Must-Read: Brad Setser: Post-Brexit

Must-Read: Post-Brexit vote, in Europe at least: It is not the Great Recession. Odds are that it is not the Lesser Depression. Odds are that it is the Longer Depression…

Brad Setser: Follow the Money: “A few thoughts, focusing on narrow issues of macroeconomic management…

…The U.K. has been… supplying the rest of Europe with demand—something other European countries need. This… will shape the economic fallout. The fall in the pound is a necessary part of the U.K.’s adjustment… will spread the pain from a downturn in British demand to the rest of the euro area. Brexit uncertainty is thus a sizable negative shock to growth in Britian’s euro area trading partners, not just to Britain itself… knock[ing] a cumulative half a percentage point off euro area growth over the next two years…. The euro area… has fiscal capacity to counteract this shock…. The euro area could provide a fiscal offset, whether jointly, through new euro area investment funds or simply through a shift in say German policy on public investment and other adjustments to national policy…. [But] I would bet that the euro area’s aggregate fiscal impulse will be negative in 2017—exactly the opposite of what it should be when a surplus region is faced with a shock to external demand….

The euro area would also benefit from additional focus on the enduring overhang of private debt…. Euro area banks should have been recapitalized years ago, with public money if needed…. But in key countries they were not…. And Europe’s new banking rules are now creating additional incentives for delay…. Putting public funds into the banks does not addresses popular concerns about the way the global economy works. Forcing retail investors to take losses in the name of new European rules does not obviously build public support for ‘more’ Europe. Keeping bad loans at inflated marks on the balance sheet of weak banks undermines new lending, and makes it hard for private demand growth to offset the impact of fiscal consolidation. There is no cost-free option, economically or politically….

A conception of the euro area that focuses on the application of common rules with only modest sharing of fiscal risks… designed… too restrictively, with too much deference to Germany’s desire to avoid being stuck with other countries’ bills…. Something will need to give, eventually.

Must-Read: Timothy B. Lee: Brexit Isn’t the Most Serious Threat to the EU — the Euro Is

Must-Read: Timothy B. Lee: Brexit Isn’t the Most Serious Threat to the EU — the Euro Is: “David Beckworth makes the case that the economic woes of eurozone countries like Spain and Greece…

…can ultimately be traced back to the euro itself… other problems… made worse by the ECB’s tight-money policies…. Without reforms, eurozone countries could continue suffering from slow growth and abnormally severe recessions for decades to come. That, in turn, will fuel public resentment against the EU and increase the danger that other countries will follow the UK’s lead. And the euro isn’t just a mistake–it’s a mistake that’s going to be hard to fix. Any country that tries to leave the euro risks triggering a financial crisis. And while deeper economic integration could help to mitigate the euro’s problems, the political obstacles could be insurmountable. Brexit wasn’t great news for the future of the EU. But the common currency is likely to create much bigger headaches for European leaders in the years to come.

Monday DeLong Smackdown: Olivier Blanchard on How the Eurozone Can Be Strengthened After Brexit

A high-quality DeLong smackdown! Keep ’em coming, please…

Olivier Blanchard: How the Eurozone Can Be Strengthened After Brexit: “Brexit raises fundamental questions…. Meanwhile, Europe must continue to function…

…In this context that a large number of prominent economists from different European countries, ranging from those who desire more political integration to those who are more skeptical, have written what they see as the essential next steps to reinforce the architecture of the eurozone…. The purpose of the project, which started long before Brexit, was twofold. First, assess the nature of the challenges and the progress to date…. Second, assess the degree of agreement among ‘experts’ about the remaining challenges and solutions. If you look at the diversity of people on the list, the answer to the second question is that, in contrast to the often strident disagreements in the press, there is, indeed, surprisingly large agreement among experts….

The basic architecture is largely in place. Some strengthening is needed but does not require dramatic political steps. The most important set of measures to take is a strengthening of the European Stability Mechanism (ESM)…. The banking union is largely in place, and with it better tools to monitor and reduce financial risks…. More progress can be made without requiring much more political integration…. [In] public finances… fiscal rules have become too many, too messy, with too many loopholes…. In many countries, the issue is not so much deficits than the high level of expenditure, which in turn makes it difficult to balance budgets without resorting to excessive taxation…. Even under the best fiscal rules, current levels of debt together with low growth imply that sovereign debt default is not impossible. Defining responsibilities and the process for sovereign default is essential. This should and can be the role of the ESM…. States have to be willing to give up some control. Otherwise the ESM will not be able to do its job…. We have learned… that liquidity runs can… be very destructive. The European Central Bank (ECB) now has the tools to provide liquidity to banks…. It would be good if it could do the same to states….

Many would like to see more ambitious steps taken, from a common fiscal policy, to euro bonds, to euro-level deposit insurance, etc. And indeed, the line taken by some US commentators today (e.g., Bradford DeLong and Paul Krugman is that this is what our manifesto should have asked for…. Our goal was less ambitious and more realistic. It was to see if the eurozone could function and handle shocks without further political integration if political realities made it impossible for the time being. Our answer is a qualified yes, but it is surely not an endorsement of a do-nothing strategy.

Must-Read: Paul Krugman: Against Eurotimidity

Must-Read: Paul Krugman: Against Eurotimidity: “The authors really are the best and brightest…. So I’d really like to say nice things…

…Unfortunately… is this really all they can offer? I understand that in the effort to reach consensus one must trim back the more intellectually daring and politically difficult parts of what an individual economist might propose. But in this case the search for consensus seems to have leached out practically all the substance…. They’re calling for liquidity support in times of crisis, and I think debt relief if necessary. But that’s sort of how Europe is already trying to muddle through. They don’t call for fiscal integration; they don’t even call for a euro-wide system of deposit insurance. I’m really not sure what they are proposing, beyond neatening up the organization chart. They allude to the possibility of secular stagnation, which some of us consider a clear argument for fiscal stimulus and higher inflation targets. But all they suggest is… structural reform, the universal elixir of elites.

The only really new thing I thought I saw was the declaration that “the level of expenditure – rather than the deficit – is the main problem” coupled with a call for expenditure rules. But where is that coming from? There is no correlation between economic performance in the euro crisis and the level of government spending as a share of GDP — Austria has a big government, Ireland and Spain small ones by European standards. And absent some clear evidence that big G was the problem, why declare that national sovereignty on the size of the public sector must be reduced?… From a macro perspective, Europe is a depressed economy with inflation well below a reasonable target, desperately in need of more demand, with this aggregate problem exacerbated by the problems of adjustment within a single currency. And here we have a manifesto calling for smaller government and structural reform. The authors of the manifesto aren’t neoliberal ideologues. So what happened?

In Which I Call for Academic Scribblers and Funct Economists to Enter into Utopian Frenzy with Respect to the Institutional Design of the Eurozone

Long Term Government Bond Yields 10 year Main Including Benchmark for Germany© FRED St Louis Fed

Must-Read: From my perspective, this piece at makes many too many bows to conventional-wisdom idols with not just feet but bodies and heads of clay. Thus I cannot sign on to it.

Eleven observations:

  1. The situation is dire. The Eurozone as currently constituted has been a macroeconomic disaster.

  2. The forecast that the authors make is that on the current policy path “economic health will eventually be restored, unemployment will decrease, and the periphery countries will regain competitiveness” is not a real forecast. I think that this is not a real forecast: if it were a real forecast, it would have a date attached, no?

  3. Thus the framing of needed policy changes as things needed to improve “resiliency” just in case things do not “go as forecast” substantially underplays the seriousness of the problem. Fewer readers will pick up on the “things rarely go as forecast” to understand that the forecast is not a forecast.

  4. The first and most obvious feature of the Eurozone is that its interest rates are at the zero lower bound and its economy lacks aggregate demand. A depressed economy at the zero lower bound needs fiscal expansion. If for some reason normal fiscal expansion is feared to be unwise by some holding veto points, the economy needs helicopter drops–backed up by strong commitments by central banks to raise reserve requirements to curb the velocity of outside money should it suddenly become higher rather than lower than desirable.

  5. The bank regulatory system needs responsibility for banks’ rescue to be transferred from national governments to the ESM now. Without that transfer, nation-level governments will continue to make the political calculation that letting supervisory and regulatory standards slide is the more attractive course. It may be true “this is the kind of political step that seems unlikely to be feasible in the near term”. But that does not keep it from being needed now. The purpose of a document like this is to set out what is needed–not to reassure people by claiming that whatever is not politically possible now is not needed now.

  6. Public debt is too high if and only if market interest rates now and forecast for the foreseeable future are about to undergo a rapid and massive jump upward. Right now g > r–which means that public debt is not too high but too low.

  7. How governments should hedge against interest rate increases in a world where g > r is an interesting research question. The obvious route is simply to sell consols. Then, when the real consol rate is higher than the societal return on additional government expenditures, we can talk about what the target debt-to-GDP ratio should be and how to get there. But those who are unwilling to advocate the sale of consols as the obvious way to manage public debt risk have, as long as g > r, no standing to complain that public debts are too high–let alone to set out the proposition that public debt is too high as a self-evident truth.

  8. A massively-underfunded ESM is not “the right institution to deal with [government debt] default”. It is the wrong institution. It is worse than no institution at all, because it allows people to claim that there is a backstop when there is, in fact, no backstop.

  9. The “structural reform” agenda is more-or-less orthogonal to the macroeconomic institution redesign agenda. To even hint that energy that would otherwise be devoted to macroeconomic institution design should be diverted to lobby for structural reform is in its essence a call to do less on macroeconomic institution redesign. And that strikes me as unhealthy.

  10. Now I think that I do understand why the economists below–who are, by and large, among the best economists in the world in their wisdom and in their understanding of the European situation–have made the rhetorical choices that they have. They want to appeal to practical men, who believe they are exempt from any trace of utopian frenzy.

  11. But if the Eurozone is to be a good thing for Europe rather than a millstone around the neck of the continent, I think that utopian frenzy is needed.

Here is the column:

Richard Baldwin, Charlie Bean, Thorsten Beck, Agnès Bénassy-Quéré, Olivier Blanchard, Peter Bofinger, Paul De Grauwe, Wouter den Haan, Barry Eichengreen, Lars Feld, Marcel Fratzscher, Francesco Giavazzi, Pierre-Olivier Gourinchas, Daniel Gros, Patrick Honohan, Sebnem Kalemli-Ozcan, Tommaso Monacelli, Elias Papaioannou, Paolo Pesenti, Christopher Pissarides, Guido Tabellini, Beatrice Weder di Mauro, Guntram Wolf, and Charles Wyplosz.: Making the Eurozone more resilient: What is needed now and what can wait?: “Britain voted to leave the EU. This is terrible news for the UK…

…but it is also bad news for the Eurozone. Brexit opens the door to all sorts of shocks, and dangerous political snowball effects. Now is the time to shore up the Eurozone’s resiliency. The situation is not yet dire, but prompt action is needed. This VoxEU column – which is signed by a wide range of leading economists – identifies what needs to be done soon, and what should also be done but can probably wait if markets are patient.

The UK’s choice to leave the EU was, we believe, a historic mistake. But the choice was made; we must now turn to damage control – especially when it comes to the euro.

The Eurozone is growing, albeit slowly. If all goes as forecast, economic health will eventually be restored, unemployment will decrease, and the periphery countries will regain competitiveness.

But things rarely go as forecast – as we were so forcefully reminded last week. Brexit was the latest – but certainly not the last – shock that will challenge the monetary union.

The question is: Is the Eurozone resilient enough to withstand the bad shocks that it is likely to face in the months and years to come?

For many observers, the answer is ‘no’. To survive the next bad shock, they argue, Europe’s monetary union needs major reform and deeper political integration. As such deeper integration is extremely difficult in today’s political climate, pessimism is the order of the day.

We do not share this pessimism. The Eurozone’s construction has surely followed a convoluted process, but the fundamental architecture is now in place. Yes, some measures are needed to strengthen this architecture. And yes, more ambitious steps would improve resilience further, but these will have to wait for a political breakthrough.

The purpose of this essay is to identify what needs to be done soon, and what would be good to do but can probably wait. To avoid the mind-numbing details that often cloud discussions of Eurozone reform, we paint our arguments with a broad brush. (We will follow up with further documents with much greater detail on specific reform proposals.)

On banks and the financial system: Think of a good financial architecture for the Eurozone as achieving two main objectives in coping with another bad shock: 1) reducing the risk of bank defaults; and 2) containing the broader economic effects when defaults do occur.

This architecture is largely built. Both supervision and regulation are now largely centralised. Supervision is improving and stress tests are becoming more credible with each iteration. The Single Resolution Mechanism is in place and private-sector bail-in rules have been defined. The Single Resolution Fund can provide some recapitalisation funds if and when needed. If they turn out not to be enough, the European Stability Mechanism (ESM) can, within the context of a macroeconomic adjustment programme, add more. In the longer term, a euro-wide deposit insurance scheme could improve resiliency, but this will take time.

So what more needs to be done soon?: Mostly to make sure that the rules in place can be enforced. Italy provides two cases in point. First, non-performing loans have steadily increased and are carried on the books at prices substantially above market prices. Second, the Italian government has proven very reluctant to apply the bail-in rules. The credibility of the rules is at stake. Either they have to be applied, or credibly modified.

What are the measures that would be good to take, but can probably wait?: Diversifying the portfolios of banks so that there are more resilient to domestic shocks would clearly be desirable. The focus has been on decreasing the proportion of domestic sovereign bonds in banks’ portfolios. This would be good, but domestic sovereign bonds represent a relatively small proportion of banks’ portfolios. Decreasing banks’ overexposure to domestic loans would also be an important step towards boosting resiliency. A different approach would be to transfer the responsibility for banks’ rescue from national governments to the ESM. But this is the kind of political step that seems unlikely to be feasible in the near term.

On public finances: Public debt is high, even if, for the time being, low interest rates imply a manageable debt service. Just as for the financial system, a resilient public finance architecture needs to:  1) reduce the risk of default; and 2) contain the adverse effects of default, if it were to occur nevertheless.

On both counts, much remains to be done: Reducing the risk of default is best achieved through a combination of good rules and market discipline. Neither is really in place. The accumulation of rules has made them unwieldy, unenforceable, and open to too many exceptions. They can and should be simplified. In most countries, the level of expenditure – rather than the deficit – is the main problem. High expenditure makes it difficult to raise taxes and balance the budget, leading to dangerous debt dynamics. Thus, a focus on expenditure rules, linking expenditure reduction to debt levels, appears to be one of the most promising routes. Market discipline, on the other hand, will not work if the holders of the debt do not know what will happen if and when default takes place. This takes us to the second objective.

The Eurozone has put in place the right institution to deal with default, namely the ESM. Like the IMF, the ESM can, under a programme, help a country adjust. In its current form however, the ESM falls short of what is needed. First, the ESM’s ‘firepower’ is too small compared to the sort of shock-absorbing operations it may be called on to undertake in the case of a large Eurozone nation getting into debt trouble. Second, given its current decision-making procedures, markets cannot be sure that action will be taken promptly. Higher funding or higher leverage, and changes in governance such as replacing the requirement of unanimity by a more flexible one, are needed to make the ESM able to respond quickly and fully to a country in trouble. Third, the current structure is silent on who should negotiate a public debt restructuring in the extreme case where one was needed. Putting an explicit process in place should be a priority; the ESM is the natural place for it.

What other measures which would be good to have, but can probably wait?: Initiatives to address the legacy of high public debt would bolster Eurozone resiliency and thus would be very useful. However, as low interest rates are likely for some time to come, debt service is manageable, and debt forecasts show that debt-to-GDP ratios will slowly decline (absent a bad shock). Since proposals for dealing with legacy national debts would require the sort of political willpower that seems in short supply for now, such plans cannot be realistically put on the ‘do now’ menu, even if they are may be necessary in the future.

Another set of measures would implement stronger risk sharing, and transfer schemes to further reduce the impact of domestic shocks on their own economy. Proposals run from euro bonds to fiscal transfer schemes for countries subject to bad shocks. These measures would make the Eurozone more resilient and thus may be desirable. But, equally clearly, they would require more fiscal and political integration than is realistic to assume at this point. We believe that the Eurozone can probably function without tighter fiscal integration at least for some time.

We end with two sets of remarks:

Solvency and liquidity: Whether it is with respect to banks or states, the two issues facing policymakers are how to deal with solvency and liquidity problems. We have argued that, when solvency is an issue, the ESM is the right structure to address it (assuming a public debt restructuring procedure is in place). With respect to liquidity, we believe that, in addition to the liquidity facilities of the ECB, which can address sudden stops on banks, the Outright Monetary Transactions (OMT) is the right structure to address sudden stops facing states. One step that could be taken soon is a clearer articulation of how to combine the two. This would clarify the role of the ECB, and eliminate a source of criticism about the allocation of roles between the ECB and other Eurozone structures such as the ESM. The resulting clarity would make it easier for markets and investors to be assured that Europe’s monetary union could deal effectively with any future shocks.

Structural reforms: In any country, at any point, some pro-growth structural and institutional reforms are desirable. Is there a particularly strong argument for them in the case of the Eurozone? To some extent, yes. The institutional problems of the euro are made worse by low growth, and demographic change. If the structural and institutional reforms delivered higher growth, this would be good by itself – ignoring distribution effects – and it would allow for faster improvement in bank and state balance sheets.

Those specific structural reforms which allow for faster adjustment of competitiveness, be it through faster cost adjustment or faster reallocation, would also improve the functioning of the monetary union. Implementing such reform is a slow and difficult process, but necessary nonetheless. The Eurozone will never be a well-functioning monetary union until it is much more of an economic union as well.

We have stressed that actions need to be taken soon, while others are more long term, but the long-term questions do need to be discussed without delay.

Do you support this view?: Starting next week, we will open this column to endorsement by economists. Details to be posted on Monday.

Must-Read: Charlie Stross: “Tomorrow Belongs to Me”

Must-Read: Brexit Edition. The very sharp Charlie Stross writes from Caledonia:

Charlie Stross: “Tomorrow Belongs to Me”: “Okay, so the idiots did it; they broke the UK…

…The Brexit referendum was initially a red herring; a proxy struggle for control of the Conservative Party, with Boris Johnson suddenly turning his coat to march in front of the Leave campaign because it offered his best–arguably his only — chance of winkling David Cameron out of Downing Street before his scheduled retirement in 2020…. But in the process of squabbling over their own party the euroskeptic Conservatives opened the door to the goose-stepping hate-filled morons of the extreme right. The results include the first assassination of an MP–unconnected with the Irish independence struggle–in nearly two centuries, an upsurge in racist attacks on minorities and the disabled, and finally a demented protest vote by the elderly (voters under 25 broke 75% for remain; the over-60s voted over 66% for leave)….

Sterling has tanked to its lowest level in 31 years, the stock market has crashed by 10% already, and we’re likely to see international repercussions as all the sovereign wealth funds that had invested in the London property market see 30% wiped off their investments in a matter of days. Longer term, this may well be the beginning of the end for the UK as a nation. (Watch who’s standing on the sidelines praising the result: Donald Trump, Vladimir Zhirinovsky, Marine le Pen — a who’s who of international fascismus.)… Scotland voted by a 62%/38% margin to remain in the EU and is being dragged out against its will…. The enabling legislation for IndyRef 2 is apparently already being drafted in Holyrood…. It’s likely that in 2-5 years Scotland will have split from the UK and applied to re-admission to the EU. As for Northern Ireland there will be urgent negotiations for some sort of federal arrangement with the Republic that allows them to retain EU access (the Republic of Ireland being an EU member and Northern Ireland having voted to remain in the EU by a significant margin).

What happens to England and Wales now? Short version: economic turmoil caused by the uncertainty. An upswing in right-wing xenophobia as the utterly odious crypto-fascist Nigel Farage makes hay while the Sun shines on his project…. The Brexiters have been selling a lie: that they’d get a no-fault divorce and keep the house. Reality is somewhat less convenient…. We’re back in the Scottish Political Singularity, with a disturbing undercurrent of violent jingoistic xenophobia down south…

Must-Read: Martin Wolf: David Cameron, the Ex-Prime Minister, Took a Huge Gamble and Lost

Must-Read: The very sharp Martin Wolf sees structural recession in Britain’s near future.

People minimizing risk are going to leave Britain. People who would otherwise locate in Britain and are risk-shy are going to pause and wait and see. The Bank of England needs to drop the value of the pound by enough to try to maintain full employment in Britain–but not by so much as to make investors feel that investments in Britain are unsafe and so lose the pound its exorbitant privilege.

As Keynes wrote at the beginning of his Tract on Monetary Reform back in 1923:

I dedicate this book, humbly and without permission, to the Governors and Court of the Bank of England, who now and for the future has a much more difficult and anxious task entrusted to them than in former days…

Martin Wolf: Brexit: David Cameron, the Ex-Prime Minister, Took a Huge Gamble and Lost: “The fearmongering of Boris Johnson, Michael Gove, Nigel Farage, The Sun and the Daily Mail has won…

…The UK, Europe, the west and the world are, this morning, damaged. The UK is diminished and will, quite possibly, end up divided. Europe has lost its second-biggest and most outward-looking power. The hinge between the EU and the English-speaking powers has been snapped…. It is, above all, a victory of the disappointed and fearful…. The geography of the outcome reveals that this has also been a revolt of the provinces against a prosperous and globalised London. It is also a revolt against the establishment…. The UK might not be the last country to suffer such an earthquake….

The UK is now at the beginning of an extended period of uncertainty that, in overwhelming probability, foreshadows a diminished future. The Conservatives… will have to do what the Brexiters failed so egregiously to do during their mendacious campaign, namely, map out a strategy and tactics for unravelling the UK’s connections with the EU. This will probably consume the energies of that government and its successors over many years. It will also involve making some huge decisions… [abandon] membership of the single market. At best, the UK might participate in a free trade area in goods. Meanwhile, the rest of the EU, already burdened with so many difficulties, will have to work out its own negotiating positions. I expect them to be tough ones….

The UK economy is going to be reconfigured. Those businesses that have set up in the UK to serve the entire EU market from within must reconsider their position…. Manufacturers… will have to consider how to readjust…. Many will ultimately wish to relocate. Businesses who depend on their ability to employ European nationals must also reshape their operations…. In the short term, however, it will be difficult for businesses to make such decisions sensibly…. This uncertainty has always been the most obvious result of a vote to leave….

The UK’s decision to join the EU was taken for sound reasons. Its decision to leave was not. It is likely to be welcomed by Ms Le Pen, Mr Trump and Vladimir Putin. It is a decision by the UK to turn its back on the great European effort to heal its divisions. It is, for me, among the saddest of hours.

Must-Read: Daniel Davies: “The Absolute Height of Irresponsibility…

Must-Read: I confess that I haven’t been following Brexit, because it has seemed to me that–whatever you think of the European Union–Britain’s strategy is obvious. It is large enough and important enough either to get an explicit carve out from European Union institutions it does not like (i.e., the Euro) or, if necessary, to nullify them. As long as it is in, it has a powerful voice to shape what happens in Brussels. Thus the right strategy is: Use your voice to pressure Brussels in positive directions, nullify the application inside Britain of European Union policies that are intolerable, and let the “leave” decision by theirs–make them throw you out if they don’t like your attitude.

“Leave” has always seemed to me to be a destructive attempt to summon the demons of nationalism, and “leave”‘s advocates have seemed to me to have careerist rather than public-spirited motivations…

Dan Davies: The absolute height of irresponsibility…:

Must-Read: Paul Krugman: When Virtue Fails

Must-Read: Paul Krugman: When Virtue Fails: “There are two narratives about the euro crisis….

…One… shocks happen, and when you establish a common currency without a shared government, you give countries no good way, fiscal or monetary, to respond…. The other narrative, however, favored by Berlin and Brussels, sees the whole thing as the wages of sin. Southern European countries behaved irresponsibly, and now they’re paying the price. What everyone needs to do, they say, is institute a reign of virtue, of fiscal responsibility with structural reform, and all will be well. So it’s important to note that the euro area’s locus of trouble is moving from the south to an arc of northern discomfort–to countries that don’t at all fit the stereotype of lazy southerners…. Finland is the new sick man of Europe. And the Netherlands… is doing slightly better than Italy but significantly worse than France and Portugal….

Finland has been hit by the fall of Nokia and the adverse effect of digital media on newsprint exports. The Dutch are suffering from a burst housing bubble, severe deleveraging, and an extra burden of austerity mania. But the overall point is that when things go wrong there’s no good answer. So maybe the woes of the euro reflect a bad system, not moral failure on the part of troubled nations? Das ist unmöglich!