The two sensible choices

There are two sensible and realistic choices for solving the Euro crisis. The sensible and realistic choices are:

  • Surplus areas like Germany give deficit areas like Greece free money, indefinitely, or,
  • Weak economies like Greece and Spain leave the Eurozone.

These really are the sensible and realistic choices. You need one of these if you want roughly equal purchasing power across the Eurozone. Otherwise, money will flow from unproductive deficit areas to productive surplus areas, people in surplus countries will get steadily richer, people in deficit countries will get continually poorer, and eventually this will come to a head by revolt or other radical means.

Free money recycles this flow, exchange rates stop it. Economically the first is better because more flow of goods and services and money turns the economy forward and makes everyone consume more in aggregate. The latter choice aims for fairness, sacrificing total volume of trade and industry in the process.

Right now we’re still discussing the free money idea. Free money could be given as tax-and-transfer grants like most states do internally, as endless monetary expansion like the US, or by recurrent debt default and restructuring. The only advantage of the third option is it makes a policy look like an accident.

If free money won’t fly, leaving the Eurozone is the choice. Greece should have left the Eurozone… any time from 2001 till tonight would be good. Cynics would say stay until 2011 while the free money vision of Europe looked ascendant, but certainly Greece should have dropped after that. Greece should leave now.

Dropping out of the currency union has only advantages for the weaker economy. The disadvantages for the stronger economy are that it stops the flow of funds from the poor to the rich and removes demand for their exports. Germany selfishly wants the Euro. Greeks are stupidly attached to it because they equate the Euro with the EU and three decades of progress.

There are also a couple of totally fantastical choices that people might believe would fix the Eurozone, but they won’t work.

  • Economies like Germany and Greece become similarly productive any time soon.
  • Regions fix trade imbalances through fiscal discipline and austerity.

These are myths. It would be great if Greece was a bit more prosperous like Germany and that would take a venture investment ethos, congenial labour relations, an orientation to global markets, nourishing a boutique economy, branding, IP rights, stability and democracy. Well, at least Greece has democracy.

Different economies may become more alike, but they won’t become the same. The Mississippi delta is less productive than Silicon Valley and that’s why the meagre social policies of the US transfer funds indefinitely from rich Californians to poor Louisianan’s. Convergence doesn’t remove the need for transfers, it makes them smaller.

As for austerity, austerity is the null policy. Austerity means to just accept the dynamic of unproductive regions being steadily poorer and productive regions being steadily richer without asking for free money to mitigate it. And fiscal discipline means don’t try the free money by monetary expansion or default routes.

Until 2011 it looked like Europe was going to work like a superstate using free money transfers. This would have been better for all, including Germans. This idea now looks dead. Weak economies should ditch the Eurozone, now.

Ranking outcomes

Greece and the creditors are in last last-ditch negotiations where the creditors aim to keep Greece in the Eurozone and avert default. Greece aims to secure a bankruptcy deal that’s friendly to the poor and which makes growth possible. In subtext, the creditors want Greece to surrender unconditionally to the institutions to discourage similar movements elsewhere, while Greece aims for sovereignty to carry out a democratic mandate.

Recently it looks like a deal might be reached. Would that be a good outcome? I don’t think so. In my opinion the situation has deteriorated enough that walking away is better. Also we must not lose sight of better outcomes that are currently closed, opportunities that are squandered. To keep everything in context, here’s my ranking of possible outcomes from best to worst.

1. A better model for the Eurozone

The best possible outcome would be to change the architecture of the Eurozone to one that suits all economies. Currently the Euro is architected like the Deutschmark, a strong currency with very tight monetary policy similar to the gold standard and strict fiscal discipline. That has been a German political demand, but such an architecture doesn’t suit the UK (who opted out), Latin countries, and least of all weak undisciplined economies like Ireland and Greece. If the Euro were changed to be a weaker and more volatile currency like the dollar, and the ECB pursued loose monetary policy at times of trouble like the US Federal Reserve, weak economies would be better performing in general and would get out of crises easily. I’m not sure how a weak Euro would hurt Germany except psychologically.

2. A Europe with social transfers

The next best thing, if loose monetary policy and moderate inflation are out of the question, is a Europe with social transfers. A hard currency and strict fiscal discipline for governments, but a European safety net to bail out people (rather than governments) when times are bad. These would be things like EU-wide basic pensions, unemployment, and poverty line income support. Really basic stuff. Right now this is anathema in Europe, as relatively well off taxpayers in relatively prosperous economies resent paying social benefits to poorly off taxpayers in weak economies. But this is exactly the system in the United States. Individual US states and large cities routinely go bankrupt, but federal programs like food stamps and Medicaid support their poorest citizens. Is Europe really unwilling to offer the meagre social benefits that the US does?

3. Positive reform for Greece (a good deal)

After several years of deceit and mismanagement, Greek voters managed to fire the corrupt political dynasties that took turns in power and bring in outsiders (SYRIZA) intent on serious reform. Inexplicably, the creditors decided that they’d rather deal with the old guard that committed financial fraud at their expense and proceeded to undermine SYRIZA at every step. This is a squandered opportunity. For the first time in decades Greece has a morally sound government with a strong mandate and a credible agenda for reform. The same reform that Europe wants: Modern public administration, effective tax collection, making it easy to start a business. If the creditors would take Greece’s proposals seriously and engage in good faith, rapid progress would be made. Except success would look bad and Podemos in Spain would want the same.

4. Leaving the Euro and staying in the EU (no deal)

The best outcome currently open, in my view, is for Greece to walk away from negotiations and leave the Eurozone while staying in the EU. Dropping the Euro and introducing a national currency does two things: It lets the state create and circulate money in the domestic economy, and it makes imports expensive relative to domestic goods. For Greece that means the domestic economy will quickly return to health and poverty will be quickly alleviated. Food, housing, and services will be cheaper as they’re domestic. Technology imports and foreign services such as studying abroad will be expensive. The standard of living, which is mainly supported by domestic goods, will rise but Greece will feel a little backward for lack of imports. People will be able to consume more tomatoes and fewer iPhones. Greeks won’t like that because they love their iPhones, but right now tomatoes are more important.

Some common misconceptions about the impact of Greece leaving the Euro:

Greece’s debt is a separate matter from staying in the Euro. Greece owes more Euros than it can realistically pay, so in the end it’ll realistically pay less. If Greece stays in the Euro the creditors have more leverage to ruin Greece, making repayment harder. If it leaves, Greece has more prospects to recover and could decide to default with fewer consequences. Leaving the Euro is not the same thing as defaulting on debt.

In economic textbooks, leaving a currency union and devaluing is good for competitiveness. That works for an industrial economy whose output can scale a lot with small differences in producer prices. Greece produces olive oil and tourism. Tourism is price-sensitive, but it already faces strong market discipline and it’s not that scalable. If Greece drops the Euro it’ll become cheaper, it’ll sell a few more more holidays and foods, and overall it’ll make a bit less in Euros. The competitiveness argument is moot.

If Greece leaves the Euro the financial fallout will be small. The Anglo-Saxon investors already took their losses and generally acted businesslike in this drama. European governments bailed out their investors and are now holding the bulk of Greece’s debt. Because Greece’s economy imploded, this debt is worth less than face value. If Greece leaves European governments can realise this loss, they can continue to hide it, or they can reflate it with ECB money creation – the same choices they face now.

On the other hand if Greece leaves the political fallout will be large. Being in the EU or EEA but outside the Euro is increasingly looking like the better option. It’s where the UK, Denmark, Norway, and Iceland chose to be. If Greece makes the transition relatively painlessly other countries will sooner or later follow and the Euro will either unravel or lose many of its members and become a new Deutschmark for countries west of the Rhine. For Germany, this will be a large political failure.

5. Parallel currencies

Various technical proposals are being floated about Greece issuing some currency in addition to the Euro. The idea is you’d have Euros and Drachmas in your wallet and you could use either, but Drachmas would be easier to come by and worth less. These proposals aim to quit the Euro in substance while retaining it for morale, for appearances, or for the convenience of travellers. Most view them as temporary measures. Parallel currencies are a risky proposition. They work well at small scale. At large scale they’ve been tried by Latin American countries in crisis, with mixed and hard to disentangle results. Overall, depending on the technical details, parallel currencies work out about the same as leaving the Euro or significantly worse. They’re a great plaything for economists, though.

6. Continued austerity (a bad deal)

If Greece accepts the creditor’s demands it will be a bad outcome for all sides. The creditors insist on austerity and prioritising debt repayments over growth, as they have for the past five years. Continuing on this path will keep Greece impoverished and heavily indebted for the foreseeable future, and will bring further suffering and extremism. The creditors appear less concerned with fostering growth or ending the crisis, and more intent to prevent any country from going bankrupt in the Eurozone and then recovering. It’s Europe of debt servitude. The only good thing about this outcome is that it’s pacified. The empire wins, the rebels are crushed, and there’s an unhappy stability. Greece will still be broke and recurrent debt crisis will be the new normal.

7. Capital controls (like Cyprus)

One officially sponsored outcome that’s worse than austerity is what happened to Cyprus. people in Cyprus use a currency that’s called Euro and looks like the Euro, but a Euro in a Cypriot bank or in your pocket is worth less than a Euro in France or Germany because you can’t take it out of Cyprus. What happened to Cyprus is a remarkably cynical way to fracture a currency union and punish a state (for accepting the money of rich Russians) while claiming your shiny currency union is intact. After seeing the kindness of Europe, Cypriots probably wish they’d stayed a British possession.

8. Continued uncertainty

A marginally worse outcome is continuing the uncertainty that we’ve had since January. Since SYRIZA was elected, creditors have been refusing to roll over Greece’s debts and instead are asking Greece to pay them off as they come due. The ECB cut off one form of finance to Greek banks and is reviewing the other kind (ELA) on a regular basis, effectively inciting a bank run. It’s like the US Fed announcing that Michigan state banks could go belly-up any moment now. This strategy aims to damage Greece’s finances and banking system so that Greece will more easily pay its debts, presumably.

9. Leaving the EU

There’s much good in the EU besides an ill-conceived and damaging single currency system. For poor and troubled nations like Greece the EU brings stronger human rights, freedom to settle and work in any member state, and an open market which for ordinary people means freedom from profiteering of various sorts. The great achievement of the EU is that we can be in each other’s countries as citizens, not as barely tolerated guests. We put up with stupid bureaucratic rulings on bananas and cookies to retain this privilege. It is important not to throw the EU out with the Eurozone.

10. Political meltdown

The worst possible outcome for Greece is a disorderly collapse of SYRIZA and the rise of the nazi Golden Dawn party as “national savours”. Greece is closest to the abyss, but throughout Europe the social damage of the new order of austerity is fuelling far-right parties. In France, Le Pen is on the rise. In the UK, UKIP. It would be a sad legacy for Ms. Merkel, our de-facto European president to bring about the rise of fascism everywhere but in Germany.

As said, I think the best outcome currently within reach is number 4, leaving the Eurozone. Taking a bad deal, such as the creditors insist, is currently a worse outcome, and there are many worse ones. There are also better outcomes that would be possible. Currently, the three best outcomes for Europe are politically blocked by Germany.

Why can’t Greece just agree to the creditor’s terms?

Talks between Greece and its creditors collapsed over the weekend with both parties appearing intransigent. The sticking point is pensions. Greece spends 16% of GDP on pensions and the IMF wants Greece to cut this. Greece. refuses. Why does the Greek state have this large pension burden in the fist place?

The answer is Greek pensions are of the “defined benefits” tax and transfer variety. The state taxes the current working generation and transfers the money to pensioners. It’s a passthrough mechanism, not an investment fund. As the economy has collapsed, tax revenues from the active economy have dropped and the pension burden is harder to bear. It’s a very similar situation to Detroit.

That might conjure up a bloated state sector with stalinist factories building tanks or a comically uncompetitive airline. OK, Greece had these two. They’re gone. For the most part though the high pension burden IS NOT indicative of a state sector that needs purging. The majority of pensioners were either private employees such as bank tellers where the state is acting as their collective insurer, or they were relatively uncontroversial state employees such as teachers and bus drivers.

Why are Greek pensions organised this way? Why aren’t they stock market investments like in the Anglo-Saxon world. For a start, the Anglo-Saxon model is a lousy deal for all income groups except the very wealthy. If you assume continuity of a sovereign state, a tax-and-transfer scheme limits downside better than market investments. The Euro ended monetary sovereignty for Greece, so for pensioners that was a miscalculation.

Secondly Greek capitalism (the portion of the economy in publicly traded companies) is too small to support pensions. Greek pension funds would have had to invest internationally. That would have been quite a leap of faith, and the pension funds did not. Another miscalculation, but understandable, I think. You have to remember people who are now pensioners put their trust on the continuity of the Greek state decades ago.

Alright, so if Greece doesn’t have the money to pay the pensions why doesn’t it cut anyway? What other outcome could one hope for? Well, if Greece left the Euro it could once again print money to partly fund pension obligations. This generates inflation, as was common before the Euro, and inflation acts as an indirect tax. It also causes currency devaluation, which makes imports expensive relative to domestic goods. Guess what: Greek pensioners consume more food and services (domestic goods) than iPhones.

A much better outcome would be for Europe to shoulder some of the social burden of these pensions. Why should they? For the same reason the US has federal food stamps that people disproportionately consume in Detroit. The “unruly” Greek government would much more readily agree to fiscal conditionality in the Euro if it wasn’t solely responsible for the welfare of its citizens. Remember these are people who bet on national sovereignty decades ago, then it was taken away with the Euro and the Europe that transpired is now unwilling to honor their benefits.

European integration would have gone much more smoothly if harmonisation of social welfare across states had been part of the project sooner (or at all). This doesn’t mean giving Swedish benefits to Greek pensioners – you get what you pay for. But it is at least arguable that Europe as a whole should not cut a nation’s pensioners out of their own modest level of benefits.

Greece and its creditors: What has been happening

Since March The Institutions have been refusing to roll over Greece’s debt, claiming that Greece is failing to comply with a program. As long as a deal is not struck they demand that Greece pays off maturing loans as they come due. No country can do that. If Greece doesn’t run out of money in a week or two, it’ll run out later. Every time Greece submits a plan, the creditors reply “No, do as we said originally”.

I feel it’s a mistake to continue this false negotiation and make significant concessions or distressed asset sales, only to postpone a forced bankruptcy by a few days or weeks.

Instead, Greece must send to The Institutions a bankruptcy plan now rather than layer. Since the creditors are not cooperating, in a few days Greece will go bankrupt like so. If the institutions still don’t cooperate, Greece could maybe agree to go bankrupt another way. Tsipras must say this and mean it. In a negotiation you must be clear what you’ll do if the other side doesn’t cooperate. You must have accepted that outcome. To go into a negotiation otherwise is to surrender.

I think a reasonable bankruptcy plan is that which SRIZA set out in its electoral program, removing the concessions that were agreed later and are now seen to be pointless. It’s not clear if bankruptcy will push Greece out of the Euro or whether the Greek State can go bankrupt in the Eurozone like a corporation, leaving the banks in the care of the ECB (like Detroit). I think SYRIZA needs to figure out what the post-bankruptcy recovery plan is, and act accordingly.

Τι συμβαίνει με την Ελλάδα και τους Θεσμούς?

Απο το Μαρτιο, Οι Θεσμοί με το επιχείρημα οτι η Ελλάδα δεν έχει συμμορφωθεί σε πρόγραμμα αρνούνται να ανανεώσουν (roll over) τα δάνεια. Ζητούν λοιπόν όσο δεν επιτυγχάνεται συμφωνία η Ελλάδα να τα εξωφλεί. Καμμιά χώρα δεν είναι σε θέση να κάνει μια τέτοια εξώφληση. Για την Ελλάδα αν δεν εξαντληθούν τα χρήματα σε μια βδομάδα θα εξαντληθούν αργότερα. Σε κάθε πρότασή μας οι Θεσμοί απαντούν “Όχι, κάντε όπως σα; είπαμε απ την αρχή”.

Βρίσκω λάθος να συνεχίζεται αυτή η δήθεν διαπραγμάτευση και γίνουν μεγάλες παραχωρήσεις και ξεπουλήματα για να πάει μια διαδικασία βεβιασμένς πτώχευσης λίγο πιο μακρυά.

Αντίθετα θα πρέπει ο Τσίπρας, πρίν την καταληκτική ημερομηνία, να στείλει στους Θεσμούς ένα σχέδιο πτώχευσης. Αφού δεν συνεργάζεστε, το Ελληνικό κράτος σε λίγες μέρες θα πτωχέυσει έτσι. Αν εξακολουθείτε να μη συνεργάζεστε τότε ίσως μπορούμε να συμφωνήσουμε να πτωχεύσουμε αλλοιώς. Και αυτό πρέπει να το εννούμε. Οταν μπαίνει κανείς σε μια συμφωνία πρέπει να είναι συμφιλιωμένος με το τι θα κάνει αν η άλλη πλευρά δε συνεργάζεται. Αλλοιώς παραδίδεται.

Νομίζω οτι ένα ικανό σχέδιο πτώχευσης είναι αυτό που ο ΣΥΡΙΖΑ ήδη προτείνει στο λαό και στους θεσμούς, ίσως αφαιρώντας τα σημεία παραχώρησς προς τους θεσμούς αν αυτό είναι πια άσκοπο. Ασαφές είναι αν αυτό μας βγάζει εκτός Ευρώ ή το Ελληνικό κράτος χεωκοπεί μέσα στο Ευρώ, σα να ήταν εταιρεία, ενώ οι τράπεζες μένουν μέλλημα της ΕΚΤ. Ο σύρζα πρέπει να εκτιμήσει ποιό απ τα δύο σενάρια προτιμά ανάλογα με το πώς σχεδιάζουμε να κινηθούμε για να συνέλθουμε μετά.

Greece and Europe are in a confrontation over democracy

You wouldn’t think so given a week of awkward handshakes, public contradictions, sternly worded demands to fall into line, and galling bankers’ ultimatums to destroy an economy, but Greece and Europe agree on most things:

Europe: You must reform your economy.
Greece: We plan to reform and modernise our economy even more than has been already accomplished. However we want growth oriented changes, not ones that are just destructive.

Europe: You must reduce graft and waste.
Greece: Our finance minister travels economy. He fired the ministry “consultants” and re-hired the outsourced cleaning ladies. Down to earth is the new normal.

Europe: You must collect taxes properly.
Greece: We’re the first Greek government determined to do that, including going after the big fish. Intrnational help would be appreciated. But sending German in tax inspectors at this time would be unwise.

Europe: You must pay your debts.
Greece: We have the interest of all European taxpayers in mind so please hear our case. During the bubble years your banks lent recklessly to Greece while our government committed financial fraud. We’re sorry. Then your governments transferred private investment losses onto the shoulders of European taxpayers. At the same time the Troika imposed austerity that crushed our economy by 25% and raised debt to GDP from 115% to 170%. European governments mismanaged the crisis and lied to you that you were helping Greece.

Right now we need to end the most damaging aspects of austerity so that we can have growth, and then agree a debt service schedule that this small economy can sustain. Greece is already making a surplus and paying back money to Europe. You are not “financing Greece”, we’re paying you back. We want to make that repayment slower, 1.5% of GDP instead of 4.5%, so that it’s possible to have an economic recovery.

Your central banks won’t get back the full value of the debt at commercial rates. You’ll get less in total or less interest or over a much longer time. However these are by now paper losses in the books of central banks. We’re trying to bury a loss of around €150 billion at a time when the ECB is crating €1.1 trillion of new money on the books of the same banks. That means there’s no need for Europeans to lose money or pay higher taxes over this, and if your politicians make you take this loss it’s their choice.

Europe: You must privatise everything.
Greece: If that’s not letting go of a profitable asset at fire sale prices, sure. Right now the income stream from public enterprises is worth more than the sale price.

Europe: You must stay in the Euro.
Greece: We want to stay in the Euro but the ECB is kicking us out.

Why then all the bluster? Greece’s new government is a popular government. The good kind. We don’t want to see the other one. With the exception of Merkel, the people they face are mostly technocrats. I don’t understand German politics, but from outside it seems clear that capital rules politics and is spinning a morality tale for the people.

Where Greece and Europe don’t agree is where people (in Greece and elsewhere, even Germany) want one thing and narrow capital interests want another:

Europe: You must continue with Austerity.
Greece: We won’t continue with this policy that destroys wealth and evidently doesn’t work.

Europe: You must take this money from our taxpayers.
Greece: We have no right to take any more money from your taxpayers.

Europe: You must do as the previous governments.
Greece: Have you heard of democracy? We have a strong popular mandate for change.

Europe: We have agreements with Greece, not a government.
Greece: It’s like marriage. If you offer solidarity we’ll do the same, and by coercion no.

Europe: You must comply with the Troika inspectors.
Greece: We were elected to end this humiliation. We’re committed to reforms but we’re not a debt colony.

Europe: We have rules here.
Greece: We’re bankrupt, party as a result of bad rules. We’ll follow the rules we can, and if we can’t you may throw us out.

Europe: You’re one country versus 18.
Greece: Have you noticed that the Eurozone is increasingly a club people want to leave? How much democratic opposition to these failed policies will it take to change them?

And that’s really the the point of disagreement this past week, and probably next week or until Greece’s democratic flare is resolved. Greece is arguing for a democratic Europe that works for its people. The establishment is arguing for a largely undemocratic status quo that doesn’t work, or works only for large industrial capital.

It’s been a while since Greece had a government that actually represents the interests of the people. Maybe more than two thousand years. If the other governments in Europe were similar, or Europe could be jolted into reviving democracy, we would find many more parallels than differences and the crisis would be quickly over.

Asmussen leaves, Schaüble stays. Bad.

German coalition government announces cabinet ministers

Bad: Joerg Asmussen is leaving the ECB. He was an austerity hawk / debt dove. He’s likely to be replaced by a Bundesbank hawk on both fronts, who will then undermine Mario Draghi’s OMT bond-buying program. The OMT is the one policy currently holding the Eurozone in relative stability and removing it will likely let the crisis spiral out of control.

Bad: Wolfgang Schaeuble is staying as German Eurozone finance minister. He will then continue on his brave plan to burn down Europe’s economy outside of Germany, while funnelling to Germany massive financial profits through capital flight and manufactured risk arbitrage. German stocks, which dipped 5% in anticipation of the cabinet announcements, will jump back. Non-german European industry will fall.

The Eurozone crisis is about taxation vs. inflation

This formidable crisis that we’re having is, still, about taxation vs. inflation as a means of surplus recycling. A handful of countries including Germany have managed to make taxation work sufficiently well for surplus recycling (sort of, given high surpluses and still rising inequality). The Germans have foolishly written that into the constitution. All other countries, including the US and Japan, find taxation politically or practically insufficient as a means of surplus recycling and make up with a measure of monetary expansion. We’ll call that inflation although it’s not the same thing.

Monetary expansion taxes all assets denominated in a currency and is thus a form of recycling. In the US the market rises when easing is expected. Why? Because investors know that firms will have an opportunity to capture the surplus that is so recycled. Otherwise surplus will be more and more concentrated in retained profits, it won’t return to the market, and investments will have diminishing yield.

Southern Europe and the so-called lazy Greeks have been especially bad at taxation and especially reliant on inflation, devaluation, and the like. All countries pay their way if inflation is allowed. Fiscal obligations are covered in nominal terms and purchasing power for imports diminishes. The Eurozone was created, foolishly, with a German-inspired “there shall be no inflation” clause, and foolishly Greece applied and was admitted knowing that making taxation work in the timescale was unrealistic (and it’s a tall order for any country ever). The Eurozone then persisted, foolishly, in denial. The Greeks will endure anything but make taxation work, and the Germans will contemplate any measure but admit that taxation is insufficient and monetary expansion is a necessary pillar.

So please, let’s not moralise about lazy this and cruel that. Let’s see how we can back out of past decisions that were foolish, and that means talking about the role of both taxation and inflation (monetary expansion) in the Eurozone.

Inspired from Yanis Varoufakis’s blog here

How the 2013 US default will play out

Here’s what will happen with the US debt ceiling over the next few weeks.

Neither side will compromise to raise the debt ceiling. President Obama, who is in the right, won’t negotiate because caving in to blackmail will undermine his and every future president’s authority. Hardline Republicans won’t negotiate because they’re reckless and want to bring about a default and a fiscal collapse in order to implement libertarian utopia.

Wall Street, defence, and regular business leaders will call their republican senators and tell them in no uncertain terms that future campaign contributions will go to Democrats unless they back off. Most Republicans will be burned by this, but the Tea Party wont back down because they have grass roots and rich libertarian supporters.

The treasury will run out of money on October 15 or thereabouts, and then will hold back all payments equally until they can be covered by tax receipts. That will include Treasury bond payments, and the US will be in default. Rating agencies will downgrade US debt to hot potato status. The market will maintain the belief that the US will eventually pay the arrears after an unknown delay.

The Fed, being the only well-funded and well-run branch of government, will intervene massively. Mr Bernanke will generate trillions of reserves (Fed credit to US banks) and use it to buy Treasury bonds from the banks. This will keep Wall Street banks solvent and mitigate the fall of Treasury prices. They’ll fall by a few percent instead of crashing. The Fed may also elect to buy stocks to calm stock markets and later gain revenue. This intervention will be held tightly by banks and not generate consumer price inflation.

A fall in the value of US treasuries means a rise in the interest rate that the US has to pay for all its accumulated debt, not just new debt (although the new rate gets phased in over around five years as bonds mature). Something like a 2% rise is burdensome. At some level, be that 4% or 5% or similar the market starts to believe that the US will never pay some of the debt and interest rates spiral to 25% or more because of the risk. That makes it certain that the debt won’t be paid in full, and US debt changes form a safe asset to a speculator’s trade. That’s what happened to Greece. It’s not clear if the Fed will be able to avert the latter scenario.

Either way, if the debt limit isn’t raised and the US defaults the US will have to pay higher interest. It may be much higher or impossibly higher. If you’re concerned about lowering the US debt burden, default is not what you want!

Central banks outside the US, particularly in Japan, may elect to cover their own financial institutions’ exposure to Treasuries by generating reserves in Yen, Pounds, etc. This will keep the financial system from collapsing and convert immediate paper losses to long-term recession, as happened 2008. The ECB, because it’s in the grip of Teutonic myths about money and debt, will be the last to react and will do so in half-measures, putting several European financial institutions in peril and adding to the ongoing Eurozone crisis.

The collapse of demand for Treasuries doesn’t pose survival challenges to real economy firms. Successful US firms have large cash reserves. The abrupt fiscal tightening will significantly hurt firms in certain sectors. However the secondary effects are severe and they’ll come back to affect all US businesses through the world economy.

The largest foreign holders of US Treasuries, China and Japan, have these bonds because for years they maintained a trade surplus with the US. Every year Americans (the private sector) import more things from China than they sell to China, so that excess dollars pile up at the Chinese central bank. Then along comes Uncle Sam, takes back the dollars and spends them in the US economy, and gives China yellow debt certificates called Treasury bonds. The Chinese effectively subsidise American consumption (they work for less) in order to boost their own production, and Americans maintain unaffordable consumption by going into paper debt. To a lesser extent the same happens vis-a-vis Japan, Korea, Taiwan, and Germany. Outside of a crisis scenario, no-one expects the US to pay back accumulated debt. To creditors it’s a long-term safe investment that pays interest.

When the US defaults, this arrangement breaks down. Suddenly the Chinese will no longer accept Treasury bonds and will demand dollars to replace the amount they hold as they mature. The Fed may decide to fly plane loads of newly printed Benjamins ($100 bills) to China and take back expiring Treasuries to shred them. China won’t accumulate the dollars but will try to spend them immediately on asset purchases, in the US and abroad. This will have three major effects:

  • The value of the dollar will fall sharply compared to other currencies, as there will be a flood of dollars chasing assets worldwide. American wealth will be reduced significantly, and there will be inflation through imports.
  • Imports to the US, including things like industrial components and iPads, will be much more expensive for Americans or unaffordable to US firms. Demand, production, profits, and stocks will fall sharply around the world.
  • America’s creditors will pick up devalued stocks worldwide, making a long term shift of capital from American to Asian and a few European holders. Iconic US firms such as Apple may come under hostile takeover by foreign capital.

The US may instead refuse to pay cash for Treasuries that mature and no-one can force them because the US has aircraft carriers. However the economic effect will be the same or worse: If the US bluntly refuses to honour Treasuries the dollar will fall further and trade will halt as foreigners will trust neither Treasuries nor dollars.

Eventually, perhaps after a few weeks, the US will find a procedural way to end the debt ceiling stalemate. They’ll remove or convince recalcitrant congressmen to vote for a permanent increase. However, the damage done to the economy will be permanent. Markets will resume their upward trajectory but will not recover their lost value. Capital will have been permanently transferred from the US to its creditors. Global demand, income, and profits will be permanently lower than they were before the crisis. The US will not regain credibility with bond investors until they make a constitutional change to put debt under control of the executive.

In the medium term the default will hurt China, Germany, and other Asian countries harder than the US. They will lose a profligate customer who’s buying on credit and will have to substitute US demand with demand of their own. That may happen, if money flows liberally enough in the Asian middle and upper income classes, but most likely demand and the overall economies will be permanently depressed. In the long run world economies will move past their dependency on US demand and move on.

The US will be left a much more insular and backward economy than it is today. With the dollar sharply devalued and no foreign credit the US will have to produce and consume domestically, which it can do. Expect American cars, American PCs and smartphones actually made in the US, a resurgence of blue-collar workers, higher nominal incomes and much higher consumer prices. People will buy durable goods and not gadgets. Sort of how it was in the 60s. In a way this will be more balanced and robust and may appeal to conservative nostalgia. However, it’s not the path to a libertarian powerhouse. If anything, with capital severely weakened and a greater need for domestic labour, a stronger social contract or New Deal will be needed to see America through the aftermath.

Ten easy ways to fix the Eurozone

I’m bored of hearing prejudiced nonsense about the Eurozone. A lot of what is said in the Anglo-Saxon press, with few exceptions such as Krugman or Ezra Klein, I interpret as either misinformed or pushing an anti EU, either pro-US or in the case of the UK exceptionalist agenda.

The Euro and the EU post-national project has many challenges, but not the ones that dogmatic US/UK commentators churn out. It’s not unsound and doomed to failure as a pegged currency system would indeed be. It’s not demanding of human perfection and discipline to work – that is just the flawed conception of the Merkel government. The Euro won’t collapse if some countries leave, though it would get stronger if a more homogeneous set of countries remain. The Euro is, indeed, a corporatist and pro capitalist construction. That is the idea, to compete with the dollar and to a lesser extent the Yen and RMB. Having the Euro doesn’t mean that European society as a whole has to change to be like America.

The real challenges of the Eurozone are: Different competitiveness amongst regions chiefly due to an imbalance of capital, unwillingness to fix that through redistribution, a single monetary policy that favors the center, and most damagingly a ban on the ECB making use of its powers as monetary sovereign. But rather than bore you by analysing the problems, I’ll offer instead solutions. There are relatively simple solutions to the Eurozone mess, and each of them involves fixing one or more of these problems. These are easy solutions, in the sense that governments can decide and do them. They do not require people or the economy to deliver an orchestrated outcome. All of these solutions are currently blocked, politically, by Germany. Continue reading

Why WikiLeaks is important

The WikiLeaks intelligence documents have started appearing in the papers. There’s no earth-shattering revelation, yet this disclosure to the public is extremely important because it brings to light our two alternative conceptions of democracy. In the classic idea of democracy, the one you learn at school and the one reflected in the structure of electoral institutions, participatory democracy is the ideal and representation is merely a device to make democracy practical at large scale. In classic democracy, the public is at all times the source of authority and arbiter of decisions. Openness is essential, and the role of the media is to keep the representatives in line with the wishes of the public. In classic democracy there is no question that the information recently released by WikiLeaks should be routinely open. While that might make the work of government at times inconvenient, this type of democracy is the safest and least oppressive form of government we have so far discovered.

The alternative view of democracy, now prevalent de facto, is the democracy of the management firm. The state is governed like a large public firm. Political parties are management consultancies bidding for contracts to run the firm for a number of years. Elections are the general meeting, where citizens vote one share but large investors (businesses) vote according to their share of the economy. The role of the media, if it’s not the firm’s own newsletter, is to carry advertising. In this kind of democracy, the management firm, once hired, is allowed and expected to work behind closed doors. Their performance is judged only by aggregates, such as economic growth. Citizens are certainly not routinely informed, and have no say unless some investor lobby (large business interest) feels that the management performs poorly and calls for an early general meeting. If that is the democracy we have, WikiLeaks is wholly irresponsible and out of place.

Which type of democracy do you think we should have?