Ben Bernankepoulos mets Erskine Fatas
Antonio Fatas debates Paul Krugman. Fatas noted that there is limited evidence that using the Euro is correlated with extreme economic distress. Krugman argued roughly that there is a strong theoretical presumption that the Euro is the work of the devil. Fatas praised Krugman’s unshrill analysis and then chose to debate his basic claim. This is not, in general, a good idea. In this case it is a terrible idea.
2. Ben Bernankepoulos.
Here is my second scenario: let’s have a Euro periphery country leave the Euro (or never join) and have monetary policy follow the policies that Ben Bernanke has followed in the US (bring interest rates down to zero, aggressive quantitative easing).
And what would happen to capital flows? It is likely that capital will flow out of the country, given that the country started with a current account deficit this would be a problem (dealing with a sudden stop is never easy). If debt is denominated in foreign currency the situation could be dramatic (as in the Asian crisis in the 90s). But even if debt is denominated in local currency there is still an issue: there is the need to finance a current account deficit and in the absence of capital inflows it would lead to a collapse of internal demand. Yes, exports might be increasing but it is hard to see that this adjustment would be fast enough to compensate for the immediate correction required given the lack of funding. Unless the rest of the world is happy holding more of our currency, in which case we can finance our expenditures via monetary expansion.
My reaction (toned down to be polite) is WTF ?!?! How the hell does this happen ? Here the idea is that a country whcih has been running a current account deficit suddenly can’t anymore so the sudden increase in netx eports causes “a collappse of internal demand” Well there is an alternative “Unless the rest of the world is happy holding more of our currency, in which case we can finance our expenditures via monetary expansion.” What ??? What does the rest of the world have to do with anything ?
Fatas asserts as plainly obvious that in a closed economy expenditures can’t be financed with monetary expansion. He gives no hint to an explanation of why this might be.
Here is a sincere attempt to try to figure out what he was thinking. German banks have been loaning money to Greece buying Treasury bonds and loaning to Greek banks which loan to other Greek entities. Then they suddenly stop. Ben Bernankepoulos has no way to replace the demand for Greek Treasury bonds or the supply of laons to Greek banks, because Central Banks don’t have discount windows and can’t conduct open market operations.
Well that didn’t work very well. OK the problem is that if Bernankepoulos creats DRachmas out of nothing to buy bonds and loan at a low discount rate, then no one will have any faith in the Drachma so it will lose value both compared to other currencies and compared to goods and services. The appraoch of making sure that a loss of international confidence doesn’t cause a recession will cause inflation. And central banks can’t allow inflation, because Bernankepolous is like Bernanke except that he doesn’t have a dual mandate.
To go on, in the real world, inflation accelerates when economies are overheated. Between recession and accelerating inflation there is a sweet spot of neither. Yes if we assume rational epectations, then the loss of confidence will worsen the inflation unemployment tradeoff (inflation need not continuously accelerate but it should jump up and stay high). I don’t believe this for a second, but will assume for the sake of argument that, given the sudden fiscal dominance (need to monetize the national debt) expected inflation will jump up and either actual inflatoin will jump too or unemployment will rise.
So ? Fatas didn’t write that with a loss of confindence a country must accept high unemployment or high inflation — he said the country must accept high unemployment.
Fatas is a very smart and, until now, always very reasonable economist. What happened ? I speculate fter the jump.
1. Esecially if it has debt denominated in foreign currency but … One possible explanation of the post is that Fatas is thinking of the cases of non Euro countries which have suffered sharp recessions following a speculative attack. He notes that the state or the state and private entities had foreign currency denominated debt. He guessed that is a difference in degree not in kind. He might also consider countries which were on the gold standard or had pegged exchange rates which suffered heavily before they abandoned those policies. These are countries which were determined to treat their debt as if it were foreign denominated.
2. Confusion of cause and effect. the loss of confidence often follows disastrous economic performance (I’m thinking of Russia). Things are not good about when foreign investors decide to get out.
3. Good news is no news. The rapid recoveries which followed crises in say Agentina or Malaysia didn’t get a lot of attention.
4. Short run long run equivocation. Pumping up the money supply can’t work forever. It leads to hyperinflation and low demand for real balances. In the medium run, wild money printing implies low not high seignorage. But the problem was that trade flows change slowly compared to capital flows. I think Fatas is saying that there is a short term problem which can’t be solved, because the proposed solution isn’t a long term solution.
5. Whatever happened to IS_LM. In the IS-LM framework recessions occur because full employment would imply saving greater than investment — output has to fall to reduce national saving. Fatas says a recession occurs because national saving suddenly has to increase. This strikes me as utterly crazy.Now it is true that most macroeconomists don’t think of IS curves at all. It is also true that the old Keynesian flow of funds models fit the data very well while modern DSGE models can be fiddled with one free parameter per summary statistic to be fit.
I think a good rule for macroeconmists is always apply the following procedure
1. Try to expalin you argument with model including an IS curve some monetary policy rule and some sort of Phillips curve (rational expectations augmented if you want).
a) you can feel reassured
b) If you can’t try to exlain why the IS etc model is not a useful approximation to the actual economy. Note “it isn’t even taught in good departments” is false as a claim of fact and not a statement about economies. lso find a historical example in which anyone was lead astray by the IS etc approach (and provide quotes and cites from the person who was lead astray not from someone else who says, long after the alleged straying, that it is well known that this happened).
c) if you can reconcile your argument with the IS curve or explain why it won’t fit the data this time, then you may avoid embarrassment by not admitting that you applied the proposed procedure. But don’t skip it, because otherwise you are likely to make a fool of yourself.
Of couirs there is a simpler pair of rules
1. Paul Krugman is almost always right
2. If Paul Krugman just wrote something which you are sure is nonsense, consult rule number 1.
It seems to me we don’t even need a model to see that Fatas is wrong.
There were five EU countries with exchange rate pegs in the run up to the crisis: Bulgaria, Denmark, Estonia, Latvia and Lithuania. The four largest CA deficits in the EU in 2007 were in Bulgaria, Estonia, Latvia and Lithuania (the BELLs). The four largest CA reversals from 2007 to 2010 were also in the BELLs. The three largest declines in RGDP relative to trend in the EU were in the Baltic States.
The Andrew Rose study includes 83 countries that were “Hard Fixers” at least part of the time from 2006 to 2012, and yet he concludes here is little difference in the macroeconomic outcomes of fixed and floating exchange rate regimes, during the recent crisis. In the case of the EU this is clearly not the case.
The countries with floating exchange rates were the Czech Republic, Hungary, Poland, Romania, Sweden and the UK. Sweden had a large CA surplus in 2007 and continued to have one in 2010. Of the rest, Hungary, Poland and Romania had large CA deficits (3% of GDP or more) in 2007. By 2010 only Romania’s was still large. Nevertheless the CA reversal in these three countries was less than a third of the size of the BELLs. The decline in RGDP relative to trend in the six “floaters” was on average less than half as large than the five “fixers”, with Sweden having only a mild recession and Poland being the only country in the EU that did not have a recession at all.
Now it seems to me that the huge CA reversals suffered by the BELLs was symptomatic of the huge decline in nominal GDP in those countries. Had they depreciated their currencies like the six “floaters” did relative to the euro between July 2008 and February 2009 (Poland depreciated the most, or by about 30%), this would not have happened.
So one merely has to open one’s eyes and observe that Fatas has this precisely bass ackwards.
Thanks for the comment full of valuable information. It corresponds to my vague impression (partly just from living in a Euro using Med country with terrible GDP and employment performance). Also nice to find that there is someone with whom you disagree even more than you disagree with me (it’s at least a tie).