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I was listening to The Economist’s podcast summarizing their special report on Germany and and when I got to the equivalent of this line:

It is the largest creditor country in the euro zone, and as chief paymaster it has the biggest clout in determining the single currency’s future.

And I guffawed. And it’s worth explaining why.

When a creditor loans money to a debtor, there is the potential for everyone to be better off – the debtor can make an investment they could otherwise not afford, and the creditor receives some interest in return. However, there is a large potential opportunity for the debtor to rip off the creditor and never pay back their money, thus getting free money. Therefore, creditors have traditionally tried to employ both the power of the state and extra-legal threats to ensure compliance. There is a long history of violence and threats of violence in this regard, from Mafia kneebreaking on the black-market side to the Venezuelan blockade on the macro-side. The reason the Iron Bank of Braavos* gets paid back is because they have proven their willingness in the past to depose and assassinate kings to collect.

But modern norms have changed that. Sure, you can still be imprisoned for debt in certain parts of the United States, but remember that the entire state of Georgia was originally envisioned as a debtor’s colony. And on an international scale, while you will suffer for sovereign default, you won’t be invaded and expropriated, and note that countries like Argentina have done surprisingly OK after even a spectacular sovereign default. Not that being shut out of most financial markets, both as an individual and a nation, is without consequences, but it’s a lot better than being behind bars or under the gun.

What’s the point? The key is the huge power of social and cultural norms, and how many can persist even as related ones change. For example, our increased unwillingness to use violence and imprisonment to punish debtors would seem to encourage double-dealing by borrowers and recalcitrance by lenders; yet our powerful social norm in favor of paying back debts and in viewing creditors as virtuous (“savers” “investors”) and debtors, especially debtors who fail or struggle to repay, as sinners (“deadbeats” “spendthrift” “profligate”) then debtors will largely continue to pay and creditors will largely continue to lend even though debtors, not creditors, are gaining in leverage and material power. They have your money! Germany isn’t invading Greece or Italy or Spain or Portugal or Ireland! But debtors don’t have anyone’s respect and that matters tremendouslyAnd economic models (and economic commentators) fail to account for it.

*You seriously thought I was going to go all day on this blog without a reference to “A Song of Ice and Fire?” Ha! Ha, I say, ha!


Tyler Cowen poses this question:

Why is there still inflation in Greece?

He thinks this puzzle is hard, but it is in fact easy. Let’s model this more simply:

There are three countries in the world, Productoland, Moderatia, and Dysfunctiony. In this model there are a few rules:

· All money is gold.

· All goods and money can be teleported and traded freely across national borders.

· There is a universal legal prohibition from a resident of any country from relocating to any other country for non-leisure purposes.

· Wages are sticky.

· The equation of exchange accurately describes these economies.

In the initial state all three economies are performing well, even though “fundamentals” (mainly institutions) are much stronger in Productoland and significantly stronger in Moderatia. However, after some unexpected shock (say, a surprising report about the economic state of Dysfunctiony), there is a “panic” about the economy of Dysfunctiony. Very rapidly money, ie gold, begins to flee Dysfunctiony.

What would we expect to see happen? Primarily, we would expect to see a substantial negative shock to AD in Dysfunctiony. Wages are sticky; and more importantly, the law of one price means that prices of all goods (since there are zero transaction costs in this model) must remain equal in all three nations. Therefore, the decrease in MV would result in a reduction in QP; but because both Plabor and Pgoods are sticky, we would expect to see most of the commensurate decline occur in Q. We would expect to see some slowdown in Productoland and Moderatia, since presumably the market for imports in Dysfunctiony is slower, and overall global NGDP would probably fall, but if labor markets remained relatively tight in Productoland and Moderatia, we may in fact see the increase in MV in those countries (due to the influx of gold, ie money) lead to an increase in P, since Q is probably nearing its upper-bound; and an increase in P in those countries would of course result in a further increase in P in Dysfunctiony to the extent it affected teleportable goods. This would of course result in a further commensurate decline in Q, which would cause MV to further flee.

Basically, if transaction costs and barriers to trade are low, we should expect to see consumer prices move in unison within a currency union, and we should expect monetary shocks to result in severe real declines in output but continued price stability. This, I believe, sufficiently explains why Greece saw massive unemployment even as prices continued along the ECB’s chosen path, for the same reason Nevada saw unemployment increase from 4.2% to 14% over the course of the Great Recession even as there is no evidence that consumer prices diverged wildly in Nevada from other parts of the United States.

Matt Yglesias and Tim Fernholz have both written great stuff about how US government borrowing is supporting US household deleveraging, a process Fernholz calls the “invisible bailout.” And they’re right, and for important reasons – as Yglesias says:

But when the household sector tries to reduce its indebtedness it needs to do something to make that happen. Stacking up huge piles of money in the closet is not a very sound method. As an individual, you don’t really need to think about this. You save by either lending money to your bank or else by purchasing a financial asset (stock, ETF, mutual fund, bond) from someone else. But that just puts the money in the bank fault or in someone else’s closet. Ultimately the money saved has to go to something.

What’s really interesting about that, though, is that it’s also true on a global level and not just a national one. One of Fernholz’s charts shows that the US has net-delevered even relative to pre-crisis 2007 levels. This should not only give a lot of pause to American austerity pushers, but austerity pushers everywhere. For if the US is net-saving, somebody else is net-borrowing. Europe? Maybe. But as austerity gets pushed harder there then that means either somebody else is saving less or some other party is borrowing more or both. Just like we can’t all be net exporters, we can’t all be net savers. In some sense, all saving is simply being the counterparty to someone’s borrowing (since saving is an attempt to push current consumption into the future and borrowing is the opposite) and therefore if you’re not affecting net global indebtedness you’re just squeezing the balloon. But net global indebtedness should be driven by the desire to save, not the desire to borrow – as long as the world is accumulating capital and is looking for some kind of store of value or investment return then they’ll find something, but in the absence of that you’re not going to magically find money to borrow. So the real question we should all be answering is “given the current global demand for savings how can we allocate that capital?” not “how can we reduce the federal government’s borrowing?”

I think this is all getting a little confused by the Euro crisis. Not being able to run experiments like this is what makes macroeconomics such a headache, but I’d bet dollars to donuts that on Earth-beta where there was never a European monetary union there is no debt crisis in Europe and most developed country would be currently borrowing at super-low rates, which is in fact what we see elsewhere.

did ya miss me?

Thinking about the Wolfson Prize whilst walking about DC this evening, a notion struck me:

There are three futures for Europe. The first is total federation and integration. This seems, at the moment, unlikely. The second is constant crisis and panic with long periods of recession and tepid growth in-between, similar to the United States between the Civil War and the Great Depression. That choice is woefully undesirable. Barring either of those, it seems as thought the Eurozone may have to be, if not unwound, reduced in scope.

But how do you leave the Eurozone? Specifically in the current crisis, forgetting the logistical nightmare of endless private contracts denominated in euros, the sovereign debt is also denominated in euros; to leave the euro and refuse to pay back creditors in euro is default, the outcome everyone is trying so hard to avoid. So how can you leave the euro?

Well, I had one idea. Let’s say this – Greece leaves the Euro and re-institutes the drachma as the national currency at an initial 1:1 exchange rate. Obviously this rate will not last, and the drachma will plummet in value, leaving Greece poorer in the sane, proper way that independent nations do so – monetary devaluation. Yet Greece now has to pay its debts. How can they do this?

What if the European Central Bank offered Greece a special privilege – the Greek treasury can, up to a certain limit, exchange drachmas for euros at a 1:1 rate with the ECB. Greece can then turn around and use those euros to pay its pre-drachma debts.

Now clearly, the ECB will be taking a loss here. However, it won’t be a bailout – as far as Greece is concerned they are paying their debts fair and square with tax revenues. So there is no (or at least much less) moral hazard. Also, this avoids the dread specter of inflation that has so gripped the ECB. So even though they take a loss, it’s an outcome where a) Greece still pays 100%, b) the creditors are paid back in full in Euros, and c) there is no default, bailout, or inflation.

This still leaves the question of private debts; I’m not sure a program like this could work for every contract denominated in euros between a Greek and a non-Greek party. You wouldn’t want to allow anyone other than the Greek treasury to exchange drachmas for euros at a fixed, favorable rate, since you’d have a mad dash to dump the drachma in anticipation of devaluation. But if you could at least solve the sovereign debt problem perhaps the magic of the market could work out private debts on a case-by-case directly negotiated basis.

Anyway, just an evening thought on the issue d’jour.

I’m quite surprised to find myself in agreement with the Tea Party but here we are:

Some House Republicans have proposed a bill which would kill the 1-dollar bill and replace it with a mandated dollar coin, The Hill‘s Peter Kasperowicz reports.

Rep. David Schweikert (R-AZ) and two other House Republicans introduced the Currency Optimization, Innovation and National Savings (COINS) Act last week, saying the U.S. would save $184 million a year by moving to the dollar coin.

But Massachusetts Sens. Scott Brown (R) and John Kerry (D) have introduced a competing bill called the Currency Efficiency Act which is supposed to protect the paper dollar from what they’re calling the "massive overproduction" of the "unpopular one dollar coin."

"The one dollar coin is misleading because it costs taxpayers so much more," Brown said. "In fact, we have over $1 billion worth of extra one dollar coins sitting idle in vaults and that’s set to double over the next several years." Their bill would stop $1 coins from being minted while the current surplus of $1.2 billion in dollar coins exist.

The Dollar Coin Alliance claims that Kerry and Brown are just covering for a business in their home state, Crane & Co., which supplies the paper used to produce dollar bills.

"Unfortunately, it seems the senators have chosen to protect a local business at the expense of the American taxpayer," former Arizona Rep. Jim Kolbe, the honorary chair of the Dollar Coin Alliance, said, according to the newspaper. "At a time when the government needs to be looking to save every dollar, we can’t continue to play the same Washington game of serving narrow special interests with half-measure legislation."

NPR’s Planet Money investigated the use of dollar coins earlier this year, finding pallets of them sitting around in Federal Reserve storage unused.

In a 2010 report to Congress, the Federal Reserve said the coins were being held "with no perceivable benefit to the taxpayer" and that banks are sending them back in increasing numbers, according to NPR.

"We have no reason to expect demand to improve," the Fed said. "We also note that a 2008 Harris poll found that more than three fourths of people questioned continue to prefer the $1 note."

Now I’m not sure if the Kerry-Brown axis is really just a front for Big Paper, but other than that everyone is right here – the dollar coin is unpopular. But it also represents vast savings for the government and should be widely adopted, and that’s why Congress ought to go the unpopular route and scrap the dollar bill. It’s more efficient and more ecologically sustainable. Plus, we’d get to circulate all the dollar coins we already printed. The euro doesn’t circulate any bills less than €5 in value but while that might annoy people at the margins that’s been the one thing about the euro that hasn’t incited riots and social unrest.

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