Interesting, but What Does it Mean?

Thomas Caton and Marcus Walker have an article at  WSJ about the prospect of economically struggling EU states leaving the Euro, that includes this interesting-but-what-does-it-mean graph.


Like the graph, the article focuses almost solely on the economic decline in these countries, and uses Argentina’s abandonment of its ten-year experiment in pegging the value of its currency to the U.S. Dollar. Since these countries’ decline in GDP is approaching, or in Greece’s case has tripled, Argentina’s GDP decline, how much further can they go before they start to break away from the Euro?

I see similar arguments for the impending implosion of the Euro from economists and financial writers with depressing frequency. Their error is not solely that they are using a unicausal explanation for a complex phenomenon, but that due to their disciplinary blinders they fail to realize that the Euro is not simply a monetary matter–it’s a political issue in ways they…well, I’m sure most of them do understand, or would find it easy to understand. But few of them build it into their calculations beyond treating it as a public policy to be a kept or abandoned.

When I say it’s political, I mean the Euro is bound up with the whole concept of the EU, which is as much political as it is economic. The most fundamental idea of the EU is to tie Europe together to avoid a return to the endless series of wars that have characterized the past umpteen centuries. That’s why retrenchment on any EU policy has been so hard–the fear of going backward has been much greater than the fear of going forward even with an unpopular policy.

I’m not arguing in favor of the EU. While it seems to have worked overall (Europe, or at least the EU members, has enjoyed something like it’s second-longest spell of peace), there are aspects I don’t much like. I’m just looking at it from the perspective of “what concerns Eurozone members?”

Nor am I making any predictions. Economic concerns in some state or other certainly could top broader political concerns at some point, and Greece may be a particularly likely candidate for that, given the appalling decline in GDP, and their lack of enthusiasm about becoming more German. But when the politics variable is added to the equation, the probability declines substantially (Hanley says, without bother to offer an actual equation or specify the variables more operationally.)

And this helps us see why Argentina is not a good comparison. Argentina’s dollar peg was solely an economic move, and Argentina was not politically integrated with the U.S. in any way comparable to European states’ integration into the EU, so when the economy went south, the solely economic move was easily reversible on solely economic grounds. Argentina is to the U.S. as Greece is to _____________? That’s not answerable by plugging in “EU.” There is no correct answer to that question; they simply aren’t comparable in that way.

About James Hanley

James Hanley is former Associate Professor of Political Science at Adrian College and currently an independent scholar.
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19 Responses to Interesting, but What Does it Mean?

  1. Matty says:

    The most fundamental idea of the EU is to tie Europe together to avoid a return to the endless series of wars that have characterized the past umpteen centuries. That’s why retrenchment on any EU policy has been so hard–the fear of going backward has been much greater than the fear of going forward even with an unpopular policy.

    Strangely enough this helps explain why there is so much hostility to the EU in Britain. The European idea was not sold to the British people on these terms but as a simple trade agreement to make selling in nearby countries easier.

    British and continental politicians are basically talking about different things when they discuss Europe. To one side sharing a currency is part of making it even more unthinkable for war to return, to the other it is a naked power grab that reduces the power of sovereign states.

  2. Troublesome Frog says:

    When they were gearing up to start circulating Euro banknotes, none of the economists I talked to about it thought it made a damn bit of sense. Reading this, it makes sense now why it looked so weird to anybody looking at it from a purely economic perspective–it really wasn’t an economic decision.

    I’ve already said that I’m not overly enamored with Paul Krugman’s popular books, but I will say that The Return of Depression Economics and the Crisis of 2008 has a lot of good examples of the risks countries take on when they tie their monetary fate to foreign central banks. It’s not as though the mechanisms for these types of problems were a myster when the EU took the plunge. I guess they thought that the political benefits outweighed the economic risks.

    World War III hasn’t started yet, so…so far so good?

  3. lancifer666 says:

    I admittedly know next to nothing about macro-economics. That said I find most of what passes for “economic analysis” to be nothing more than post hoc ergo propter hoc story telling that is arranged to fit whatever hypothesis is favored by the analyzer.

    There seems to be plenty of opportunity for such shenanigans in that graph.

  4. Troublesome Frog says:


    I won’t disagree with you too much on that front, but there are pretty well understood mechanisms for how things can go terribly wrong when governments do things like maintaining currency pegs or borrowing money in a foreign currency. Those things aren’t necessarily always bad policy, but they come with certain failure modes that shouldn’t be a big surprise. Two examples:

    Borrowing in a currency you can’t print: We have a central bank that can buy our bonds if the market ever panics about our ability to pay. But the very fact that the Fed could keep our bond prices from crashing in a panic means that there probably never will be a panic. Not so much with the EU.

    Monetary policy: As one of my econ profs said (in 2002), “So, what do you think will happen when Spain and Germany need different monetary policies?” Well, that works about as well as it sounds.

    These aren’t the speculative pie-in-the-sky stuff. They’re the simple first-order problems that have been observed in the wild, so it was kind of a mystery that they weren’t taken more seriously. I can sort of see a nation underestimating the likelihood that everybody will dump their bonds, but the monetary policy question seems crazy.

  5. lancifer666 says:

    Troublesome Frog.

    So if you can set the rules you can control for catastrophic outcomes? Then why worry about debt ratios at all? Just print enough money to cover all bets. I must admit that the entire world economy seems like a giant confidence game to me. So long as people believe that the money has value… it does. Once the rats run for the gunwales it seems there is nothing that can keep the ship afloat.

    The EU seems like a bucket with holes that have more surface area than the opening at the top. How anyone could have thought that a single monetary policy could be designed to accommodate Greece and Germany is beyond me. But maybe if the shills can calm the masses it will putter along as well as the separate economies would if left to their own illusions.

  6. Troublesome Frog says:

    Not all catastrophic outcomes, but some of them. One source of failure is self-fulfilling prophecies. If you’re rolling over debt at reasonable rates when everybody suddenly starts to worry about your solvency, you could become insolvent simply because everybody started to worry and not because of anything “real” that changed.

    Having a lender with infinite capacity to lend who could loan you money if something like that happens keeps everybody calm. It’s like the FDIC: the fact that it’s there prevents bank runs from happening in the first place, making it very unlikely that it has to pay out.

    Debt ratios are not irrelevant, but let’s be realistic–if you plot risk of default against debt:gdp ratio, it should be relatively smooth and continuous. There should be no spot when $1 in additional debt suddenly quadruples your bond yield. But bond markets don’t always work that way. You may sell Spain’s bonds because you think that Spain is marginally more likely to default than it was yesterday, but you may also sell bonds because you think that all of Spain’s other bondholders are about to sell theirs. When that happens, it’s bad for everybody.

  7. lancifer666 says:


    Thanks for the very cogent mini economics lesson, as I said I am pretty much illiterate when it comes to economics.

    I have noticed that every time there is a report on NPR about the rate of GDP growth the analyst invariably blames part of the less than hoped for rate of growth on decreased government spending due to the “sequester”, even though the rate is pretty much indistinguishable from before the sequester.

    This smacks of advocacy. As I said above I am no economic wunderkind but while I know that government spending is part of GDP it is surely not the important part. Otherwise every country with a central bank could just government spend it’s way to whatever GDP it felt was optimal..

    At some point there must be consideration made to debt ratio and a country that is attempting to pay down its debt is certainly going to be seen as more attractive by other trading partners and private investors. Because if you are spending more money on debt service than on goods and services you are headed for disaster.

    Or so it seems to me, but what do I know, I’m just a humble Math/Physics instructor.

  8. James Hanley says:

    At some point there must be consideration made to debt ratio

    The standard answer to this is, “of course, but while you’re recovering from a recession is not the time; once we’ve recovered, that’s when we should do so.” E.g., you don’t try to pay down your debt when your hours at work have been temporarily reduced, but after you’re back to full time.

    That’s logical, financially, but it ignores two important political dynamics. One is that for the last three decades we’ve stopped–as a public–really worrying about debt, so that enough people say in bad times that Keynesian debt is good, and enough people say in good times that the economy is so strong that we can afford more debt, that at present there’s no forseeable political constituency of any size for getting our debt under control once things get better. This is the type of political dynamic I think the Krugman-type folks too readily overlook, no matter how right they may be about the economics.

    The second dynamic is that currently we have a GOP that refuses to raise revenue (taxes) and a Democratic Party that refuses to cut spending. So I say sure the sequester is badly designed, and sure it doesn’t actually do that terribly much to reduce the deficit, but towards that end it’s the best thing we have going at the moment.

    And our GDP growth for the first quarter this year, while not terribly strong, was better than all of last year. So at worst we seem to have shaved a few tenths of a percent off our annualized growth rate, rather than actually sinking it, in pursuit of at least some minimal fiscal constraint.

  9. Troublesome Frog says:


    The lower GDP growth due to sequester cuts follows pretty much automatically from most models. The money to pay for the additional spending would have been borrowed, and under current conditions, the borrowing isn’t really crowding out private investment. The result is that $1 less in government spending doesn’t mean $1 more in private spending as it might when the private economy is healthy. I’ve done my grasshopper/ant toy model here before, so I’ll skip it, but the gist is that it’s really hard to argue that the private sector will take up all of the slack.

    The exception here is whether or not the Federal Reserve will step in and offset whatever Congress does. In theory, a perfectly governed Fed could neutralize just about any stimulus or spending cut (in terms of GDP numbers, at least) because it acts faster and has practically infinite capacity to act. Whether it really does (and if it does, the extent to which it is successful) is a matter of some debate. I tend to think it does to some extent, but not really 1 for 1. Scott Sumner and recent Fed statements have me leaning more in favor of the Fed than in the past.

    You’re right that you can’t send your debt to GDP ratio to infinity, but the empirical data doesn’t really support any reason to panic in the short run, especially with rates being what they are. In fact, during a time when we were being offered negative real interest rates, we were panicking about reducing the deficit. That’s crazy behavior. It fails the “What would Goldman Sachs do it it ran the federal government?” test. Given the choice between taxing $0.99 later and taxing $1 today, we preferred the $1 now option.

  10. Matty says:

    How much control does the government have over the Fed? Only if I were an elected politician and saw an appointed body effectively cancelling out things I’d worked and voted for I would get pissed off.

  11. Matty says:

    Just realised my error, you’re talking about neutralizing the effect on the wider economy right, not reversing the effect of congressional decisions on spending or tax rates?

  12. lancifer666 says:


    Again a very cogent explanation.

  13. lancifer666 says:

    James Hanley,

    “So I say sure the sequester is badly designed, and sure it doesn’t actually do that terribly much to reduce the deficit, but towards that end it’s the best thing we have going at the moment.”

    My sentiments exactly.

    If your hours at work are cut and you have huge credit card bills it’s still a pretty good idea to toss a few extra bucks at them if you can. Also, as I understand it, the sequester just cuts the rate of increase of spending not actual spending.

  14. Troublesome Frog says:

    OK, with the credit card bills point, I guess I should throw out the grasshopper and ant model. Imagine this: You have a closed economy of a grasshopper and an ant. The ant works hard and spends less than he earns. The grasshopper works hard, but he spends more than he earns. Because the economy is only these two entities, the following are true:

    * Ant spending = grasshopper income.
    * Grasshopper spending = ant income.
    * Ant savings = grasshopper borrowing.
    * Ant savings = ant income – ant spending.

    If the grasshopper wants to pay off his debt, it means that he must spend less than he earns during some time period. This means that during that time period, the ant must spend more than he earns.

    This works OK in the real world because we’re not all grasshoppers or ants. Sometimes we spend more than we earn and sometimes we spend less. But if people sort themselves into grasshopper and ant classes, the amount of debt will grow monotonically until the grasshoppers can’t service their debt.

    In a panic, grasshoppers will try to curtail their borrowing, but ants will not increase their spending to offset it. They’re panicked too, so they’ll try to save even more, causing grasshopper incomes to drop. Grasshopper incomes are all spent with the ants, so ant incomes drop as well. If everybody behaves this way at once, bad things happen.

    Now let’s create a third entity called “government” that is currently acting like a bunch of grasshoppers. During a panic, it doesn’t do anybody any good by taking part in the “spend less, save more” trend. It just increases the imbalance. Likewise, if it borrowed more, it could provide the income grasshoppers need to pay down their debt while giving the ants safe bonds to buy so they don’t have to go against their nature and spend down their savings.

    The picture gets more complex when you have a central bank and foreign lenders, but this first first approximation is a useful way to think about a lot of problems.

  15. James Hanley says:

    Well, let’s work with that first approximation. If the government’s going to repay the loans with interest, then it has to create new money. A monetarist like Sumner might ask why not skip the borrowing part and just create the money (and he’s not impressed by arguments like the zero lower bound and non-arguments about pant gnomes).

    Further, what if lending to the government (or it’s appurtenances, like the Fed) becomes the preferred investment? Then gov’t spending props up demand, but doesn’t stimulate the investment that creates real economic growth.

    But mostly I’m dissatisfied with the exclusion of foreign lenders. When so much of the borrowing comes not from the ants but from the crickets, then your two party model has been surpassed. We have to go beyond first approximation to second approximation.

  16. James Hanley says:

    Let me put it this way. If I had any confidence we’d have some fiscal responsibility when the economy recovers, I’d have little concern about borrowing to stimulate (even though I remain unpersuaded that it doesn’t crowd out investment, a claim that seems more an article of faith to me than a proven fact). But if it takes a crunch to get us back to anything like fiscal discipline, then I say never let a crisis go to waste, even if doing so makes that crunch worse in the short term.

    The return to fiscal discipline in the future is my main concern, and you glossed over it, just as Krugman does. You really have no choice but to gloss over it, because you can’t provide a good model for how we’ll get to Congress constraining itself again–the best models predict differently. Your main concern, like Krugman’s is recovery, and then I guess we’ll let the future take care of itself (**cough** underpants gnomes Mr. Krugman **cough**). My main concern is not recovery, but future discipline, and given our last three decades, I can hardly scoff hard enough at the claim that we’ll take care of it when the economy recovers.

    But in a nutshell, as long as our primary concerns are not the same thing, we’re kind of talking past each other.

  17. Troublesome Frog says:

    There’s a lot here, and one of the reasons I gloss over things is that I don’t want to monopolize the space here and derail other things that are going on.

    Regarding future responsibility, what’s your question? If it’s, “How would you use this crisis to cut the budget deficit?” my answer is that I wouldn’t. If it’s, “How do we get onto a long term sustainable path?” my answer is a return to full employment combined with a change in the trajectory of health care. Deficits shrink very rapidly when the economy is at capacity. We were bumping up against a surplus less than 15 years ago.

    I’d be happy to see the Fed take charge and make something happen, but I think that recent history shows that they’re pretty satisfied with the way things are. I can’t justify it, but there it is. But even if they weren’t, that doesn’t mean that the best course of action for Congress is to work in the opposite direction. Congress controls what Congress controls, so it should act rationally at its own margins.

    If we want to talk about crowding out, we should talk about the mechanism. Normally, private industry allocates everything (loanable funds, labor, resources) about as efficiently as possible, so government increasing its share of any of those things results in a net loss in efficiency. But what about now? Assume for a moment that we’re borrowing to continue the same baseline set of services (and nominal growth to keep up with population and inflation). What resource will we be consuming, and in what way is it a constraint on our growth?

    Better yet, let’s keep spending the same, cut taxes by $1B, and borrow an extra $1B. What’s the result then?

    As for the model, they’re not a huge part of the overall system, but let’s add crickets. The crickets are basically just more ants (albeit ants whose economic welfare doesn’t really concern our electorate). We borrow from them and send them income. A reduction in our trade deficit would make the crickets less ant-like and make it easier for the grasshoppers to pay of their debt. If Congress had a great way of ramping up our net exports, that would be neato.

    Further, what if lending to the government (or it’s appurtenances, like the Fed) becomes the preferred investment?

    I’m not sure what you mean by this, but I’m interested in hearing your thought process. I can interpret it a few different ways, and I’m not sure which way to go.

  18. James Hanley says:

    Deficits shrink very rapidly when the economy is at capacity. We were bumping up against a surplus less than 15 years ago.

    Eh, that’s leaving out a lot. Like a Dem president facing off against a Republican Congress. And an unsustainable bubble in tech stocks that brought in lots of tax revenue on purely paper earnings. It wasn’t something that automatically happened because the economy was strong–it still depends on fiscal policy decisions made inside the beltway. That’s why I can’t accept your “return to full employment” as a sufficient answer to returning to a sustainable path. (And it sure smacks of a magic fairyland we-can-do-it-with-no-pain approach.)

    And I don’t buy the trade deficit issue. Sure, it means the crickets have lots of our currency they’re looking to do something with, but that doesn’t mean we have to choose to borrow it from them. Slash our rate of borrowing and they’ll have to make other choices. Hopefully they’ll follow the Japanese model of just giving it back to us by buying immobile assets high and sellng them low.

    As to preferred investment, I mean U.S. securities are very sound (and that’s good), so people may be too willing to invest in them rather than make riskier investments, which may be more what we need to stimulate our economy. And I’m talking about the Fed paying interest on deposits. Who needs to invest in business when the govt’s got you covered? When does Keynesian stimulus get perverted into a safety net for the investment class? And if it does, is it not clearly crowding out?

    This is why I get kind of pissy about the underpants gnomes business. There’s an awful lot of assumptions about relatively automatic outcomes in the fiscal stimulus theory as well, that don’t take into account the potential perverse incentives, and the real world of congressional policy making. Macroeconomics as a whole, if you ask me, is overrun by underpants gnomes, because it’s not thoroughly grounded in microeconomics.

  19. Troublesome Frog says:

    So, we’re just going to ignore the whole thing about health care costs in order to make the “underpants gnomes” thing stick? OK.

    Like a Dem president facing off against a Republican Congress.

    It seems like you’re describing the political process that has no history of cutting deficits in good times cutting deficits during good times.

    As for the stock bubble, yes it was certainly a major factor, but we’re talking about a period of high but not insanely unprecedented growth. If the claim is that we simply can’t have GDP growth in that range again, fine. But even then, our current situation looks bleak for three major reasons: GDP is well below potential, programs that people use when they’re unemployed are costing more, and revenue as a percent of GDP is well below historical norms. These three issues attenuate dramatically with a return to normal growth rates.

    The major piece of the long run puzzle is health care spending. If we were debating a bill that would actually address the long-run cost of health care (even at the cost of short run economic pain), I’d be on a different side of the fence on this. But we’re not. We’re talking about more or less arbitrary cuts that were specifically designed to be a kick in the balls.

    One other note: I think that furloughs are stupid. If you fire an employee,you save money and he becomes a resource available for somebody else. If you cut his wages while keeping his output constant, you increase efficiency. If you cut his output and his pay proportionally but keep him on the payroll, you don’t achieve anything but $1 in savings exchanged for every $1 drop in output. Blah.

    And it sure smacks of a magic fairyland we-can-do-it-with-no-pain approach.

    Is that an emotional aversion to solutions that don’t hurt as much, or is it based on numbers? I get the strong impression that a lot of people think that “the burning feeling means the medicine is working” somehow applies in macro policy.

    When does Keynesian stimulus get perverted into a safety net for the investment

    I still don’t understand your train of thought here. Short term US debt pays basically zero. If you want something safe that yields zero, you can hoard cash or you can buy short term US government debt. With a <1 year maturity, it pays less than the Fed is paying on excess reserves*. So the money either comes from the Fed (in the case of the Fed buying new issue at auction) or from excess reserves. I think we may be agreeing about the excess reserves thing, but I'm not sure.

    *The Fed paying interest on excess reserves simply blows my mind. It makes me think that they're either so smart that I'm light years behind them or that they're nuts. I try not to assume people are nuts, but the most>recent hearing with Ben Bernanke have me leaning in the direction of “nuts.”

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