Friday, April 27, 2012

Europe. Rinse. Repeat.

So Spain has got the downgrade and now folks have worked themselves into a lather.

The question remains, as it has for the last 18 months: what did you think was going to happen? And the truth is, it's going to happen again.

This is not happening, primarily, because Southern European countries refuse to cut spending.  Many of the countries may need to cut spending and regulation but these crises are happening because Southern European countries aren't growing and when you don't grow, your deficit blows up.  Recessions do that (Mr. Ryan, take note).

Europe has a banking crisis from under capitalized banks who hold rapidly depreciating assets (in the form of these government bonds) so there is a constant danger of insolvency and runs on them.  It's not so different from the US banks in 2008 in that way.  But, rather than directly recapitalize the banks a la TARP, the ECB is giving the banks cheap loans to keep themselves running. They are taking the money and calling in every loan they can to reduce their leverage.  So it has set the stage for an awful credit crunch which undermines growth.

Europe also has a direct growth crisis/fiscal crisis (depending how you are inclined to describe it).

Southern Europe has had low productivity growth and Northern Europe high productivity growth.  Normally, a country getting into trouble like that of Southern Europe would have a devaluation and use exports as their growth strategy.  But locked in at the high exchange rate, S. Europe can't do that.  Without growth and with the credit contraction from the banks trying to reduce their leverage because of the banking crisis, these countries' deficits are awful and likely to get worse.  Even the most savage austerity really isn't going to fix this problem. 

We know a lot about how very different economies can be held together in a monetary union.  Choose one: 1) The rich guys subsidize the poor guys permanently. 2) A massive exodus of people goes from the poor guys to the rich guys or 3) the poor guys experience massive, extended unemployment and stagnation as they try to grind down everyone's wages and do the equivalent of a devaluation.

Sometimes, as when East Germany joined West Germany at an over-valued exchange rate, they can have all three and have it last for decades. 

The problem is, each of them seems impossible but the hard part is coming up with an alternative.  Some might add a 4) ECB prints money to monetize the debt and creates inflation but I tend to lump that into the permanent subsidy hypothesis. Regardless, it also seems impossible.

What this means for investors and spectators is the following prediction:

Europe will struggle and find a way to adopt an approach they describe as temporary/one-time/final/emergency that calms the market about Spain.  It will involve something vaguely financial market sounding and have some acronym--XLRPTO--but will be some explicit or implicit subsidy--loan guarantees, extra liquidity from the ECB, or anything of that sort would count in the style.  It will come with a lecture from the stronger part of Europe about how Spain needs to get their house in order and cut spending and Spain will probably start such a program.

Within three months, the grim iron logic of no growth will blow the deficit up in some other country in Southern Europe--Portugal, Italy, maybe Greece again--and then spreads will rise again and they will do the same dance.  Then within three months of recession and no growth, deteriorating finances in another country will lead to another scare and the same thing.  Then within three months ...

It will be the most painful version of the permanent subsidy solution that could possible exist.  It will hold things together for as long as the rich countries remain willing to foot the bill (or implictly foot the bill in the case of Euro guarantees). 

I dread this outcome.  I really don't want it to happen.  But, please, someone help me understand why the argument is wrong. 

Wednesday, April 25, 2012

Did Hubbard Really Mean to Raise That?

I just read the Glenn Hubbard editorial in the WSJ claiming that the President's budget is really a secret plan to raise everyone's taxes by11%. 
Glenn and I have been friends for pushing 20 years but on this one, Glenn seems to have jumped the shark. 
Basically Hubbard says he has looked at the Obama budget and, according to his calculation, after subtracting off the revenue projected from returning to the Clinton rates for high income people plus adding a Buffett rule, Obama's budget will raise everyone's taxes by 11% to stabilize things as a share of GDP.
Two things stuck out to me here:
1) Hubbard's numbers seem in pretty serious danger of violating the league's substance abuse policy. 
His claim that the President's budget requires large tax increases on the middle class to stabilize the debt is just factually wrong.  Just go look at the Congressional Budget Office's numbers.  They examined the President's budget and directly refute the central claim of the op-ed:
Figure 2 on page 6 shows their forecast of debt as a shareof GDP with the President's budget--and it's stabilized and falling without any taxes on the middle class.  Figure 1 shows similar stability on the deficit.
I can understand the argument of some people when they say that Republicans will never allow the Obama budget to pass so it would be better to debate the right approach to reaching a grand bargain rather than arguing about the administration budget. That's probably true but unlikely in the election season.  I can also understand the people who think that we shouldn't raise revenue only from high income people but to spread it around.  But Hubbard isn't saying either of those.  He's saying something that looks to me (and the CBO) like it just fundamentally isn't true.
Sadly, I'm being only slightly flip about it.  Hubbard imputes future policy based on the implications of the budget plan.  So what happens if you do that for Romney's budget promises?  Well, he has proposed a multi-trillion dollar tax cut, a balanced budget amendment to the constitution and a cap on government spending at 20%. 
The cap forces a cut of social security and medicare (and everything else) of 26% (you can see the numbers for yourself at
But his tax cut reduces revenue by an additional $3 trillion or so.  Using Mr. Hubbard's argument then,the Romney budget will raise taxes on everyone earning less than $200,000 per year to cover it (and since the deductions Romney says he will limit don't come remotely close to paying for the cost of the tax cuts, it's a bit like having your cousin take all the money from your wallet but offer to let you rummage through the couch for coins as repayment).  
I agree with Glenn that one of the key debates in the election should be about how America should deal with our long  run budget challenge (that comes from the aging of our population). 
And that debate is coming down to one camp saying let's have cuts to spending and interest of around $3 trillion and tax revenue of $1 trillion to hit the deficit cutting target and the other camp saying let's have cuts of $7 trillion to hit the deficit target plus pay for $3 trillion of tax cuts.
Hubbard closed his op-ed by saying that he just wants people to see the prices on the menu.  Well then, next item: The Romney Budget.  Glenn, you may want to practice your Heimlich maneuver.

Tuesday, April 24, 2012


I have finally started following lots of folks on twitter and giving some comments of my own (@Austan_Goolsbee).  But some things need a bit more treatment than 140 characters so I am experimenting with putting some other things here.

We'll see how it goes.