible to say when the next recession will come. But when it does, it is likely to be worse than the 2001 recession. Why? Precisely because we will enter it at a time when the budget deficit and national debt are already alarmingly high…Thus when the next recession hits, we will not have luxury of being able to cut taxes and increase spending as George II has done. … The resulting pain will make the economic travails of George II’s first term pale in comparison…”  (Oct. 30, 2003.  Also Dec.2003 and Nov.2004).    
That seems to me precisely what has happened.

Budget deficits   At the start of the decade:  “We need to think about using our budget surplus to provide for the retirement of the baby boom generation, not to blow it on a big tax cut” (May 16, 2001).  But of course the Administration chose the latter policy.   Like many others, I continued throughout the decade to warn that fiscal policy was irresponsible.  The “White House forecast of cutting budget deficit in half by 2009 will not be met,” and “Further, the much more serious deterioration will start after 2009.”  (May 24, 2006.)   Indeed.

Market underestimation of risk        I was dubious of the “Great Moderation.”   By 2006, I was warning frequently of serious risks facing the economy, arguing that even though the odds of each sort of possible setback were small in any given year, the cumulative probability that at least one of them would hit the economy over the next couple of years was relatively high.  (May 24, 2006.)  The markets were underestimating this risk:
 ”How can the implied volatility in options prices be so low?  Perhaps investors are judging risk solely from the statistics of recent history, and not from a forward-looking open-eyed consideration of the risks facing the global economy.”  (Nov. 2006.)    “The implicit volatilities in options prices are substantially too low, and will rise.  … market estimates of risk are lower than they should be.  … the market is basing its perception of risk on recent history, not on a forward-looking assessment of the risks facing the US and global economies.    Such risks include further falls in housing or rises in oil, a hard landing for the dollar, and geopolitical risks arising from the Middle East.”   (Jan.12, 2007. And again, May 14, 2007.)     
The VIX (the CBOE index of market-expected volatility) was close to 10 when that was written.  It was to go as high as 80 when the full financial crisis hit in 2008.

The carry trade “should be reversing.” (Jan.12, 2007.)    Market perceptions of risk had “fallen to irrational lows, as reflected in the low interest rates at which governments of developing countries, unqualified American homebuyers and high-risk businesses could borrow money.” (Nov.19, 2007, and Jan. 2008.)   

International crises    When asked “Have financial developments made the International Monetary Fund obsolete?” my answer was “The IMF is by no means obsolete. …. It is foolhardy to think, just because emerging market spreads have been very low recently, that there will be no more crises in the future.”    (March 1, 2007)   I identified Hungary and other Eastern European countries as particularly vulnerable.  (Jan. 2008.)

The coming financial crash       The comments I made at a Cato conference held in November 2006, shortly before the sub-prime mortgage crisis hit in 2007, look good now:

 ”The Greenspan Fed probably erred by providing too much liquidity in 2001-2004….If the Fed erred in keeping interest rates so low so long after the 2001 recession, what cost are we paying? None yet; but dangers lie in the future. It is not that I am especially worried about inflation at the moment. … what cost do I fear might come from the extraordinarily easy monetary policy of 2001-04? As the Bank for International Settlements points out, some of the biggest financial crashes and some of the longest recession periods have followed liquidity-fed booms that never did show up as goods inflation, but rather as asset inflation…”     (In Responding to Crises, Cato Journal, Spring 2007.)

Housing          Of the various asset markets, housing was the area where policy had most clearly gone awry.    I had long thought “that some people were being pushed to buy houses who couldn’t afford it, that (mirabile dictu) there was such a thing as too high a rate of national homeownership, and that the default rate would shoot up as soon as real interest rates rose or house prices stopped rising.”   (March 26, 2007.)    “Many people bought houses they could not afford unless prices continued to rise rapidly or real interest rates remained extraordinarily low, which predictably did not happen.”  (April 28, 2007.)     

The start of the recession     “[A]t the time of writing [Jan. 2008], the United States appeared to be poised on the brink of recession….A coming recession may be more severe and long-lasting than the last one in 2001….”   By May 2008 I had figured out that a recession was indeed probably underway– at a time when some Administration officials were still ruling it out and indeed GDP figures appeared to show positive growth in the first part of that year.   

Banking crisis resolution       When the Obama Administration announced its revised form of the Bush Administration’s Troubled Asset Relief Program, I argued that maybe they actually knew what they were doing and that the plan should be given a chance to work.  (March 23, 2009.)  I felt pretty isolated.  Others attacked the plan, from both left and right.  They expected Tim Geithner’s stress tests to be phony.  The critics were sure that the taxpayer would end up paying hundreds of billions of dollars to bail out the banks.  They wanted either to nationalize the banks or leave everything to the free market.  As things developed, however, financial collapse was averted without nationalization and the banks have since repaid the Treasury with interest.   

The trough      Financial markets stabilized in the first half of 2009.  Turnarounds in the rates of growth and job loss led me to believe in the summer of 2009 that the economy had probably hit bottom by then.   This turns out in fact to have been the case: The record shows that the recession ended that June.

Predictions gone wrong          Needless to say, I got plenty wrong in the decade as well.   For one thing, I kept expecting U.S. long-term interest rates to rise, because of the alarming long-term fiscal profile. Yet the bond market correction never came.   For another thing, based on econometric estimation of reserve currency holdings, Menzie Chinn and I projected that the euro might eventually rival the dollar in international currency use by 2015 or 2022.    It now seems unlikely.   I certainly thought that the sort of financial crisis that began in the U.S. in 2007-08 would be accompanied by a fall in the dollar.  Yet flows into the U.S. showed that the dollar is still a safe haven.  For this reason I abandoned my euro-bullishness, even before the mismanaged Greek crisis in early 2010.

My most spectacularly wrong predictions were all in the area of politics.  I had thought that if any presidential candidate gained the White House without winning the popular vote, his entire term would be consumed by divisive efforts to reform the Electoral College.   (This did not happen after January 2001.)   I had thought that if a high-casualty international terrorist attack hit the U.S. (September 11, 2001), American foreign policy would thereafter become ruled less by jingoism and more by expertise.  (Not!)   In 2008 I suspected that a Democrat who was perceived as a northern liberal could not be elected president.   (Wrong again.)  

In the coming decade, I resolve to eschew political forecasts, and stick to economics.

[Comments can be posted on the Belfer site.]

 
The members of the eurozone and the EU have apparently decided that they must heroically rescue Greece, that this is better than having the IMF do it.   Senior figures in Brussels feel that the latter alternative is unthinkable.   I am a little confused about why.   Martin Wolf writes in the Financial Times this week that to bring in the Fund  ”would demonstrate that this is not a true union at all.”    But the EU and EMU and not true fiscal unions.  If the citizens of Germany and other more successful countries were willing to bail out the Greeks, then fine;  the EMU would be ready to be a fiscal union.  But they are not; so it is not.   Given that reality, what is wrong with something that “demonstrates” it?

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