Thursday, June 24, 2010

Reply to ls: We are not really apart, yet ... (amv)

Too much time has passed since my last post. Opportunity costs are quite high at the moment. Sorry for that.

This post provides an answer to ls and his take on Chicago's John H. Cochrane, who has stepped into the debate on the Greek sovereign debt crisis in the WSJ. To keep it short, I concentrate on what I consider to be the marginal differences in our views. It must be noted that we share much common ground. For one, I totally side with Buiter and Sibert that the "Eurosystem's Treatment of Collateral in its Open Market Operations Weakens Fiscal Discipline in the Eurozone" However, small deviations in theoretical interpretation often leads to wide differences in policy conclusions.

First, I do not see Cochrane making the points rejected by ls. I guess this is the core of ls's argument:

"Therefore it's not relevant whether a Greek default is a systemic event in a quantitative dimension; it's relevant whether the market considers is as one."
Maybe, but why should the market consider a problem as relevant, if simple reasoning can show that it is not? It seems that in such a case someone could make a lot of money, while others may lose control over resources due to their bad choices. Usually, arguments that rely on "trust" rest on some kind of reciprocity in the formation of expectations. Thus, even if a single agent knows the fundamentals of the underlying decision-problem, his optimal response may deviate from the socially optimal answer as far as he takes into account the fears, whims, and passions of other market participants, who in turn react strategically as well. But this understanding of financial markets as prone to animal spirits and driven by self-fulfilling prophecies leaves out an important aspect on which Cochrane's arguments heavily relies and which ls seems to overlook: Whereas markets are always imperfect (note that perfection is defined by the complete and competitive Arrow-Debreu economy which is no real alternative) there is always room for strategic behaviour, sunspots, and some kind of mania. The best thing we can do is to impose an institutional setting that to some extent neutralizes the impact of diverse fricitions on the market process. So I agree with ls on the description of the problem faced by monetrary policy given the institutional context of discretionary choices:

"We all don't know what would have happened to the interbank and bond markets without this consensus. But it's plausible to assume that the market sentiment would have been severely affected which might have led to a evaporation of both market and funding liquidity."
Sure, but why are expectations not anchored by sound policy? We are in times of institutional change, rapidly converging to a transfer union, so the debate is not restricted on the pragmatic choices of policy, but also on its long-run direction. Institutions are to some extent policy variables and we all know that if institutional settings are reliable and in harmony with economic reasoning, speculation fosters stability. We know that if this is not the case and policy tends to ignore or even overrule economic laws, speculation will sweep away such institutions and thereby reveal the flaws in political decision-making. Milton Friedman once wrote a defence for such destabilizing speculation. It is the end of a lie, not the beginning of a problem. It comes as no surprise that politicians are eager to blame the markets. I think ls should address the following problems:

What kind of rules of the game and what kind of policy commitments leave expectations unanchored and fundamentals ineffective in the selection process called 'competition'? Why do agents generate sunspot equilibria, and much more importantly, why does the institutional setting not rule them out over time?

On all this, Cochrane is quite explicit:

"The problem isn't liquidity, psychology or speculators. Germany and France simply cannot borrow or tax enough to cover Europe's debts and looming deficits. So, barring a fiscal and growth miracle, we will either see sovereign defaults (larger and more chaotic for having been postponed) or the ECB will have to print euros to buy worthless debt, leading to widespread inflation."
Thus, no kind of market psychology can undo the real problems of the European debt crisis, which are quite obvious indeed. Further:

"Notice who is missing: Greek bondholders are not being asked to miss a single interest payment, reschedule a cent of debt, suffer any write-down, take a forced rollover or conversion of short to long-term debt, or any of the other messy ways insolvent sovereigns deal with empty coffers. Those who bought credit default swaps lose once again."
How should the market mechanism work, if we do not allow it to learn? Bailing out decision-makers prohibits the anonymous updating process called "the market system" (which is much more important than individual learning routines. Proper institutions coordinate even agents with zero-intelligence following a purely random choice process). A transfer union is the worst case scenario, because it restricts learning routines to political processes. Substituting the wisdom of Merkel, the chutzpah of Sarkozy, and the incentives of Berlusconi for the market process seems to be a pretty bad idea. I wouldn't put my two cents on such a politically dominated system. Would you? Cochrane goes on:

"We're told a Greek default would imperil the euro. The opposite is true. Allowing Greece to default, or to renegotiate with bondholders, would be the best way to save the euro. A currency union is strongest without fiscal union."

"But the euro will be a disaster as a monetary union with loose fiscal controls and constant speculation about willthey-or-won't-they (or can-they-or-can't-they) trillion-euro bailouts and ECB financing. The Europeans have found the worst possible combination."
"The euro founders should have said instead, "Go ahead, use our currency if you like. Rack up any debts you want. We don't care, because we are not going to bail you out—we've set it up so we can't bail you out. Bond buyers beware."
"Any "contagion" here is entirely self-inflicted. If everyone knew there wouldn't be bailouts there would be no contagion."

"If Greece had sold long-term debt, there would be no sudden crisis. In all the talk of restructuring euro finances, nobody is talking about forcing governments to borrow long-term, nor of managing the crisis by forcing short-term debth olders to accept new long-term debt rather than cash."
Bailouts are no short-run solutions that give us time for proper long-run reforms of European institutions. They rather directly impair the long-run health of our communities. Not a transfer union, but a union based on standardized and thus transparent bankruptcy rules backed by a more reliable and transparent liquidity provision by the central bank is the right way out. Thus, the single major difference between ls and me is that he takes the institutional context (which is co-determined by policy) as given in his evaluation of the market process, whereas I see the institutional setting as the major problem (including the decision to target inflation rates, not some initial price level as well as its growth path).