24/07/2009: You can never leave

With its sweet Mediterranean climate, great wines, and world class skiing, it’s a popular destination for tourists around the world. With its 1.8 Trillion US dollar GDP, it is the eighth largest economy in the World. It’s part of a currency union and considered by many – especially outsiders – to be ungovernable and basically broke. If you’re thinking Italy, think again, because I’m referring to California.

Of course, that wasn’t exactly fair. When taking a first glance at the finances, California does not look at all like Italy. Its outstanding debt in form of General Obligations is currently in the neighborhood off 60 billion US dollars. This is at best a rounding error when compared with Italy’s government debt, which hovers somewhere above 2.3 trillion USD. But, remember, California is not a sovereign nation and therefore isn’t burdened with the usual governmental big ticket budget items like defense and a the majority of social security expenditures. Once you take this into account, California’s looming 2009 budget deficit, at a projected 24 billion USD, is even more worrisome than the 100 billion dollar deficit that Italy is likely to face.

So defining California as the Italy of the US is not so far fetched after all. What is puzzling though is that no one seems to notice the 800 pound golden bear in the room and ask whether California should trade in the US dollar for its own currency? This is a case that many investors — especially outside of Europe — are lightly making not only for Italy but for all other “PIGSI” nations (the acronym stands for Portugal, Italy, Greece, Spain and Ireland, all members of the Euro-Zone and confronted with heavy government deficits).

When you think about it, there is not much upside for those countries to leave the euro (or, for that matter, California to leave the US dollar). Yes, having flexible exchange rates would probably allow those countries to export more to their former currency partners and even to other countries, since their currencies would depreciate. A similar phenomenon happened after the UK had to leave the European exchange rate mechanism back in 1992. However, those countries would also be confronted with much higher interest rates on the debt expressed in a new currency and an old debt still denominated in euros. This would make the burden especially expensive if not plainly unbearable. The recent fate of Iceland, which had to default on its debt and wants now to join the Eurozone, comes to mind.

If there is not much incentive for countries with debt and deficit problems to leave a currency union, there might be at least some incentive for sterner member countries to kick the profligate out. Many New Yorkers remember the 1975 Daily News Headline: “Ford to City: Drop Dead,” when then-US President Gerald Ford menaced that he would veto any bail-out of Big Apple. In fact, despite already having to pay higher interest rates than the average Eurozone member, PIGSI nations might still weigh on the overall euro interest rates and exert a negative externality on the public finances of countries like Germany, Austria or the Netherlands. But this negative effect is more than counter-balanced by the reality that if PIGSI countries were kicked out of the currency union their currencies would devaluate and the remaining countries would see their exports crumble. The same argument would apply if one of the more sober countries decided unilaterally to leave the currency union.

To make the case against a break-up of the Eurozone, therefore, you don’t need an international treaties lawyer. I believe that Italy like the Golden State will ultimately remain in its currency union or to quote the last verse from The Eagles’ this time: “You can checkout anytime you like, but you can never leave!”

10/07/2009: Hard questions for a soft science

If a modern economics journal fell open at your feet, you might be amazed at all the mathematical formulas it contained. Numbers nerds argue that only elaborate mathematical models can illustrate economic truths, while the numerically challenged counter that the math papers over a lack of pragmatic ideas. Either way, neither bashing nor praising Wall Street’s quants, those unloved scapegoats of the current financial crisis, is my purpose here.

Given its mathematical basis, economics can fairly be regarded as a science, but it is surely not a “hard” science like physics or engineering. For one thing, no experiment can really test an economic hypothesis—leaving aside the trials where university students are paid to respond irrationally to microeconomic questions.

History is economics’ only laboratory, the only arena where its empirical results can be judged. And the idea that history repeats itself probably applies more to its lessons than its details. Going by how often the word “unprecedented” has been invoked in connection with the crisis, it follows that history can offer us only limited guidance now.

Legend has it that Thomas Edison made 10,000 duds before managing to produce a working light bulb. Obviously, depending on the complexity of the challenge, mastering something new can be extremely difficult. Thus, as an economist, I am astonished at the public’s faith that the world’s central banks and governments will somehow succeed, in their very first attempt, to steer us clear of depression, deflation or downright disaster, getting us gently back on track, unharmed and inflation-free. I find this optimism naive.

Many parallels have been drawn between the current crisis and the one that followed the stock market crash of 1929. Back then, the Fed and other monetary authorities remained inert and it took the US government four years to start the New Deal. Most economists think that this inaction turned the crash into the Great Depression.

This time around, central banks have been quick to respond, massively increasing their balance sheets and unleashing a flood of fresh money into their economies. Governments have launched large, even “unprecedented,” stimulus packages that will thrust public deficits into the stratosphere.

However, given the universal lack of experience with this kind of rescue operation, especially on such a grand scale, no one can honestly pretend to know how much monetary and fiscal expansion is enough, and even worse, how much of it can safely be withdrawn once the crisis finally passes.

In physics, elasticity is the property of a material to return to its original shape after having been deformed. If too much force is applied, the deformity will be irreversible. The hard question now is whether the economic damage is still reversible or has the deformation been too large? While we can answer this empirically in the hard science of physics, in economics, unfortunately, those who apply the remedies can only guess. History’s verdict awaits us.