The Eurozone has its “does not compute” moment

First, it was there, then it left and then suddenly the Spanish prime minister Zapatero assured us that it was gone, but somehow the lingering European crisis of confidence in relation to the status of sovereign and private debt sustainability in key membership economies never seem to have gone away.

Now, please don’t think that the headline above is in any way related to the flurry of whether Spain has been faking its GDP numbers. FT Alphaville ran the story, got cold feet and took it down (although I reckon you can easily find the report if you try). Now, the flurry was real and the questions asked by the report fair I think. Clearly, if it was such nonsense it should be easily refutable and while some of the explanations I have seen for the the sudden dis-correlation between the Market Services Gross Value Added (GVA) and the Indicator of Activity in the Service Sector (IASS/SSAI) make sense (especially the import component point) the Spanish statistical office is still mute and the ministry of finance is just playing the part of an insulted child. So, if those of us who are skeptic are so stupid then really, now is the chance for those much more clever than us to give us a lecture.

But I digress.

Moving on, Ireland has recently been at the center stage of things and the latest number from the finance ministry is that the butcher’s bill for bailing out Anglo Irish amounts to more than 30% of GDP in the form of a running deficit in 2010. That is a almost unbelievable number by any standards and I would take very little comfort here in the fact that Ireland remains fully financed until mid 2011. What really matters here is that with this amount of debt overhang that needs to be transferred to the government’s balance sheet and ultimately over to the private sector in the form of taxes Ireland is being played straight into the hands of the IMF and the European Stability Fund. But this is not only about Ireland since the all the fundamental questions are still left unanswered.

• How do you correct external competitiveness deficiency from within a currency union at the same time as implementing fiscal austerity without risking debt levels to spin out of control?
• How long should Southern Europe and Ireland endure deflation relative to the core to restore external competitiveness (will Germany accept a lower external surplus as result)?
• How might a sovereign restructuring in a Eurozone economy play out?

The last one is particularly important since no official inside the Eurozone has even begun to voice an opinion on this even if it is blatantly obvious that this is where we are headed. I mean, I am not talking about the entire stock of PIGS bonds being wiped out and marked to 0, but merely of a reasonable and fair estimate of the haircut we all know that is coming. Yet, so much water has gone under the bridge that it is difficult to see how such a memo would look. For starters, the stress tests carried out recently on Eurozone banks would have to be, uhm, redone with proper assumptions of haircuts and impairment in the context of real sovereign stress in the Eurozone.

However, what really clinched it for me and what leads me to note that we have now had one of (several to come) those does not compute moments was Wolfgang Munchau’s basic bond arithmetic of the the European Stability Funds lending conditions and the means with which it allows access to its funds. From FT Alphaville …

Münchau comes up with a rough estimate that borrowers could end up paying a total interest rate of about 8 per cent — far above and much more than the 5 per cent Greece paid when it tapped its €110bn European Union emergency loan back in May.

BarCap’s back-of-the-envelope calculations has the total borrowing cost above 8 per cent. That’s about 80bps (3m Euribor) + 300bps (EFSF mark-up) + 150bps (due to the fact that the interest has to be paid on the whole loan) + 300bps (service fees). As BarCap also note, requesting EFSF funds would also likely entail some strict policy conditions, similar to IMF conditionality.

Now, let me be quite clear here. 8% or even anything in that vicinity makes the whole exercise quite pointless since there is no way that any of the Eurozone economies would be able to pay off their debts at these conditions. So, if one or more Eurozone economies were to find themselves in a situation where they could no longer tap international bond markets due to the yield on offer, the alternative would be no better. I called this a catch 22 recently and even wrote a paper, in part, about it. However, Munchau’s article makes it all so clear. Whatever funds that are paid out of the stability fund at these conditions would in itself be subject to a haircut in the context of an inevitable sovereign debt restructuring and thus it is really and ultimately a question of on whose balance sheet the final loss will be put. One would only hope that this soon will come to compute a little better with the agenda that will and has to emerge in the Eurozone at some point.

Some (academic) food for thought

As many of you might have noticed I am about to start my research degree here in the UK and while I am in general surprised and disappointed about the utter lack of creativity on the part of the economic faculty in terms of constructing a curriculum with the sole purpose of testing your abilities in math (rather than you know, uhm economics!) I hope and believe it will be fun. On that note and while the cracks have clearly not yet transcended to the way underlings such as myself are treated, I found the following paper (The Dahlem Report) interesting and important (thanks Scott for sending it over).

The economics profession appears to have been unaware of the long build-up to the current worldwide financial crisis and to have significantly underestimated its dimensions once it started to unfold. In our view, this lack of understanding is due to a misallocation of research efforts in economics. We trace the deeper roots of this failure to the profession’s insistence on constructing models that, by design, disregard the key elements driving outcomes in real-world markets. The economics profession has failed in communicating the limitations, weaknesses, and even dangers of its preferred models to the public. This state of affairs makes clear the need for a major reorientation of focus in the research economists undertake, as well as for the establishment of an ethical code that would ask economists to understand and communicate the limitations and potential misuses of their models.

Now, as an immediate testament to the importance of this paper and echoing my points above I can say for certain that my generation of economists will be trained no differently on a PhD level than they were, I suspect, 30 years ago. Same old axioms, same old models, same booring (and often stupidly difficult) math problems. Two of the co-signers of the paper are David Colander and Alan Kirman and I recommend readers to have a look at their work if you want a good critique of the way we (still) do economics today (don’t forget James E. Hartley too). I don’t want to be a cry-baby, but surely; running through the proof of why a utility function should and might exist (in mathematical terms) is not only waste of good time, it is an insult to any serious economist eager to get on with some real work. But now, I really(!) digress.

To balance things a bit I did actually find much enjoyment in Oded Galor’s recent synthesis of what really kicked off the demographic transition back in the days of the industrial revolution.

This paper develops the theoretical foundations and the testable implications of the various mechanisms that have been proposed as possible triggers for the demographic transition.Moreover, it examines the empirical validity of each of the theories and their signi…cance forthe understanding of the transition from stagnation to growth. The analysis suggests thatthe rise in the demand for human capital in the process of development was the main triggerfor the decline in fertility and the transition to modern growth.

Here in the 21st century such a paper essentially reads as a piece of economic history as the demographic transition never really ended and whereas some form of the quantity/quality tradeoff might have started the whole process, we are now dealing with a much more complicated process in which both a quantum and tempo effect acts as a driver of the fertility decline (and eventual or potential(?) catch-up as the tempo effect fades). However, Galor’s recent paper provides an important finetuned representation of the way we think about the quantity/quality trade off and as such it is important.

I also take more than a passing interest here since it is after all my field and while I eventually opted for the original quantity/quality model by Becker and Lewis in my thesis I have almost been turned to Oded Galor’s theory with this recent paper. Yet, the two theories are still ultimately very close to each other and for laymen the finer grained theoretic subtleties of the trade-off are not important.

Perhaps you should read Oded Galor first and then the Dahlem paper afterwards. Actually, yes you definitely should!