The Economist discovers social democracy

Interesting to see The Economist lauding Sweden: The new model. Sweden has a generous welfare state, strong trade unions, and high living standards. What's more, at the moment Sweden is one of the few advanced democracies that is growing and has a budget surplus. So it's about time some of the mainstream commentariat starting to notice what was going on.

In fact Sweden is not really an outlier or an exception. If we look around the advanced democracies, the best performing countries have been those with the most generous welfare states and most entrenched trade unions (Sweden, Netherlands, Finland, and of course Germany). In contrast the countries with deregulated financial markets, weak trade unions and limited welfare states are mostly suffering, and the PIIGS of the Eurozone periphery, despite popular myth, also have weak unions and patchy social coverage.

So the crisis, in fact, has exposed the bankruptcy of the free market, anti-social model that has dominated politics and economic policy since the 1980s. Strangely, political leaders have failed to catch on, and continue to plug the same snake oil, in the guise of 'structural reform', which has brought disaster. The misery of the current recession, instead of sparking a search for equitable solutions, has instead led to a descent into masochistic and self-defeating austerity policies, with a bit of free market liberalism thrown in. After 2-3 years of this medicine has failed to turn around any of the economies it has been applied in, a rethink is overdue. Unfortunately it will probably take total social breakdown (probably in Greece and/or Spain) before the humble pie is consumed.

'via Blog this'

Stress-testing European democracy

One thing we have learned so far in the Great Recession is that stress tests for banks are pretty much a waste of time, because nobody seems to take them that seriously. Like all other estimates of the depth of our financial crisis, the stress tests understate the scale of banking losses and overstate their ability to withstand further shocks. Current estimates of Spanish banks' shortfall -  around 60 billion euros - are scarcely believable, given that the collapse of the housing bubble in Ireland - a country with a tenth of the population of Spain, was over 50 billion. So much for stress tests for banks.

But we are doing quite a lot better at stress-testing the democratic regimes of periphery countries. Yes, that's right, those countries with the most recent experience of dictatorship, the ones whose democracies are scarcely two generations old. Greece, Spain and Portugal began the 1970s, the last great economic crisis, as authoritarian regimes of varying degrees of brutality. By the time the years of stagflation were over, dictators had been booted out of all three countries and replaced by democracies which, on the whole, have been as successful as anyone observing events in the 1970s could have hoped.

Until now. Unemployment of 25% in Spain and Greece, well over 50% youth unemployment, a total GDP contraction in Greece of 25% since 2007, and more austerity to come.

I'm still pretty confident of democracy in Spain and, as far as I can tell, Portugal. And I think Italy, with all its huge failings as a political system, has far too powerful a democratic majority to regress to where it was in the 1930s.

But Greece, I have to say, really worries me now. Stories of the police referring citizens to the viligante arm of Golden Dawn, and the recent polls placing the thugs as third party ahead of PASOK, set my hair on end. In Spain, democracy is being stressed in different ways - not only on the streets, with increasingly tense demonstrations by the real victims of the crisis, the young (and a nostalgically brutal response by the police), but also with the Catalan challenge to the 1978 constitutional settlement, which has the potential to create political chaos.

Not only are we unlearning the economic lessons of the 1930s, as Paul Krugman keeps reminding us, we are also unlearning the political ones. When placed in an impossible situation, there is no guarantee voters will respond with trusting patience in the established elites when there are political entrepreneurs out there with easy solutions to their problems. So far, only Angela Merkel amongst major European leaders has survived an election since 2008. In Greece, rapid turnover has decimated the party system and opened up a huge space for the worst kind of racist nationalist demagoguery. And the worst thing is, that the mainstream parties are, generally speaking, at a loss to respond to the crisis, so we can hardly blame people for turning to the alternative.

There's more at stake here than economic growth. The EU elites need, as Samuel L. Jackson might say, to 'wake the f*** up'.

Italy and the EU debt crisis

Commentary on the Euro crisis to be published in the autumn:

In 2012, the Eurozone crisis has begun to follow a predictable script. First, a member state begins to show signs of financial stress, with a growing public deficit and debt burden alarming markets. The spike in borrowing costs sparks a policy response by the member state government, raising taxes and cutting public spending, which depresses economic activity further. The resulting poor growth data leads to further increases in borrowing costs. When these costs hit an unsustainable level, the European Union institutions intervene by lending the struggling country bailout money, in return for further commitments to reduce the deficit.  A further fiscal squeeze follows, sending the debtor nation into what economist Paul Krugman describes as a ‘death spiral’.

A footballing lesson

So Spain triumph again.

Not just triumph, but crush an Italian side that in turn had crushed the fancied Germans the other side. Maybe a game too far for the azzurri, they looked tired and barely got into the game. But how on earth do you play against this team?

And team is the operative word. Great international sides of the past have often been associated with one great player: Pelé's Brazil, Maradona's Argentina, Cruyff's Holland, Zidane's France and so on. And sure, Xavi and Iniesta have stood out in particular. But what is striking about Spain is that they could probably put out two elevens that would give any other team a game. Villa breaks a leg? Never mind, there is Jordi Alba. Torres is out of form? Who cares, we'll just play 8 attacking midfielders and let Fabregas and Silva score the goals. Puyol injured? No worries, play Arbeloa alongside Piqué and Ramos. If Casillas ever got hurt, you would get Pepe Reina, maybe the best keeper in the Premiership. Arsenal's Arteta doesn't even make the squad. In the end, Italy's players expended so many resources to get to the final they had little energy left, Spain could rotate and give key players a break without missing a kick.

God knows what would have happened had England encountered this team.

So much for dynamic provisioning

Nice piece in Bloomberg by Jonathan Weil (The EU Smiled While Spain’s Banks Cooked the Books), pointing out the perverse effects of the Spanish regulatory practice of demanding that banks adjust their accounts for the potential vagueries of the economic cycle ('dynamic provisioning'), supposedly giving them a buffer against downturns.

Turns out that Spanish banks were able in this way to hide their losses from the popping of the housing bubble until quite recently. Has this helped smooth the financial consequences of the downturn? No need to answer that question.

All this goes to show that tweaking accounting practices is never going to achieve much if the financial system is based on the kind of Ponzi schemes we've been seeing in the past two-three decades. Governments are going to have to start getting on top of what banks do, and providing better regulatory and fiscal incentives to real investment in real productive activities. How do they do this? Don't ask me, I'm not an economist.

From technocracy to populism

A blog post for the LSE's EUROPP blog:


In upcoming elections across the Eurozone periphery, voters are likely to react to austerity by replacing technocracy with populism | EUROPP

"As Spain lurches into economic and financial collapse only months after electing a new government with a landslide majority, the difficult relationship between crisis management and democratic politics once again comes into view. Spain’s rapid descent into economic meltdown has been greeted by anti-austerity commentators such as Paul Krugman and Martin Wolf as further evidence of the need for fiscal and monetary expansion on a massive scale in the Eurozone. But it also has important implications for the nature of democracy in the European Union...."

The myth of moral hazard, or why punishing debtors is futile

This crisis, and its Eurozone variant in particular, is teaching us an awful lot about the political economy. Sadly, most of what we are learning is entirely at odds with the conventional wisdom which still informs policy. And a good part of the wrongheadedness that we are subject to revolves around the concept of moral hazard.

The plausible expectation of bailouts creates moral hazard, we are told. Yes, it does. There is plenty of evidence that big financial institutions take risks because they expect governments to pick up the pieces if everything goes pear-shaped. Certainly, if top bankers are anywhere near as smart as their paypackets suggest, they should lever up and max on risk, confident that governments will plug the gap if their bets go bad.

Trouble is, we also know that finance is also prone to bouts of irrational exuberance and panic. Moral hazard may exacerbate the exuberant parts of the cycle, but it also mitigates the panic when things turn bad. Part of (maybe most of) the reason that the Eurozone periphery is in such a self-fulfilling debt trap is that there isn't enough moral hazard around - investors are terrified that if their paper goes bad, they will lose everything. And so the downward spiral accelerates, making bailout infinitely more expensive as panic sets in.

What about governments? Well here the virtuous Northern economies in the Eurozone are afraid that bailouts now will encourage Southern sovereigns to ignore their fiscal problems in the future, leaving Germany and the others on the hook forever. Moral hazard here gives politicians an incentive to run deficits and buy popularity, whilst others pick up the tab.

The trouble with this one is that the politicians that are punished are not usually the ones who exploited moral hazard. Mariano Rajoy took over when Spain's fiscal situation was already out of control, yet he is the politician being exposed to popular anger now. For the anti-bailout policy to work, voters would have to be sophisticated enough to gauge how likely it is that a party's fiscal proposal at time t will result in another party having to impose brutal austerity at time t + 1. Very often, as in Greece, successive alternating governments are responsible for the fiscal mess. How can voters cast a partisan vote that sends the correct signal to politicians, so that the risk of irresponsible policy is averted? Do we really think that if this crisis ever ends Greek voters will become eager observers of fiscal rigour on the part of their politicians, anxious to avoid this all happening again? For this to happen some Greek politicians would have to offer voters fiscal prudence whilst others stuck to deficit-fuelled patronage politics, making elections a clear choice between happiness and hazard. That's rarely the way politics works.

In short, moral hazard is a red herring, and theorizations of its role in the crisis are crude, confused and make no historical sense. In the real world of politics and markets, when you get to the point where bailouts are necessary, it's far too late to worry about moral hazard. This is what we should be worrying about.