Monday, December 17, 2012

Lack of progress in Macroeconomics

In today's Financial Times, an article by Jeffrey Sachs presents all kinds of arguments to conclude that Keynesian economists have been wrong during the crisis, that fiscal and monetary policy tools have not worked and that the US and other advanced economies need a different kind of policy (education, infrastructure,...).

The issues raised are complex and there will always be a debate on the mix of economic policies that are right to help growth in a given circumstance. But the article does two things which are difficult to justify: first it reaches conclusions about what we have learned without citing any proper empirical evidence (the "it is so obvious" syndrome). And, second, it presents arguments which are inconsistent. Let me take on both of these issues separately.

The article argues that Keynesian policies have not helped and cannot help in the current economic environment. This has been and still is a debate where one needs to go to the data and come up with some clever way to produce a proper test. Jeffrey Sachs knows this and opens up his argument by saying:


Yes, empirical tests in macroeconomics are challenging. But then he says


Is that a test? Is this the counterfactual that was so difficult to build? That was easy!

And if you want to know what is the cause of low economic growth in Europe, it is not austerity:

"The crisis in southern Europe is often claimed by Keynesians to be the consequence of fiscal austerity, yet its primary cause is the countries’ and eurozone’s unresolved banking crises."

I wonder what type of counterfactual he built to reach this conclusion.

And as it is also obvious that austerity is not responsible for the UK slowdown, it is all due to

"the eurozone crisis, declining North Sea oil and the inevitable contraction of the banking sector"

That was another quick conclusion to reach.

Let me move now to the second point I wanted to make, one of inconsistencies in the logic used. The article criticizes monetary policy for ignoring the risk that current low interest rates might be creating another bubble. Here is what I find interesting: the only mainstream models that I know where monetary policy can affect real interest rates are Keynesian models (the ones he is criticizing). It is only in models where prices are sticky that you have the central bank, who sets the nominal interest rate, having an effect on the real interest rate and economic activity. But even in these models, this effect is transitory. As soon as prices adjust, real interest rate go back to equilibrium, out of control of the central bank.

The narrative that suggests that the Federal Reserve is responsible for low interest rates since 2003 is not supported by any economic model I know. The drift in real interest rates that we have witnessed for more than 10 years has to be more fundamental than a switch to expansionary monetary policy.

And nothing more fundamental than supply and demand which in this market is represented by world saving and investment. It is well documented that there has been a significant shift in global saving during the last decade. One that justifies the global imbalances that we have witnessed and also the fact that global interest rates have decreased. And after 2008 a global crisis that resulted in yet another increase in the supply (saving) and a decrease in demand (investment) has brought these rates to even lower levels. Central banks are not responsible for this trend. And if you do not believe in Keynesian models they cannot be even responsible for the small movements around the trend.

Economists will never agree on everything and the excuse we (economists) have is that it is impossible to build empirical tests that definitely prove or disprove alternative theories. But we can do better than this article. We can at least build on a set of knowledge that is commonly accepted rather than reopening the debate starting from zero whenever we want to make a clever or controversial point.

Antonio Fatás

Wednesday, December 12, 2012

The confusing identity once again

One of the first concepts taught in any macroeconomics course is the identity that links the financial balance of the private sector, the financial balance of the government and the current account (which is the financial balance of the country as whole). In a closed economy the financial balance of the private sector has to be equal in size to the financial balance of the government but with the opposite sign. I find this identity very powerful when I teach my students as it links concepts that are normally seen as independent by those who have never studied macroeconomics before.

The identity is also a great source of confusion when it is used in a dynamic setting, to understand growth. For example, there are those who wrongly claim that this identity shows that government deficits cannot create growth because by definition the private sector would be saving every dollar that the government spends. This is wrong.

Via Mark Thoma I land on this interview published in Business Insider of Jan Hatzius (Goldman Sach's  chief economist). Most of what I read in the interview is fine but I find, once again, that the identity is being misused to understand growth. Here are a couple of paragraphs from the interview:

"...every dollar of government deficits has to be offset with private sector surpluses purely from an accounting standpoint, because one sector’s income is another sector’s spending, so it all has to add up to zero."

This is only correct if we assume that the economy is closed, but that's not the point I want to make.

"That’s the starting point. It’s a truism, basically. Where it goes from being a truism and an accounting identity to an economic relationship is once you recognize that cyclical impulses to the economy depend on desired changes in these sector's financial balances. If the business sector is basically trying to reduce its financial surplus at a more rapid pace than the government is trying to reduce its deficit then you’re getting a net positive impulse to spending which then translates into stronger, higher, more income, and ultimately feeds back into spending."

This paragraph is misleading (I will ignore again the fact that in an open economy things are more complex). It states (at least this is the way I read it) that growth depends on the "desired changes in these sector's financial balance". This is not correct. I can imagine an economy where those financial balances are not changing at all where output is growing very fast (and I can also imagine another one where output is collapsing). There is no connection between growth and these financial imbalances. As long as demand (private or public) is feeding into production and income, the private or public sector might be spending more than last year but their income is also increasing which can make the financial balance remain at the same level as before.

If we believe that we are in a situation where the output gap is large, there are unused resources and, as a result, output is determined by demand, what matters for growth is whether demand increases relative to last year and not so much the change in the desired changes in the financial balances of either the private or public sector.

Antonio Fatás

Sunday, December 9, 2012

A narrow definition of supply

Economic debates are many times portrayed as a fight between economists who think that demand defficiency is the main cause of economic crisis and those who believe that what really matters is the supply side. In the current crisis we had the camp that saw the crisis as mainly a cyclical phenomenon and advocated for policies to increase demand and those who saw it as an outcome of excessive spending, whose effects could only be addressed by structural policies that improve the productive capabilities of a country.

Portraying economists as falling in each of these two camps is an oversimplification. Most economists in the profession recognize the important of structural reforms and improving the supply side of an economy. In fact, all economists I can think of when they write or teach about growth in the long term they talk about how a country can improve its productivity, effort, capital stock, all of them variables that are associated to the supply side of an economy (the assumption is that demand adjusts at the same time as production feeds into income and then expenditures).

What I find interesting is that the consensus that supply (incentives, productivity, innovation) drives output and welfare in the long run is then used in the political debate to push the argument that small governments and low taxes are the only sensible economic policy (at any point in time). And any argument in favor of higher taxes or a stronger roles for governments is dismissed on the grounds that it will create massive distortions and low growth.

Best way to find the extreme use of this simplifying argument is the definition of "Supply-Side Economics" that one can find at the Laffer Center (for Supply-Side Economics):

"Supply-side economics emphasizes economic growth.."
So far so good, we all like higher economic growth
"...achieved by tax and fiscal policy that creates incentives to produce goods and services." In particular, supply-side economics has focused primarily on lowering marginal tax rates with the purpose of increasing the after-tax rate of return from work and investment, which result in increases in supply. The broader supply-side policy mix points to the importance of sound money; free trade; less regulation; low, flat-rate taxes; and spending restraint, as the keys to real economic growth.  These ideas are grounded in a classical economic analysis that understands that people adjust their behavior when the incentives change.  Accordingly, the lower the regulatory and trade barriers, and the lower and flatter the tax rate, the greater the incentive to produce."
Why the focus on tax and fiscal policy or marginal tax rates or restrained spending? What about other institutions, rules, incentives that can affect growth? What is surprising is that the academic literature that has explored the determinants of economic growth finds limited support for many of these variables as key determinants of differences in growth rates across countries. Other things such as investment, education or innovation matter much more. And while one can argue that these variables themselves could be ultimately driven by taxes, the evidence is once again very weak on inexistent.

The point is not that taxes do not matter when it comes to economic growth but that the oversimplification that makes supply side = small governments and low taxes seems to miss many of the variables that the academic literature identifies as determinants of growth, some of which could require a larger and not a smaller role for governments and regulation.

Antonio Fatás

Wednesday, December 5, 2012

The defeat of the Euro bond vigilantes?

Paul Krugman has written many blog posts downplaying the fears of a sudden increase in US government bond interest rates (what he calls the invisible bond vigilantes). Despite continuous warnings by some market commentators about the risk of high inflation and the possibility that investors start dumping US government bonds, interest rates on these bonds have gone in the opposite direction and are now lower than when some of these fears were first expressed.

In Europe the evolution of interest rates for governments bonds has been very different with several countries seeing very high levels and in some cases no access to funding. The fear was due to probability of default and potentially an exit from the Euro area, not so much inflation. But after a volatile period and following the statement of Mario Draghi supporting the Euro (no action yet) and the more recent agreement for funding for Greece and Spain, interest rates are coming back to levels which are not far from the historical average during the Euro period (and significantly lower than what these countries faced before joining the Euro).

Below are 10-year government bond rates for Spain and Italy.

Rates remain higher than the low values of 2006 but they are at levels which are not far from what we had seen in the early years of the Euro. Of course, this does not mean that the level of confidence is the same as those years, for that we want to measure the premium relative to German bonds, where we will see higher levels. But, at the same time, what matters for sustainability of government debt is the interest rate that a government pays and not its relative value relative to other countries.

There is still plenty of uncertainty in both of these countries and I am almost sure we are not done with swings in confidence and some negative surprises but it is good to see that, at least measured by these rates, there is a growing sense of stability in financial markets.

Antonio Fatás

Tuesday, December 4, 2012

Planning for (fiscal) miracles









Antonio Fatás

Sunday, December 2, 2012

The wrong benchmark for tax rates

The New York Times presents a comparison of average tax rates since 1980 to make the argument that most taxpayers in the US face lower taxes today that back in 1980. Greg Mankiw does not like the fact that they link the year 1980 to Ronald Reagan's policies as instead he picks the end of Ronald Reagan's second term.

It is important to look at the evidence on how tax rates have changed but what should be the benchmark here? Should we be alarmed if were to find that tax rates have gone up in the last decades? Should we be pleased that tax rates have gone down?

Governments need to raise revenues in a way which is consistent with their levels of expenditures. Their level of expenditures is determined by political choices (demands for services that are provided by governments) combined with the efficiency that governments have at providing those services. It is impossible to make a general argument about the need for governments to become smaller or larger over time unless one is willing to provide the details on what are the services that should or should not be provided by the government or what are the efficiency gains that could be achieved. It is only after those arguments are presented that one can talk about whether tax rates should be flat, increasing or decreasing.

One thing we know is that some of the services that we ask governments to provide, are becoming more expensive over time. In particular, if we look at health care we all are interested in buying more of these services and when we buy them, their cost is growing faster than inflation. As a result, when we look at health care expenditures as a % of GDP, they keep increasing. And this has nothing to do with governments. I produced the chart below in an earlier post that shows how the share of health care expenditures in private consumption has increased dramatically over the last decades (US data).

Given the above trend and given that healthcare expenditures represents a large share of total government expenditures in advanced economies, it should have not been a surprise to see that governments are becoming larger and that, as a result, tax rates are going up. That is the benchmark against which we need to compare the data, not one with a constant tax rate.

Antonio Fatás

Monday, November 26, 2012

Ignorance as an excuse

Via Greg Mankiw I read a response to the argument by Peter Diamond and Emmanuel Saez that the top marginal tax rate in the US should be raised to about 73%. I do not want to enter into the substance of the debate but instead discuss the logic used by the criticism of Diamond and Saez work.

The authors of the response present a contrast between the willingness of Peter Diamond to offer a concrete policy recommendation with the answers that two other Nobel Prize winners (Tom Sargent and Chris Sims) gave after receiving their prize. When asked in 2011 what should the government do to help growth, Sims answered:

"I think part of the point of this prize in the area that we work in is that answers to questions like that require careful thinking, a lot of data analysis, and that the answers are not likely to be simple. So that asking Tom [Sargent] and me for answers off the top of our heads to these questions — you shouldn’t expect much from us."

And when asked for a specific policy conclusion he added:

"If I had a simple answer, I would have been spreading it around the world."

The authors praised Sims' answers as the "model of how academic economists should behave when facing questions about specific policy." I find this to be an odd and depressing conclusion as it portrays a very pessimistic view on what academic economists should (can) do. I understand that some of what we do as academics is not useful enough for policy makers, and in these circumstances is better to be honest and stay out of the debate. But as Sims points out in his statement, one can find answers to those questions after careful thinking and a lot of data analysis. That's what Diamond and Saez have done. One can disagree with their analysis but one cannot simply disregard it because they are academic economists.

The authors of the response then go into the details of the analysis and they present their arguments on why the calculations of Diamond and Saez are wrong. But when presenting their arguments they protect themselves from criticism by saying that they do not have an answer to this policy question: "if we had a simple answer we would be spreading it around the world". Although "they can be pretty sure that the answer if significantly lower than 73%". Isn't this a simple answer? Or maybe the fact that they are not willing to provide a number but a range ("significantly lower than 73%") makes it a complex answer?

There is no simple answer to the question of what should be the top marginal tax rate. But policy makers need to chose a number, not a range. Diamond and Saez presents their arguments and data analysis in a way that is at least as competent as any other analysis on the same subject. They can be criticized on their assumptions or calculations but not on their willingness to advance the knowledge on an issue of great policy relevance. If any, they should be praised as academics who want to go beyond writing great papers to make those papers useful for policy makers or society at large.

Antonio Fatás

Wednesday, October 17, 2012

Semantics and the Debt Burden





The lack of consensus in this particular debate is much more about semantics that about disagreements on how the economy works. My reading of the debate is summarized well by Noah Smith long list of updates to his blog entry. In particular the following question: is government debt an indicator of the (fiscal) burden we are imposing on the next generations? And the answer is a clear no. Debt does not matter. What matters is taxes and spending, debt is just a vehicle to deal with imbalances between the two. Debt is not a burden per se but it can be the outcome of tax and spending decisions that lead to redistribution of resources.

We can construct examples where a government with high debt levels is not imposing any costs on future generations. We can also construct examples where a government with very little of no debt imposes large burden on a given generation (tax everyone under 50 and give the revenues as a transfer to everyone over 50).

And while seeing these debates come back without a resolution is frustrating, the advantage is that I can cut and paste below a longer and more detailed post that I wrote last time the debate happened. Just for those who still want to read more about it.

Antonio Fatás


(Repost) Debt does not matter. Spending and taxes do.

Monday January 2, 2012.

Paul Krugman makes the point that government debt matters less than most people think because in some cases we simply owe money to ourselves. He is right and what he has in mind is the notion that government debt is (in many countries) mostly held domestically. Japan is an extreme case where more than 90% of the government debt is held by its nationals but even in the US the majority of government debt is held by US citizens or institutions. For some it is debt but for others it is an asset, they cancel out from a national point of view.

We can think of an extreme case where government bonds are held by all taxpayers in proportion to their income - in a way that mimics tax rates. In that case, government debt is not imposing a future burden on anyone, it simply cancels out with the assets that all investors/taxpayers have.

How do future generations enter into this analysis? What if we try to pass the bill to future generations? Let's start with the case of a closed economy/system. In a closed system (the world, no international trade or capital flows) the debt that the current generation has will end up in the hands of the future generation in one of two ways: either it gets simply passed to the next generation as a bequest or, alternatively, the current generation could try to sell their assets and spend all their wealth if they do not want to leave a bequest to their children. But the debt must be bought by someone. And given that this is a closed economy, it can only be bought by the future generations. In both cases the bond holders are also the taxpayers.

If we bring other countries into the picture then the analysis is different. The government debt that other countries hold is a claim on our current and future income and as such it is a financial burden that either the current generation or the future one will have to pay for. But Krugman's point, which is correct, is that many make the mistake of assuming that government debt is equivalent to external debt and they overestimate the burden that it imposes on a country.

Let's go back to the case of a closed economy: is it really true that debt does not matter? Not quite, because there are distributional issues of two types: first there is no perfect match between bond holders and taxpayers so it is not quite true that we owe money to ourselves. Some citizens owe money to others. The second distributional issue is about generations and here we need to go back to the example above to understand how difficult the analysis can get. The best way to understand the argument is to stop talking about debt and talk about spending and taxes, which is what really matters. A government spends some income today (builds a road, provides health services to the population). It decides not to tax anyone but instead it issues debt bought by the current generation. The government decides that it will only pay back the debt in the future when it raise taxes on the next generation, not the current one. Are we passing a burden to the next generation? It all depends on what the current generation does. If they decide to spend all their income and leave no bequests for their children then the answer is a clear yes. The current generation enjoyed services that they did not pay for themselves and did not compensate the next generation in any way for the future taxes they will have to pay. Just to be clear, the future generation will be holding the debt that the previous generation sold to them when they were spending their inheritance, but this is not a transfer of resources, the asset was sold at market price. So the fact that in the future bondholders are also the taxpayers does not mean that we are not passing a burden to the next generation.

There is a second scenario where there is no burden passed to the next generation. It can be that the current generation is responsible, understands that the government is asking future generations to pay for the goods and services that they enjoyed and they decide to leave a larger-than-planned bequest to their children so that they have resources to pay for all the taxes (you can think about the bequest being the government debt itself). In this case no burden is passed to the next generation.

This simple example (*) makes it clear that answering the question of what distributional impact government debt has across generations requires an understanding of the patterns of spending, taxes and saving of different generations. What matters is not debt but who enjoys the spending that the government does and who pays for it. Debt is just a vehicle that can be used to transfer resources across different individuals or generations. Debt is not a problem, the problem, from a generational point of view, is the potential mismatch between spending and taxes (even if future taxpayers are also the holders of government bonds when they are paid back).

(*) The example ignores many issues: the type of goods government buy, the possibility of default, the possibility of crowding out (government bonds displacing other forms of saving),...

Wednesday, October 10, 2012

Coordinated Fiscal Contraction

The new issue of the IMF fiscal policy monitor is out. As usual, a great reading to understand the state of fiscal policy in the world. There are many issues I could highlight from the report but here is one that caught my attention: below is a summary of what fiscal policy has been doing since 2009.

The red dot in the chart represents the change in the cyclically-adjusted primary balance as a % of potential GDP in advanced economies during the period 2009-13. This variable is the best way to capture discretionary fiscal policy, as the balance is adjusted by the cycle and we use potential output (instead of output) to avoid the ratio to be influenced by cyclical variations in GDP (the blue and yellow columns just show how much of the action comes from expenditure cuts of increases in taxes).

Not only we see a majority of countries reducing budget balances (a coordinated fiscal policy contraction) but the numbers are extremely large. Greece is an outlier (16.3%), but many others are large (Spain, Portugal and Ireland close to 10%), the UK around 7% and a significant number of countries around 4%.

How this coordinated fiscal policy contraction is affecting the pace of the recovery (or the likelihood of another recession) depends on your views on the fiscal policy multipliers (see my previous post), but what remains a fact is that the amount of coordinated fiscal policy contraction during the current cycle is  very large and I doubt that we can find a similar experience in any of the previous recoveries.

Antonio Fatás

Monday, October 8, 2012

Underestimating Fiscal Policy Multipliers

The October edition of the IMF World Economic Outlook is out with very strong warnings about risks to growth (full report can be found at the IMF web site). In Chapter 1 there is a nice analysis about whether in our most recent growth forecasts we have recently underestimated fiscal policy multipliers. Quoting from that chapter:

"With many economies in fiscal consolidation mode, a debate has been raging about the size of fiscal multipliers. The smaller the multipliers, the less costly the fiscal consolidation. At the same time, activity has disappointed in a number of economies undertaking fiscal consolidation. So a natural question is whether the negative short-term effects of fiscal cutbacks have been larger than expected because fiscal multipliers were underestimated."

And the answer is yes and here is my reading of what has happened. About eleven years ago there was a series of academic papers that estimated fiscal policy multipliers. The conclusion of the earlier papers is that multipliers were somewhere in the range 1-1.5. In other words, a 1% increase in government spending raised GDP by somewhere between 1% and 1.5%. This was the conclusion I reached together with my co-author back in 2001 (paper is available at my web site).  This was also the conclusion of the paper written by Oliver Blanchard and Roberto Perotti written around the same time and available here. The academic literature on this issue grew very fast with a large number of papers confirming the earlier estimates but also with a set of other papers that challenge the size of fiscal multipliers. In particular, papers that used events such as wars tended to find smaller multipliers. Because this is about fiscal policy, the debate has not gone away and there are still those who believe that multipliers are close to zero or even negative (i.e. when public spending goes up, private spending goes down by the same amount).

Despite the debate, my reading of the literature up to that point was that there was a significant amount of consensus around multipliers being around or slightly above 1.

As soon as the 2008 crisis started the debate went from a simple academic discussion to an urgent policy issue. What will be the impact of fiscal stimulus? The Obama administration produced a report (co-authored by Christina Romer) that suggested multipliers around 1.5 to justify the need for fiscal policy stimulus. These multipliers were criticized by those who believed that there is no room for aggregate demand management even in the presence of a large crisis. Since then the debate has become much more ideological than academic. We have had a series of additional academic papers that, if any,  suggest that multipliers are even larger than the initial estimates because of the special circumstances we are in (monetary policy stuck at the zero-lower bound and a deep recession caused by develeraging forces that reduce private demand).

But these new (and old) academic results have simply be displaced by the ideological debate that followed the fiscal policy stimulus of the 2008-2009 period, which somehow led to the conclusion that those policies did not work and that what we now needed was more austerity. And when over the last two years we forecasted GDP growth rates in the face of coordinated austerity by many governments we somehow forgot to consider that multipliers can be large.

This is what the IMF suggests now in their analysis, which, by the way, is also self critical. They look at their recent forecasts for global growth and they suggest that their model was implicitly using fiscal policy multipliers around 0.5 when measuring the impact of fiscal consolidation. Given that their GDP growth forecast has been overestimating growth, the IMF now wonders whether multipliers are higher than 0.5. The analysis in the current World Economic Outlook suggests that multipliers might be within the range 0.9 to 1.7. A range which happens to be very almost identical to the one produced by the early papers and confirmed by the most recent academic literature. It is also not far from what most economic models would predict given current economic conditions.

Antonio Fatás

Monday, October 1, 2012

Cyclical Zombies

Stephen Roach argues in this article that the "current medicine being applied to America's economy" is wrong. The real disease is a "protracted balance-sheet recession that has turned a generation of America’s consumers into zombies – the economic walking dead. Think Japan, and its corporate zombies of the 1990’s. Just as they wrote the script for the first of Japan’s lost decades, their counterparts are now doing the same for the US economy".

This is an argument that has been used before during the current crisis: we are trying to fix a structural problem with medicine that can only deal with cyclical misalignments. Using Roach's words: "Steeped in denial, the Federal Reserve is treating the disease as a cyclical problem – deploying the full force of monetary accommodation to compensate for what it believes to be a temporary shortfall in aggregate demand."


Antonio Fatás

Wednesday, September 19, 2012

Can you Spare a Few Trillion?

Most governments in advanced economies have been unable to deliver on debt sustainability for the last decades. In some cases increasing spending is not matched by their ability to find additional sources of revenues, in other cases taxes have been reduced without the corresponding reduction in spending. And it will only get worse going forward as worsening demographics will put enormous pressure through the corresponding increase in spending. 

As we can see in the US presidential race, solutions are not easy to find. Everyone talks about finding a sustainable path for the government debt but details on how this will be achieved are difficult to find. This is probably more obvious in the case of Mitt Romney and his promise to cut taxes. This is only compatible with debt sustainability if you find enough spending items in the budget to cut, but that is where the difficulty lies. Societies ask governments to provide certain services that are considered to be necessary. Yes, we can make governments more efficient and eliminate some unnecessary bureaucrats but when you look at the numbers, this is not going to be enough - in some cases there is very little margin to reduce spending if you just follow that route.

Here is a picture from the US that makes this point as clear as possible. Government spending on pensions and healthcare (medicare and medicaid) from 1972 until today and then extrapolated to 2030 (source: Congressional Budget Office).

What is striking about this picture is not so much the shape but the magnitude of the increase. From 4% of GDP in 1972 to about 10% today and reaching 14% in 2030. This is measure as % of GDP (not % of government spending). In the absence of a reduction in spending in some other budget items, this has to be met by increasing revenues (taxes) by a similar amount. 

This looks like an impossible task. But let's try to look at it from a different angle to see if we find a solution. Forget about governments, imagine a world where all goods are purchased by the private sector (e.g. you pay for your own healthcare). Because of changes in taste, income and technology, we continue spending more on certain sectors (such as healthcare). We have satisfied all our basic needs (food, housing), our income keeps increasing and there is a technology out there that allows us to live healthier and longer so we choose spending more on it. Sectoral changes in the composition of our spending are not rare. How visible is the above trend if we look at consumer expenditures? Do we also see a large increase in healthcare spending in the private sector? And, more interestingly, are there other components that are going down at a similar speed to ensure that budgets are not overstretched? 

Here is a quick look at Personal Consumption Expenditure by type of good (Source: Bureau of Economic Analysis). I picked the sectors that have moved the fastest and I particularly looked for two moving in opposite directions. 

This is what you find: Healthcare is the fastest growing component and has gone from 4% in 1960 to 16% today (this is measured as % of the total expenditures). The component that follows the opposite trend and almost by the same magnitude is Food and Beverages. From 18% down to 8%. So we spend less in food and beverages to be able to afford the increasing cost of going to the doctor more often and enjoying a healthier and longer life.

In some sense we expect governments to do one of these two things:

1. Either they find some spending in their budget that we do not want anymore and they reduce as fast as healthcare and pensions public spending is increasing.

2. Or they do simply pass the bill to the private sector (you will need to pay for those doctors). But if they do so, then the private sector will need to find something else to cut.

What we have seen is that #1 is not obvious. There are not that many things that governments do that we do not want them to do. And #2 is exactly what politicians do not want to do (and we do not want them to do it), to pass the bill to us in the form of higher taxes - and I am ignoring here the question of who exactly gets the bill. So we end up with debt levels that keep increasing and will do so until we find a way to deal with long-term sustainability of government finances that is very different from what we have done in the past.

Antonio Fatás

Thursday, September 13, 2012

QE3 and the Fed Dual Mandate

The US Federal Reserve just announced the third round of quantitative easing (QE3) by signaling a commitment to keep rates low for a long(er) period of time and engage in additional purchases of assets at a rate of $40 Billion a month.

Reading the press commentary on this move I can see once again the difficulty in making strong and clear economic policy decisions to end the crisis. I do not want to discuss in this post the potential effects of QE3 but simply the way it is being interpreted in the context of the mandate of the US Federal Reserve.

Let me take an example from this morning's Financial Times: John Authers starts the front-page commentary by saying
"The Federal Reserve did not need to do this. Its dual mandate, to ensure full employment and combat inflation pointed in different directions. Political pressure against taking action (...) was intense".
At the end of the column, after reviewing the decision of the Fed, the author concludes that the weak US data and the fact that fiscal policy will not do much about it forced the Fed to move
"That is why, by default, the Fed felt it had to do this."
Notice the different choice of words for the two sentences. The article opens up with the statement that the Fed did not need to do this and then it tells a story of why the Fed felt it had to do it (even if they did not need to do it?).

The dual mandate of the US Federal Reserve is as explicit as it can be even if the precise definitions of full employment and price stability can be open to interpretation. Imagine that inflation had been higher than the implicit or explicit Fed target for several years with an economy at full employment. Would we be saying that the Fed does not need to raise interest rates? No. We would be screaming for the Fed to raise interest rates as aggressively as possible.

The US economy has now been producing at a level which is clearly below its potential for the last four years. The unemployment rate is at levels that are higher than any sensible estimate of the natural unemployment rate. To make matters worse, inflation and inflation expectations have been consistently below the Fed target. How do we go from here to the conclusion that "they did not need to do this"? I can imagine a discussion on the effectiveness of additional quantitative easing measures. Will they have an effect on output and employment? I can see a debate on this question but not on one about the need to find additional ways to effectively stimulate the economy.

Antonio Fatás

Thursday, September 6, 2012

Why not Earlier?

Mario Draghi presented yesterday one more plan with great promises but short of details (as usual) to save the Euro. Markets are happy, but will this plan follow the fate of the previous announcements? Will the excitement die out in a matter of weeks or days?

The ECB is now finally sending a strong message that they will do whatever it takes to defend the Euro. In many ways this is a game changer and it is difficult to understand why this was not done earlier. When we think about monetary or fiscal policy as stabilizing tools we see them as forces that can make recessions shorter and recoveries stronger. Clearly what we have seen in the last years is a slow moving process towards the inevitable solution, the only way this crisis could be resolved.

Did it really take that long for the ECB and European authorities to realize that this was necessary? Or was this a strategic move to push countries to do reform? My guess is that there is some truth in both. Even today some still believe that ECB intervention is a bad idea. And it is also quite possible that from the beginning some understood that this move had to happen but they wanted to wait until things got worse to extract concessions from the other countries before saying yes.

Will the positive effect of this announcement vanish with time as it has happened with some of the previous ones? I doubt it, there will still be swings in the market mood but this time it can be different. The nature of unlimited intervention by the ECB to support the Euro is very different than any of the previous vague statements about creation of bailout funds without real support and no details on when and how the money would be disbursed. Here we have a statement from the central bank saying that they will do whatever it takes to keep the Euro alive and that they are willing to fight market distortions on bond yields (this is always a very risky statement to make for a central bank).  The same way the Swiss Central Bank has been successful in its recent effort to stabilize the Swiss Franc or the same way the German and French central banks managed to defend the French Franc / German Mark exchange rate during the crisis of 1992/93, central banks can be very powerful when they want.

Of course, the statement of Mario Draghi was very carefully drafted with strong references to price stability and sterilizations of interventions. If this signals a strong level of disagreement within the ECB, one that could potentially lead to an institutional crisis if the plan needs to be implemented at a large scale, then there is a risk that the announcement will not be effective. But it is hard to imagine this scenario. If the announcement has been made it must be that there is enough political support within the ECB (and the Euro area governments) to make this a reality, if necessary. And the beauty of credible statements of unlimited support is that they might work even if the ECB never has to intervene in bond markets.

Antonio Fatás

Monday, August 27, 2012

Excess Reserves Explained

I have written before about the confusion that exists in the press about the interpretation of the excess reserves that commercial banks currently hold at central banks as money that is being "parked" there as a safe investment. The level of reserves is ultimately determined by the Central Bank as it decides on the optimal size of its balance sheet.

A recent post (via Mark Thoma) at the Federal Reserve Bank of New York presents this argument in detail.
"The language used in the press and elsewhere is often imprecise on this point and a source of potential confusion. Reserve balances that are in excess of requirements are frequently referred to as “idle” cash that banks choose to keep “parked” at the Fed. These comments are sensible at the level of an individual bank, which can clearly choose how much money to keep in its reserve account based on available lending opportunities and other factors. However, the logic above demonstrates that the total quantity of reserve balances doesn’t depend on these individual decisions"
The full post is required reading for those who want to understand how the level of excess reserves is determined.

Antonio Fatás 

Thursday, August 2, 2012

Draghing their feet

Mario Draghi disappointed markets yesterday by not offering a clear commitment to any concrete policy action to resolve the turmoil in European financial markets. Nothing new: the inability of European policy makers to resolve the crisis continues as markets keep going back and forth between excitement and depression.

My reading of his statements (a few days ago) and yesterday is slightly different and possibly more optimistic. Mario Draghi has made very concrete statements about what the ECB is willing to do that go beyond what was said before. In particular, what I heard yesterday is that

"Risk premia that are related to fears of the reversibility of the euro are unacceptable, and they need to be addressed in a fundamental manner. The euro is irreversible."

These are strong statements in support of the Euro (not that surprising) but also about mispricing of certain risks in bond markets (this is more surprising). Some are disappointed that he only talks about risks related to the reversibility of the Euro and not about default risks, but central bankers need to choose their words carefully. It would be difficult to expect from a central banker an explicit statement about specific country default risks.

He was also as explicit as one can be about intervention in bond purchases:

"The Governing Council, within its mandate to maintain price stability over the medium term and in observance of its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective. In this context, the concerns of private investors about seniority will be addressed. Furthermore, the Governing Council may consider undertaking further non-standard monetary policy measures according to what is required to repair monetary policy transmission. Over the coming weeks, we will design the appropriate modalities for such policy measures."

These are strong words and open the door for a more flexible discussion on seniority of debt. Less concrete than what some wanted but they clearly signal further actions in the coming weeks.

Some found it surprising that he established a connection between ECB actions to involvement of EFSF/ESM.

"The adherence of governments to their commitments and the fulfilment by the EFSF/ESM of their role are necessary conditions."

This is not ideal but understandable. Fundamentally, the Euro/EU area has a very complex set of institutions. They might play a role in certain occasions but when it comes to reacting quickly to economic events they are slow (very slow!). The EFSF/ESM were created to deal with economic circumstances like the ones Europe is going through. Some national governments would love to see the ECB intervening in financial markets to reduce their risk premium without having to involve any supervision from European authorities. But the political reality is that intervention by European institutions requires some risk sharing to be successful. And risk sharing requires some recognition that we are all in the same boat and as such the decision on the directions in which the boat has to go have to be made together. If the disagreements about these directions are that strong, then the Euro project is bound to fail.

Compromises are necessary on all sides. Some need to understand that sharing risks is the only way to move forward even if it exposes them to loses on debts originally accumulated by other countries. And those countries which are being helped need to acknowledge that the help comes with a price and certain amount of interference in internal political decisions. This has proven to be a very tough dialogue among all European countries where blame should be assigned to all parties involved (how much blame you assign to each party is another issue...).

I do not expect miracles going forward but I see progress on several fronts: the words by Draghi yesterday are reassuring and bond yields in Spain or Italy are under pressure but contained. To find an exit we are waiting for more actions and they will require additional dialogue between all governments involved and a sense of even larger compromise than what has been agreed so far. Progress will be painfully slow and costly but at least we are moving in the right direction.

Antonio Fatás

Thursday, June 7, 2012

The Difficulty in Accepting "Discretionary Stabilizers"



Antonio Fatás

Monday, June 4, 2012

Fiscal Federation or Fiscal Policy







Antonio Fatás

Friday, May 25, 2012

With or Without the Euro

UK GDP contracted faster than previously announced in the first quarter of 2012. What would the evolution of GDP have looked like during this crisis if the UK had been part of the Euro area? Impossible to tell as we cannot do a proper counterfactual exercise. But here is a potentially interesting comparison: the evolution of the UK and Spanish economies since the beginning of the crisis.

Spain and the UK are both large (by European standards) economies. Both of them started the crisis with current account deficits and suffered a real estate bubble prior to the crisis. There are, of course, differences: the UK financial sector is larger than that of Spain; the real estate bubble was larger in Spain,... But the difference that tends to be highlighted more by economic commentary is the Euro membership. Spain could not depreciate its currency as the UK did, Spain cannot resolve its government debt problems by relying on its central bank, and Spain could not lower the interest rate to zero as the UK did. Are these factors visible in the evolution of GDP from the beginning of the crisis to today?

Not obvious. If we take the end of 2007 as the beginning of the crisis, real GDP is today at the same relative level in both economies. The UK suffered more in the first quarters and then recovered. The Spanish economy was doing better earlier and then fell faster. Since the second quarter of 2010 both economies have been moving in parallel.

This is clearly not a scientific proof that Euro membership has not made a large difference (I am not controlling for all the other factors). But at a minimum, it raises questions about the statement that membership in the Euro area is a key factor to understand the performance of Euro members during the crisis.

Antonio Fatás

Tuesday, May 22, 2012

Ignore Competitiveness?

Wolfgang Munchau in the Financial Times argues that competitiveness is not the real problem of Southern Europe and that internal devaluation is not the solution. Paul Krugman disagrees with him and argues that the evidence is clear:

1. Prior to the crisis, inflation was higher in Southern Europe.
2. These countries displayed large current account deficits, a sign of an overvalued real exchange rate.

I have presented arguments before that support Wolfgang Munchau's conclusions. Let me repeat some of the arguments and show additional evidence.

Unit labor costs grew faster in Spain or Greece or Italy than in Germany. But Germany was the outlier here. The behavior of unit labor costs in some of the countries in Southern Europe was not too different from that of France or the Netherlands. Here is a chart from an earlier post.

It is correct that Greece, Spain and Ireland saw higher increases in unit labor costs during the 10 years of the Euro. But the difference is small compared to France or the Netherlands. For example, comparing Spain and the Netherlands the difference is about 5 percentage points over a decade. This is not a large number given how volatile exchange rates are. 

Estimates of unit labor costs are very imprecise and maybe they are not capturing the true loss in competitiveness of these economies. So why don't we look at the outcome? What about the current account balance? Countries like Spain or Greece run large current account deficits during these years. Isn't this a proof that they had lost competitiveness? Possibly, but there are other potential explanations for a current account deficit, such as an increase in spending fueled by a real estate bubble. It is not clear how to tell the two stories apart but here is a piece of evidence that I find useful. What happened to exports in Spain during all these years? If the story of lack of competitiveness is true one might expect that exports did not behave well during this decade as unit labor costs grew too fast. But the data reveals the opposite pattern. Compared to France or the UK (just to pick an outsider), Spanish exports grew faster during the last 10 years.

Does it mean that competitiveness is not a problem? No, but it might be a small factor compared to many other factors that have led these economies to the crisis. And if this is true, focusing on internal (or external, via exit from the Euro) devaluation as the solution to the crisis might distract us from dealing with the real issues.

Antonio Fatás 

Sunday, May 6, 2012

Germany and the Benefits of the Euro

Since the launch of the Euro, there has always been a question about the benefits that Germany could enjoy of sharing a currency with other countries. While for the other countries (the "periphery") the benefits in terms of credibility and stability of a strong currency were obvious, for Germany the benefits were simply the additional trade integration that the Euro would produce. Some believed that this benefit was too small to compensate for the potential risk of being part of a club with riskier countries. The current crisis has provided arguments for those who believed that Germany should have never been part of the Euro.

There is, however, a different perspective of the first 12 years of the Euro when looking at the performance of the German economy. During those years Germany managed to engineer a reduction to its relative labor costs that paid off in terms of increasing exports, a large surplus in the current account and faster GDP growth. A model that some see today as an example for others to follow. As Paul Krugman has pointed out several times, this model cannot work for everyone, not all countries can run current account surpluses!

In his most recent article Paul Krugman argues that the current German model needed the Euro to work. Germany had tried to keep labor costs under control in the past but without success. The launch of the Euro locked the exchange rate and sent capital flows to the periphery producing inflation in those countries. Even if German inflation was still positive (so no painful disinflation), there was an inflation gap with others, one that allowed Germany to be more competitive as the periphery became less competitive.

Quoting from Krugman's article:

"Or to put it differently: Germany believes that its successful adjustment was the result of its own virtue, but in reality it was successful in large part because of an inflationary boom in the rest of Europe. And here’s the thing: the Germans are now demanding that the European periphery replicate its achievement (and actually surpass it, because the required adjustment is much bigger) without providing a comparably favorable environment — they’re demanding that Spain and others do what they never did, which is deflate their way to competitiveness."

The corollary of this argument is that Germany benefited from the Euro in a way that was not expected at the time when it was launched: by allowing an increase in competitiveness relative to the other Euro members.

I agree with this argument but I think that there is part of the story that is missing. Not all other members of the Euro area had high inflation. Let's compare Germany to France.

Since the launch of the Euro unit labor costs in France increased faster than in Germany. By the way, France resembles many of the other "periphery" countries in terms of unit labor costs, as I have discussed earlier. Here is the early chart.

But France did not lose competitiveness through higher inflation. Prices in France and Germany behaved in a similar way, there was no inflation gap.

So in the comparison between France and Germany the story above does not seem to work, adjustment did not come from inflation in other countries but by the relative control of wages in Germany (relative, of course, to changes in labor productivity and all of this relative to French wages). But here is where I the Euro could still have played a role: when Germany had its own currency, it was very difficult to engineer a "competitive devaluation". Reductions in wages or prices could easily be compensated by a stronger currency (the German Mark). This might run contrary to our intuition that competitive devaluations are easier with flexible exchange rates. For a country very committed to keep inflation low and a strong currency, it is difficult to deliver a competitive devaluation through monetary policy. But once the exchange rate is fixed, a combination of control on labor costs and the inflation that was generated in some of the periphery countries finally allowed Germany to produce a reduction in unit labor costs and growth via expansion of exports. And that is how Germany benefited from the Euro.

Antonio Fatás

Monday, April 30, 2012

Euro and US Coordinating Austerity

To add yet one more perspective on how significant the shift to austerity among advanced economies has been since 2009, I decided to add the Euro series to a chart from Paul Krugman's blog. This is real government consumption for both the US and the Euro (17 countries) area.

It is remarkable how the Euro area and the US display a strong coordinated contraction in fiscal policy starting in the first quarter of 2009 that accelerates during 2010 and 2011. This has come at a time when advanced economies (and the world) were starting a recovery from a very deep recession. No surprise that the recovery is not going as well as some thought and some countries are going back into recession.

Antonio Fatás

Thursday, April 26, 2012

Ideology and Facts in the Economic Policy Debate

The fact that ideology matters in the economic policy debate should not be a surprise to anyone. But the influence that ideology has has in some of the economic analysis we have seen since the beginning of the financial crisis has led to completely contradictory statements about the facts behind the causes and potential remedies to the crisis.

Via Greg Mankiw's blog I read a strong criticism of the Obama administration written by James Capretta. Quoting from his article:
When he (Obama) came into office, he favored a massive injection of new government spending into the economy in the name of “stimulus” — counter-cyclical federal activity aimed at offsetting depressed consumer demand emanating from a recession-battered private sector. The net result provides little if any boost to aggregate demand because the states — and to some extent private citizens — simply pocket the federal money and reduce their deficits and debts. Meanwhile, what federal taxpayers get is a permanent increase in the size of government.

We have all heard similar statements before which tend to be supported by references to $800 billion to $1 trillion stimulus packages and bailouts both in the US and Europe.

But have we really see an unusual expansion of government size? Quite the contrary. As I argued in a previous post, what we have seen during the current crisis is exactly the opposite. Relative to previous crisis government spending has been growing at a much slower rate this time. Paul Krugman makes an even more interesting comparison in blog, a comparison that reveals how inaccurate the above statement is. He compares government employment under the Obama administration to the Bush and Clinton administrations. The Bush administration is probably the most relevant comparison because it also started in the middle of a recession. Here is the chart from Krugman's analysis.

The data speaks for itself. 40 months into the Obama administration, the number of government employees (all levels of government) has gone down by 600,000. During the Bush administration the number had increased by about 700,000. A difference of 1.3 million. So where is the increase in government size?

Antonio Fatás

P.S. A few months ago I wrote a post with almost the same title discussing the mistaken view that some economists have of the link between taxation and labor market outcomes in Europe - another debate that seems to be heavily influenced by ideology and not enough by facts.

Friday, April 13, 2012

Convergence in US-EU labor markets

Out of the many signs that the US economic recovery is not as strong as previous ones, the variable that possibly best demonstrates the weakness of the recovery is the stagnant employment to population ratio. This ratio summarizes two labor market variables: the unemployment rate and the participation rate. A declining ratio indicates that out of the available population, we are using fewer resources either because workers cannot find jobs (high unemployment rate) or because they are giving up and leaving the labor force (low participation rate). The current level of the employment to population ratio in the US remains at a very low level (by recent historical standards) and has not increased since the recovery started. This behavior is very different from what we have witnessed in previous recoveries.

The dynamics of the employment to population rate are not just cyclical. We have seen several interesting trends over the last years which can possibly explain the abnormal behavior during the current crisis. Albanesi, Sahin and Abel provide an in depth analysis of the dynamics of the US labor market during recessions. The authors argue that some of this difference can be explained by the different behavior of he female and labor force participation rates as well as demographic factors. I am borrowing the picture below from their analysis showing how the employment rate is much flatter than in any previous recovery.

Their analysis provides a good amount of detail regarding the US labor market, but how does it compare to other countries?

In the charts below I compare the behavior of the US labor market to the European Union labor market (I chose the 15 countries that formed the European Union in 2002 a smaller group that the current 27 members).

The overall employment to population rate (for the population between 15 and 64 years old) in the EU has been converging to that of the US. This convergence started after 1995. In the US we see a stable ratio prior to the 2001 recession followed by an overall declining trend that accelerates during the post 2008 crisis. In Europe the mid 90s show an increasing employment rate that stops post 2008 but not as dramatically as in the US.

By gender, we see very different patterns although both pointing to convergence of labor markets. In the case of female workers, the US displays a flat or declining ratio (but at a high level), while Europe shows a strong upward trend. In the case of make workers, the EU trend is flat but there is a strong decline in employment rates in the US.

There are many other ways to cut the data, all of them interesting. Below are two charts where I look at a specific age range.

For workers in the 35-44 range (the analysis it would be similar for 45-54), we see strong increases in the EU employment rates that bring the ratio above that of the US. If we look at workers over 65 we see that not only the US has a much higher employment rate but that it has been increasing relative to the EU number that remains low and at a similar level as in 1990.

Overall, the US-EU comparisons of labor markets reveals that Europe has caught up with the US when it comes to employment rates, something that was not expected in the 90s where the US labor market was seen as an example of a dynamic market and the distance between the two kept growing. For some age groups (between 35-44) not only there is convergence but the EU rates are now clearly above those in the US. However, the US maintains the lead in workers close or "over" retirement age, with a gap that has increased over time.

Antonio Fatás

Tuesday, April 3, 2012

The Euro Divorce

Arnab Das and Nouriel Roubini write today in the Financial Times a commentary suggesting that Euro members should get a divorce (they call it an "amicable divorce settlement"). The current policies will not work and the only solution is the break up of the Euro area to allow some of the economies in trouble get a boost from a depreciation of their (newly created) currencies.

The argument is not new but the article provides a blueprint of how it should be done, which makes the reading more interesting but, of course, it also opens up their argument to more criticism. Let me summarize their proposal before I take my turn on bringing some arguments that suggest that this might not work as well as the authors suggest. Das and Roubini want:

1. Portugal, Ireland, Italy, Greece and Spain to abandon the Euro.
2. A system of fixed exchange rates (or managed exchange rates) to be introduced in the transition where the ECB will play a strong role defending the announced targets. This system will provide during the transition, the necessary adjustment to exchange rates.
3. After a transition, all central banks will implement congruent inflation targets to avoid competitive devaluations.
4. Contracts made under domestic laws will be renominated to the new currency. Contracts made under foreign law will remain in Euros.

As I said, it is good to see a proposal with details on how to make the break-up of the Euro area work - and also one that admits its difficulties. Although their arguments are good I remain unconvinced that this would be a good solution. I disagree with their assessment that a one-time shift in intra-Euro exchange rates would generate enough growth. And I have (like anyone else) some "cheap" criticisms about why there are still details that need to be worked out and that in its current form this proposal cannot work.

Let me start with the disagreement on their analysis. At the center of their argument there is a a logic that there is a fundamental misplricing going on in the Euro area. Some countries have lost competitiveness and we need to reset some relative prices back to where they belong to allow for the necessary external rebalancing. This is a standard macroeconomics textbook argument about why systems of fixed exchange rates tend to be unstable and likely to generate misalignments in relative prices.

But the Euro area is not a system of fixed exchange rates where national central banks run independent monetary policy. It is a group of countries (regions?) that share a currency. Inflation does not exist at a macroeconomic level in Greece or Spain. Inflation can only be seen as a microeconomic phenomenon: some prices move in directions that make the factors behind those prices too expensive. We now need to reset to reset those prices to the right level and internal devaluations does not work fast enough so a depreciation of the exchange rate will be a much better tool.

But depreciation of the exchange rate means that all local prices are being reset in the same direction by the same amount? Is this optimal? Is this the right change in relative prices that these countries need? I do not have a perfect answer to this question but I feel uncomfortable making the argument that all domestic prices or wages in these countries are too high. The argument that Greece or Portugal or Spain have lost competitiveness relative to the other Euro countries since the launch of the Euro has been made many times before but as I have argued earlier in this blog, the data is not as clear as many think. What we have seen is one country (Germany) going through a process of increased productivity with limited wage growth and relative to other countries they have managed to reduce their relative unit labor cost. See graph below that I have shown earlier in this blog. Germany is the outlier and not Southern Europe + Ireland.

Looking at the performance of exports during the same period of time provides us with a similar message. Let's compare (volume of) exports of four European economies: Germany, France, Spain and the United Kingdom post 1999.

Yes, Germany's exports grew faster than any of the other countries but there are small differences between France, the UK and Spain. And out of the three, the one that showed stronger exports growth was Spain. So how can we be so sure that we need to reset the relative prices between Spain and some of those other Euro countries?

One can argue that maybe the past performance was fine but that given the current difficult economic situation of some of these countries, a depreciation will be helpful for a while. This argument is much less convincing. It cannot be that a depreciation is always good for growth (otherwise why don't we depreciate by 99% the value of their currencies?). The argument needs to be one of setting some relative price to the correct level not simply a one-way argument towards depreciated currencies (the authors agree with this statement when they talk about avoiding competitive devaluations after the transition).

I am also concerned with how some of the details in their proposal will work. To be fair, the authors are aware that the details are not easy and that the potential for capital flights and financial sector instability are very high if we were to have a group of countries leaving the Euro, so I am sure that they share some of the following concerns:

1. How are the new exchange rates decided? And I do not mean the day of the conversion (this is arbitrary and meaningless) but after that. The only way to make this meaningful is by creating a depreciation the months that follow the exit of the Euro area. The authors suggest that it will be a controlled depreciation. Who will make that decision?

2. The moment the depreciation happens, these countries will be poorer as all their imports will be more expensive (e.g. price of oil will jump by whatever is the amount of depreciation of their currency). How will this impact economic growth (consumption, investment,...)? We all understand that there can be potential benefits to exports growth in some sectors but are we sure this is going to work in the short-run? Why is this an important question? Because the debt of governments will be at least as high as today after leaving the Euro. Without growth, the fiscal problems of Spain or Italy will be as bad or worse than today. Are we sure that the loss of confidence in their currencies combined with the immediate shock of making everyone else poorer is going to be compensated fast enough by increasing exports?

3. The authors suggest that contracts under foreign law will still be denominated in Euros. The details matter here. Suppose we convert all the government debt of Italy to the new Lira. The moment the Lira depreciates, the foreign investors will see a loss in their investment. From the perspective of the Italian government nothing has changed. The value of the debt is in Liras and so are all its future revenues (so the Debt to GDP ratio is the same as before). But it is very likely that interest rates will be higher because of the uncertainty and lack of confidence. Will Italy be able to avoid default? Are we sure that exports will grow so fast to compensate for all these costs or risks? I remain skeptical of the ability of exports to react significantly and fast enough to compensate for all the potential costs.

Antonio Fatás