End of the Euro?

Standard and Poor's downgraded Spain's credit rating from AA+ to AA yesterday. Less than a day earlier, the IMF grudgingly agreed to more than double the size of its aid package to Greece from $45 million to $120 million. The EU's poorer states declined to contribute to Greece's rescue package leaving the IMF and Germany to cover most of the costs. The problem is: if investors lose confidence in Spain's ability to pay its debts, then its going to collapse in the same way Greece did, but there will almost certainly be no bail out for Spain since its economy is four times the size of Greece's.


What is most disturbing about this development is that Spain was actually an ideal member of the EU, keeping its debts low (in 2007 it had a lower debt to GDP ratio than Germany) and running a budget surplus. Spain's problem was that its economy became too intertwined with the housing bubble. It was receiving huge inflows of capital from the rest of the EU to invest in its housing sector (everyone loves Spanish villas), which pushed up its gdp, but also wages and prices. When the bubble collapsed, output from the housing sector fell with it, but wages remained high (wages are generally not adjustable downward), so output from other sectors was inhibited by these higher labor costs which then resulted in higher unemployement. This then led to decreased consumption (unemployed people don't buy that much) which further reduced output, and obliged the government to enact large social insurance outlays despite the huge hit to its tax revenue.

If the European labor market was more efficient (language barriers tend to prevent workers from moving around very much), then wages would not have risen so much and prices would have remained in check. Right now, if Spain had its own currency then it could devalue it to make its exports more competitive, stimulate its economy, compensate for the lost demand, and bring its internal prices back in line with the rest of Europe. But Spain doesn't have its own currency. It is stuck with the euro, and there is no monetary levers for it to pull. Rather than a quick devaluation, it is going to have to grind through a slow deflationary process as its internal prices gradually adjust.

The larger issue is whether or not other EU member states will see Spain's crisis as a signal of the EU's viability. In good times, European integration has been beneficial to all of its member states, but as the situation in Spain has shown, the integration is neither deep enough to ameliorate the negative effects of powerful macroeconomic shocks nor relaxed enough to let the member states solve their problems by themselves. Europe is stuck in an uncomfortable middle ground between full integration and independence. The only way to prevent future problems is either further integration (which is unlikely; there will not be a United States of Europe in our lifetimes), or the slow process of dissolution. If Spain collapses and the rest of the EU isn't there to lend a hand, then the EU's days are definitely numbered.

IMF Proposes that Governments Tax More

Got a long post today…

The IMF has proposed a series of bank taxes to avoid future meltdowns of the international financial system. Its proposal is basically two pronged: tax financial companies to the extent that they represent a systemic threat to the economy as a whole, and tax excessive profits so that these companies avoid risky investments. The idea has some merit, but it will probably not burst any future bubbles. Market distortions helped bring about the financial crisis, and distorting investment markets further will not provide any remedy.

The road to the financial crisis started with loose fiscal policy in the United States that encouraged home ownership. Since the price of debt was kept artificially low with the help of huge currency reserves amassed by foreign lenders this positive demand shock to the housing market created a positive feedback cycle that culminated in the housing asset bubble. Banks for their part had poorly calibrated risk models and brand new investment instruments that diffused risk as well as responsibility and destroyed information about the composition of their investments. When the asset bubble burst, as they always do, lenders had tied up billions of dollars in houses that nobody could afford and none of the investment banks could tell who owned the bad debt. This caused credit to tighten, which then affected the “real” economy through decreased demand.

I can identify several market distortions in this narrative: fiscal policy to subsidize housing, monetary policy that permitted the amassing of foreign debt, the investment vehicles (derivatives) that destroyed information about debt ownership, faulty risk models, the “too big to fail” strategy of the banks that led them to take on excess debt, and a principle-agent problem between the banks as an institution and their representative agents (their executives).

Levying taxing on banks is very tempting for policymakers right now. Not only is there a lot of political support for it (Tax the rich! They got us into this mess!), but the US, UK and others who are stimulating their economies with aid packages need a way of paying off all their new debt. However, I am firmly convinced that the best solution to this problem will not come through tax laws. Taxes can be evaded, and are subject to too much political jockying. The only permanent and real reforms must come from the industry itself. Banks (as an institution) need to make their executives more accountable for the risks they take, and expend the time and resources to gather proper information about the assets they are buying with their money. Tax laws are not needed for this, though legal reforms making executives more liable for taking excessive risks would definitely be an improvement. This will also help remove the moral hazard of the "too big to fail" mentality. Why would executives care if the government steps in to bail out thier company if they are still going to be held criminally accountable for thier actions? Governments also need to learn the lessons of their own mistakes, and stop relying so much on fiscal and monetary policy to achieve political goals (this will also have the duel affect of reducing public debt).

As for preventing any and all future bubbles… that’s not going to happen. Liberalizing investment means giving agents the latitude to make risky decisions, and every once in a while those risky decisions will agglomerate into an asset bubble. Shocks and volatility are the costs of having free markets. If you don’t like bubbles, you shouldn’t be a capitalist.