Friday, December 10, 2010

Follow up on Eichengreen (amv)

This post builds on the Eichengreen-paper introduced by ls (see below). I totally agree with Eichengreen as quoted by my fellow colleague. Eichengreen points to a major inconsistency in contemporary policy. Given the Eurosystem as it exists today, and thus the necessity to substitute internal for external devaluation, it is impossible to equilibrate imbalances and to protect claim holders at the same time. Internal devaluation necessitates haircuts!

Imbalances are unstable and some mechanism will inevitably correct them. We have no choice and must cope with this fact. Throwing good money after bad only sustains ill structures and accelerate adjustment costs. Usually, external devaluation is the mechanism that minimizes the costs of adjustment, which sustains the structure of production somewhat, but which of course doesn't eliminate the need for haircuts (since old claims have to be denoted in the new, weaker currency). Within the Eurozone we have to rely on changing relative prices and the associated reallocations of resources. To the extent weak members cannot produce more preferred commodities, or cannot produce the same commodities in a more efficient way, they must forego nominal and real income on their factors invested such that the tax base erodes (this is the case, since capital imports weren't used to import investment goods that enhance capacity, but wasted on foreign consumption goods or driving up domestic prices). Either way, prohibiting haircuts of €-denominated claims in face of adjustment processes must result in accelerating debt crises in fiscally weak Euromembers.

The point is that punishment of claim holders is a crucial aspect of this equilibrating process, as is the reward to those who hold claims to more useful economic activities. This relative asset-price adjustment on financial markets is an integral part of the general process of correction (often neglected in policy debates): control is taken from bad-decision makers and given to those, who invest in more preferred and thus more profitable processes - including government activities that rely on the capital market. In concrete, those who financed the activities of the Greek government should face a haircut, while those who have financed the activities of the German government can and should sell their bonds at profit.

Most importantly, this mechanism is automatic (the invisible hand at work, if you wish). There is no need for political decision-making to mimic the market process. Since policy discriminates against private institutional solutions to bankruptcy, the best it can do is to provide some feasible procedures itself. Yet, policy usually steps in to counteract the laws of markets. E.g., haircuts are countered to protect important hubs in the financial system, those institutions that are 'too big to fail'. For this reason Fama suggests heavy equity requirements for such big players (up to 40-50%!): because large institutions put the entire system at risk, investments in largeness should become increasingly risky as well, such that the design of incentives imposes sufficient constraints on dangerous activity (this, of course, comes at costs in terms of economies of scale which are presumably small).

There is, however, another reason why policy attempts to counter market forces, beyond the concern with financial fragility (BTW, you detect such attempts whenever you hear politicians lamenting over 'speculation' and undertaking measures to fight it.): governments are interested in protecting the owners of their debt. As vote-maximizing actors, politicians try to evade the uncompromising and incorruptible constraints imposed by financial markets on reckless spenders by shifting the burden of adjustment to succeeding generations. You remember, "in the long run we are all dead". Now this long run has become the present for some members of the Eurozone. Contemporary Greece, for instance, suffers from the fiscal sins of past administrations. The necessary adjustments have already grown to extremely high levels. Without allowing Greece to exist the Eurozone, such adjustments will continue for many years, if the population is willing to accept the burden.

Yet, European rescue packages continue the old habit of postponing (and thereby accelerating) adjustment costs. Transforming Europe into a gigantic transfer system is a most outraging attempt to neutralize market operations. The problem is that a complex adaptive systems like the economy cannot be managed other than by price signals which decentralize activity (and spreads on European bonds due to speculation are an integral part of the price system). Thus, we have to rely on the autopilot! Imposing a transfer union is like turning off the autopilot of a plane that you cannot fly. A bad idea for sure.