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How to fix the Euro

I broadly agree with the Angloamerican consensus about the, um, challenges associated with the Euro from an economic perspective. (David Beckworth has a very nice explainer.) We do understand that the Euro was adopted for political more than economic reasons. Unfortunately, with the benefit of hindsight, the hoped-for political benefits of the common currency seem to have materialized less than the long-warned economic problems, and the economic problems have now poisoned the politics. But we are where we are. I think it unlikely that the Euro will be dismantled except in the context of a crisis that would put the whole European project at risk, even more than recent crises already have. So the challenge, I think, is to come up with institutions that would help mitigate the economic flaws of the common currency, and that might be acceptable in a political union whose electorates, for the moment, feel no great solidarity with one another. Ideally, Europe might pursue a US-style union, where transfers made upon universal criteria to households and business blunt regional wealth and income asymmetries, without provoking the indignation that direct intergovernmental transfers provoke (and would provoke in the US as well). But, after the trauma of recent events, I doubt that a Pan-European safety net will be politically achievable anytime soon.

If “ever closer union” is on pause for now, perhaps Ashoka Mody has it right when he advises, “To stay close, Europe’s nations may need to loosen the ties that bind them so tightly.” Mody’s specific suggestion is that Germany and other Northern European countries depart the Euro, replacing one very suboptimal currency area with two more reasonable blocs. He makes a good economic case, but the political symbolism of a Dollar/Peso Europe would be pretty terrible. I think there is a better way.

In the heat of the recent Greek crisis, many commentators (Coppola, Koning, Mason) noted that “membership” in a currency zone is not a discrete, all-or-nothing thing, but rather a continuum. Many people advised Greece to loosen its bonds to the currency zone just a bit by issuing its own scrip, not denominated in a new Drachma, but in the Euro itself. This is not a new or radical idea. Even in the United States’ famously functional currency union, the State of California has periodically resorted to issuing dollar-denominated “registered warrants” in order to sustain necessary spending through cash crunches. For related proposals, see Bossone & Cattaneo (1, 2), James Hamilton, Rob Parenteau, and of course Yanis Varoufakis.

Issuing Euro-denominated scrip would not mean leaving the currency zone, any more than California’s registered warrants took California out of the dollar zone. However, in the context of the current crisis, if Greece had issued such notes, it would have been interpreted as a first step away from full-fledged membership in the common currency. Looking forward, what would be better would be to normalize the practice, throughout the currency zone, of having governments make domestic expenditures (and only domestic expenditures) in scrip. Greece would issue scrip, and so would Germany. The characteristics of the scrip (but not the value) would be standardized across the Eurozone. In particular, each country’s scrip would be a zero-coupon security, to be redeemed in Euros at face value over an uncertain term. (I think fixed-payout, time-varying claims represent an underused design for securities; I’ve suggested them elsewhere.) Each week, each government would issue a new batch of scrip, to cover that week’s domestic payments. The rules for redemption would be simple: first-issued, first-redeemed, at a pace determined at the discretion of the Treasury without precommitment. Governments whose tax receipts easily cover their expenditures could choose to redeem the scrip nearly instantaneously (after some minimal period, perhaps one week). Governments that wish to run a deficit would redeem scrip more slowly.

The scrip would not become a de facto domestic currency. It would be too fragmented; each week’s vintage would have a different market value. Scrip would not be redeemable at face value to pay taxes.

What this all amounts to is a means by which states can finance themselves with forced borrowing from their own citizens who receive government payments. That sounds a bit mean, but it solves two important problems that currently plague the Eurozone:

  • International fragility — As the Greek crisis highlights, sovereigns ought not rely upon foreign borrowings in a currency the state cannot issue. The future is always uncertain, and when things go wrong debt securities must default or be renegotiated. That is awful even in small-scale private contexts. In an intersovereign context, it can lead to immiseration on a large scale through depression or war. Successful states mobilize the risk-bearing capacity of their own populations in order to finance government activity. Domestic politics can adjucate conflicts between local creditors and the public’s interest in government services in ways that outside institutions cannot. The interests of domestic creditors overlap much more with other domestic constituencies than the interests of foreign creditors do. International creditors have very little reason to support the work of a foreign government (other than taxation and debt service), while domestic creditors balance their interest in getting paid against other interests related to government performance.

  • No constituency for taxation — The Euro was conceived as currency of “prudence”, with its Stability and Growth Pact intended as a straitjacket on government borrowing. So it is ironic that the architecture of the Eurosystem destroyed the incentives of domestic constituencies to support efficient tax collection. By design, the Eurosystem preserved the practical ability of Eurosovereigns to borrow from the banking system inexpensively and at will (a privilege which remains intact, supported by the ECB, for all countries except Greece). Beneficiaries of government expenditures had little reason to support taxation, since the funds they wanted spent could be borrowed. More importantly, the Eurosystem absolved domestic constituencies of the usual consequence of undertaxation, that their incomes and saving would lose value from inflation. Ordinarily, creditors in any country are powerful constituencies for balanced budgets and “sound money”, which sometimes means cutting expenditures but also means raising taxes when expenditures cannot be cut. [1] While Eurozone states that borrowed (whether as sovereigns or through banking systems) did experience higher inflation than creditor countries, the difference was modest. Citizens knew that the value of their money was externally anchored, a Euro would always be a Euro. This imported stability hindered the emergence of any domestic constituency in favor of developing (and exercising) the state’s capacity to collect taxes.

    If government domestic expenditures, including transfer payments like pensions, are made in the scrip proposed, the market value of those securities would be directly related to the perceived willingness and ability of the state to tax in order to retire the IOUs at a reasonable pace. The villains’ in lazy creditor morality tales — beneficiaries of the welfare state, govenment employees, vendors of goods and services to the state — would become powerful constituencies for building and maintaining an efficient tax system. This would restore the natural tension in domestic politics, a balance that Eurozone institutions uninintentionally destroyed, between domestic constituencies with an interest in taxation, and other domestic interests who would be net payers of tax and so lobby to streamline expenditures.

This proposal would not fragment the Eurozone. The Euro would remain the universal unit of account and medium of settlement. [2] The proposal would loosen the strictures on government expenditure compared to existing arrangements, but importantly, the risk associated with that extra fiscal freedom would be borne entirely by domestic constituencies, not by external creditors. It would restore to Eurozone states some of the tools they lost for managing domestic shocks, without requiring unpopular transfers or destructive borrowing from other states. It would strengthen Eurozone states, as polities.

The lesson of the Asian Financial Crisis and the extraordinary reversal of financial flows that many Asian countries were able to engineer is that the strength of a state is largely a matter of its capacity to mobilize domestic risk-bearing, rather than rely upon external finance. Eurozone institutions unintentionally short-circuited that capacity. It’s time to restore it.


Some institutional details:

  • Universality — This proposal should be implemented universally within the Eurozone, as an institutional innovation for the common currency. Within states that have no immediate need for new borrowing, the market value of “state expenditure notes” would be par, and no one would have reason to complain. However, if adoption of the notes were made optional and became associated with perceived-as-weak states, states that could really benefit from financial flexibility and incentives to develop an effective tax system would be reluctant to adopt them for fear of stigma. A fig leaf — “Even the Germans do it!” — is the one concession to solidarity that this proposal requires. Otherwise, this proposal segregates risk, rather than blurring borders, which might be a relief to Northern European publics.

  • Liquid Markets — All states would be required to arrange low-transaction-cost, liquid markets in state expenditure notes. Recipients of government expenditures who need to make immediate payments may choose to convert them to cash Euros at a discount. Others may hold their notes and await redemption at face value. The discount to face at which the securities trade would provide ongoing information about the perceived fiscal strength of the state, and a very visceral incentive for recipients to see to that strength.

  • Banking considerations — Domestic, and only domestic banks, would maintain custody of the notes on behalf of customers. However, the notes would be held in segregated accounts, not on bank balance sheets. The Eurozone desperately needs to eliminate bank exposure to the sovereign debt of member states. These proposed notes would be an unusually speculative form of sovereign debt, and absolutely inappropriate as bank assets. Banks would merely provide the service of holding notes for customers and liquidating them into customer accounts on demand, as an important convenience and at regulated spreads.

  • Definition of “domestic expenditures” — A “domestic expenditure” by a member state would be defined as a payment to a domestic bank account. All domestic bank accounts would be paired with custodial accounts for expenditure notes. States could insist that transfer payments be made to domestic accounts, and might prefer to purchase goods and services from firms with domestic accounts as well. Foreign firms wishing to do business with cash-strapped governments and willing to accept the financing terms might open local bank accounts, but in general this restriction would ensure that most of the notes are spent to domestic constituencies. Speculation in the notes by nonresidents would be discouraged, in order to keep incentives (maximize the rate at which notes can be redeemed) and control (vote and participate in domestic politics) well-matched.

  • Interaction with traditional debt — The rate of redemption of expenditure notes would be entirely at the discretion of the issuing government, while coupon and principal payments on traditional debt must be made on a preagreed schedule. In that sense, one might imagine expenditure notes to be “junior” to Treasury bills and bonds. However, in the event of default, debt restructuring, or sovereign refinancing by ESM / EFSF / ECB / IMF / etc., expenditure notes would be treated as senior to other Treasury securities. (Expenditure notes would be treated analogously to uninsured deposits in bank capital structures, available for “bail-in” only after other unsecured creditors have been wiped out.) This is very important, as it would encourage buyers of traditional securities to price the credit risk of the sovereign’s full capital structure, including the debt embedded in outstanding expenditure notes. Formal seniority also reduces the risk that foreign creditors will be able to use the notes to shift the consequences of their own poor credit allocation decisions onto involuntary domestic creditors.

    Of course, short of an outright restructuring or refinancing, governments might choose to slow redemption of expenditure notes in order to retire traditional debt, which is fine. Strong domestic constituencies would limit the pace of such a reprofiling. If, eventually, finance via expenditure notes largely replaces traditional sovereign debt, that would be great. Domestic finance is much better for a polity than foreign finance, and variable maturity notes decay in value gracefully, while overextension of traditional debt causes disruptive oscillations between complacency and crisis.


Update: Perhaps the first proposal to address Eurozone problems via issuance of scrip came from Warren Mosler. When putting together cites for this post, I did not find that proposal where I had linked it previously, and simply omitted it. Fortunately, my commenters are not as lazy as I am, and point me to this 2012 version by Mosler and Philip Pilkington. I am very glad to acknowledge the prescience of Mosler’s work and the very strong influence of his “Modern Monetary Theory” on the thinking that underlies this post. My apologies for the original omission, and thanks to commenters JKH and Roberto for helping to remedy it.


[1] This may seem a little far-fetched in a US context, where creditors prioritize low taxes over any other thing, but that is unusual. The United States’ “reserve currency” status blunts the effect of debt and money issue on currency value, so creditors have less reason to prefer taxation to borrowing. In a small country with a floating currency, the potential hazard of overissuing government paper is more immediate to holders of local currency debt.

[2] Currencies are no longer “media of exchange” except for very small transactions. They are means of settlement. When I make a purchase with my credit card, I do not trade dollars for goods, but issue a bond (guaranteed by my bank) that may be eventually settled in government money if the recipient demands it. Currencies are media of settlement, not exchange.

Update History:

  • 24-Jul-2015, 5:20 p.m. EEDT: Bold update highlighting and acknowledging MMT and Mosler’s earlier work.
  • 24-Jul-2015, 10:30 p.m. EEDT: Added links to Bossone & Cattaneo proposals.

Price stickiness is not a mystery, and it is not psychology

I mean to write about something else today, so this will be short.

But I’d like to point out, as gently as possible, a mistake in the premise underlying this post by my friend Tyler Cowen. To be fair, it is not a mistake that is uniquely Cowen’s. Macroeconomists invoke price stickiness as an assumption in their models. They treat it as an axiom, a given, and therefore a mystery. Often they lazily fill in the darkness with catch-alls like “psychology” or “money illusion”, hypotheses about as useful as pomegranate seeds are as an explanation of seasons. Let’s not have the lazy conventions of macroeconomists stand in for actual thinking on a subject.

Downward price stickiness is a coordination problem, plain and simple. It has nothing whatsoever to do with illusions or cognitive biases or failing to spit after staring too intensely at a small child. Economic entities, both firms and humans, have liability structures rigid in nominal terms. A business has made forward-looking contracts — leases of facilities and equipment, price-stabilized arrangements to acquire raw materials, and yes, contracts with employers that cannot be altered without renegotiation. Businesses have also financed themselves in part with debt, and so taken on nominal obligations whose sustainability is based on forward-looking nominal prices of the goods and services they will sell. Individuals have signed rental agreements or taken mortgages. They have financed their education or their children’s, perhaps they have even taken on consumer debt. For both individuals and firms, these forward-looking nominal arrangements create a very large asymmetry between unexpected price adjustments upwards and downwards. For any economic unit, firm or individual, an unexpected price adjustment upwards in the commodities they sell to market is welcome news. The unit gets more money, its balance sheet expands in the happiest way of all, more assets matched by more equity. But for a leveraged economic unit — and we are nearly all leveraged economic units, if only because we are born short a future stream of housing and food — a downward nominal price shift may force deadweight adjustment costs, which may range from renegotiations of existing contracts to formal bankruptcy to discontinuous shifts in consumption of amenities like housing, education, and local community. (Since these amenities are marketed in sparse bundles, units are not able to continuously optimize consumption tradeoffs, and small changes in budget may lead to large changes of utility.)

Taking account of largely uncontroversial behavioral assumptions like habit formation and reference group anchoring reinforces this case, but is by no means necessary to it. Rational profit-maximizing firms exhibit downward price stickiness as do irrational left-wing humans, although how powerfully either exhibits it depends upon their solvency position and the flexibility of their capital structure, and upon a perceived probability distribution of revenue realizations under different prices. The naive microeconomic case why rational firms would not exhibit downward price stickiness — past arrangements are sunk costs, a rational firm will set prices to maximize future revenue in a forward-looking way — is flawed. It fails to take into account uncertainty surrounding the forward-looking revenue realizations. It ignores the fact that firms are usually quantity constrained in production over the short-term over which payments on their obligations come due. It ignores capital market imperfections, which yield correlations between access to external finance and downward price pressures that are unhelpful. For many firms, the costs and risks associated with an abrupt downward price adjustment are sufficiently large that the rational choice under a reduction of nominal demand is to gamble for the upside of their quantity-constrained revenue-realization distribution. So firms maintain prices higher than Marshallian scissors would advise, and try to sustain anticipated nominal revenues through marketing, product differentiation, and exercise of whatever market power they may have via relationships, network effects, etc. Of course, a strategy that is rational ex ante for firms with imperfectly flexible capital structures will only prove successful ex post for some fraction the firms that pursue it, which helps to explain why reductions of nominal demand tend to provoke consolidations in industries rather than mere rescalings of all the firms that contested the market in good times. When nominal demand collapses, prices fall less than naive economists would guess, some firms sustain quantities sold at the “too high” prices offered, others do not and start to experience large deadweight costs of insolvency. The winners can then buy the losers for a song and quickly dispell those costs.

Precisely the same dynamic accounts for adjustment to changes in labor demand on the extrinsic rather than on the intrinsic margin, for why we see unemployment rather than wage reductions in a recession. In the US (more, perhaps, than in other countries), workers’ lives tend to be leveraged against anticipated, uninsured, market incomes. Accepting a significant wage cut may imply selling a home into a bad market. (Here again, correlations between wage pressures and financial market developments are unhelpful.) It may imply pulling ones kids from schools, excision from civic and social communities, loss of difficult to replace health coverage, loss of ones automobile, and in extremis the humiliations and deadweight costs of personal bankruptcy. The operating and sometimes financial leverage of households sharply magnifies the loss associated with a wage cut, and the discontinuity of the bundles in which crucial amenities are offered magnifies that yet again. Even without invoking a Dunning-Krueger effect, these costs may be large enough that workers rationally prefer to gamble on staying employed at their anticipated wage rather than accept a very painful adjustment with certainty. Firms rationally accommodate this preference among workers, since grateful survivors make better employees on an ongoing basis than people bitterly distracted by their own insolvencies. By firing the workers on whom labor cost adjustment will fall, firms rationally externalize insolvency costs that they would be forced to partially bear if they retained those workers. Even among fired workers, it may be rational to hold out for wages high enough to restore solvency rather than quickly accept work at wages that render inevitable a disruptive adjustment. If they hold out and fail, they face a similar adjustment. But they might not fail. Holding out to search yields a valuable lottery ticket, for a while.

I said at the start that nominal price stickiness is a coordination problem, and it is. If nominal price reductions and nominal wage cuts were accompanied by simultaneous reductions in the nominal burden of each unit’s capital structures, the difficulty of downward price reduction would disappear. For a given household with no financial debt, if it were certain that existing housing, food, education, transportation, and health outflows would scale downward with a wage reduction, the household would rationally accept the wage reduction rather than risk unemployment. But even in a world where households don’t bear financial debts, even during a general depression, there is no assurance that prices will scale down with wage reductions. (On recent historical experience, there’s little evidence at all prices will scale down, that’s the equilibrium we’re in.) So it is rational for many households to resist wage reductions. The prevalence of nominal debt, which bears the stickiest price, renders resistance to downward price and wage adjustments more rational and more likely.

For both firms and individuals, resistance to downward price adjustment is often rational, even when at a macroeconomic level universal downward adjustment would be desirable (perhaps because the central bank and/or state have failed to accommodate the expected path of nominal incomes, perhaps because nominal exchange rates are rigidly misaligned). If we could wave a magic wand and have wages, prices, and especially debts all simultaneously scale downward, that might be awesome. But, unfortunately, we can’t.

If this sounds like some left-wing apologia of unreasonable wage demands (really? does it sound like that?), I’d note that the person who most famously made this argument was one Milton Friedman:

The argument for a flexible exchange rate is, strange to say, very nearly identical with the argument for daylight savings time. Isn’t it absurd to change the clock in summer when exactly the same result could be achieved by having each individual change his habits? All that is required is that everyone decide to come to his office an hour earlier, have lunch an hour earlier, etc. But obviously it is much simpler to change the clock that guides all than to have each individual separately change his pattern of reaction to the clock, even though all want to do so.


Note: I’ve written about this once before, see also an objection by the excellent RSJ.

Update: Nick Rowe generously discusses the ideas (and interacts with me in comments) in three new posts.

Update History:

  • 23-Jul-2015, 8:25 p.m. EEDT: Added bold update Re Nick Rowe’s posts.

I love Germany. And Greece. And especially Finland.

If you are sympathetic to Greece and therefore mad at Germany, you are a sucker. If you think the Greeks are lazier and more dishonest than is usual in the human species, you are also a sucker, and have let a political framing cajole you into bigotry. If you think Germans are unusually cruel, you have also let politics make a bigot of you. If you are taking sides in a conflict framed as nation versus nation, you have already taken the wrong side. You’ve made a basic error, like picking a day when a tricky prosecutor asks whether you committed the murder yesterday or last Thursday. (I presume your innocence.)

You can usually find evidence in support of lots of different narratives. Hypotheses of human affairs are not in general mutually exclusive. Many different stories can in some sense be true. Among those in-some-sense-true narratives, we should choose to emphasize those whose application will lead to better social outcomes over other potentially defensible narratives. That’s why I frequently argue that we should emphasize the role of creditors rather than debtors when lending arrangements go bad. I am not making a claim about God’s view of the subject. Perhaps Hell is a debtors’ prison, and there is truly no greater evil than failing to repay a loan. Perhaps Hell is full of creditors who failed to fit through the eye of a needle. These questions are, I think, beyond the sort of knowledge that should inform policy. What is clear is that unserviceable debt arrangements, when they accumulate, are enormously costly in human and economic terms, and so we need norms and institutions to regulate credit extension. My view, which I think almost anyone with a passing familiarity with the human species would have to concede, is that people under financial stress make decisions with a view to a shorter-term time horizon and with less capacity to be fastidious than people who have already financed their own immediate term. That is why I argue that we should emphasize norms that hold creditors accountable more than norms that hold debtors accountable. Creditors as a class are capable of regulating the initiation of debt arrangements at lower cost and with greater effectiveness that debtors are. If we want societies that yield good outcomes, then, we should impose a heavy regulatory burden on creditors, and we must choose moral narratives consistent with that.

Perhaps the very worst moral narratives in all of human history are those that allocate blame on the basis of tribal, ethnic, or national groups. There is just never, ever, any sufficient reason to go there in my view. It is perfectly reasonable to hold leaders and governments accountable, as well as the institutional embodiments of interest groups. This is not because leaders individually are worse people than members of the public who may agree with their decisions. I carry no water for fairy tales about the inherent virtue of ordinary folk. The reason we hold people and institutions that act consequentially within the political sphere accountable is because those entities are points of leverage on whom relatively humane forms of accountability — career impairment and financial loss, shame or loss of reputation, in extremis imprisonment — may powerfully regulate the behavior of the polity. To impose accountability at the level of “the people” is the logic of Dresden, barely fit even for warfare, to be avoided at all costs. (I hope in this context the World War II analogy will not further inflame national passions.) “Collective punishment” — regulating the behavior of a polity or nation by imposing consequences on all of its members — is inefficient in terms of human suffering provoked. It is also risks being much worse than counterproductive unless it lives down to the Machiavelli’s dictum that “If an injury has to be done to a man it should be so severe that his vengeance need not be feared.”

Civilized people do not blame nations, even when publics of those nations are holding mass rallies in the street supporting bad actions. Civilized people hold leaders and institutions to account for the conditions under which their constituents’ passions got that way, if the passions are misplaced. This is not to assert, as a positive claim, that political leaders and elite institutions “control” the will of their populations. Like most causal arrows, this one runs both ways. As with creditors and debtors, where we impose the accountability is a function of which choice leads to better outcomes. However hollow it may ring (and however hypocritical in the face of what people who use this rhetoric have sometimes done) claiming that “we have no argument with the people of Oceania, only its government” is a healthy impulse. [1] As civilized people, we ought to try to define political, economic, and social institutions that make good decisions on behalf of polities. Those institutions should both genuinely represent the diverse interests and views of their publics, and also constrain and shape those views so that the democratic will of the polity is consistent with high quality outcomes in both a functional and ethical sense. When things go awry, it is those institutions we must hold to account. To hold institutions to account effectively we must hold people to account, but we focus our scrutiny on people in roles of disproportionate authority rather than extending it to nations as a whole.

By all means blame Schäuble or Merkel or Varoufakis or Tsipiras. I have my views about who is more blameworthy, your views may differ. You may blame people like me, if you like, members of “the press” generally, and hold us accountable by reputation and career. My view is that banks and securities underwriters on both side of the Atlantic, as well as many individuals who worked in that sector, ought to have been held to much greater account for events of the financial crisis (but I also think it is too late for punitive accountability to make much of a difference now). You may disagree. These are all fine arguments to have.

But do not blame “France” or “Germany” or “Greece”, do not blame the “United States” or “Iran” or “North Korea”, tribes and nations cannot be held to account, only institutions and leaders can be.

I have not visited Germany, but I very much want to, and admire very much about its culture and economic arrangements. My own family’s difficult experiences 75 years ago do not temper my affection for Germany. It is, I think, a wonderful country. I have visited Finland, and despite the fact that I think its government’s role was less-than-constructive with respect to the Greece crisis, it remains one of my favorite places in the world. As a student of political and economic systems, I admire the Scandinavian countries above all others, regardless of their role in this crisis.

The European crisis is a crisis of bad framing. Characterizing Europe-wide credit problems in terms of national actors, then fixing that characterization into place via intersovereign lending, were deeply pernicious, deeply destructive, errors. I don’t doubt these errors arose more from increments than ill intentions. There were pressures and interests and paths of less resistance — no need for any vast conspiracy. [2] The international framing was convenient to domestic constituencies throughout Europe. In every country, elites find it convenient to deflect passions to an external bad actor rather than take responsibility for mistakes at home. Sometimes on the merits they have a case, sometimes not. Regardless, inflaming passions against another nation is always a terrible choice. Even when a dispute really is a zero-sum conflict of interest between two nations, great diplomacy is called for. That may be a lot to ask for, but it is what civilized countries do. I wish my own country lived up to it more often.

The credit crisis that has writhed and recrudesced into a Greece crisis never needed to become a conflict between nations. I believe Europe’s current crop of leaders must be held to account for having made it that, and I repeat my admonition. Shame. I hope (against the odds perhaps) that a less narrow and compromised set of leaders replaces the current generation, that Eurofinance is reformed much more deeply than it has been, and that as passions fade the European project can resume. I even hope that the Euro survives, although I think the economic case against it is powerful and correct. Fixing the Euro is possible. It just requires institutional innovation that at the moment seems unthinkable. But, in the recent cliché, the unthinkable has an odd habit of becoming inevitable in politics. There is still room to hope.


[1] Yes, the Orwell reference is intentional. We are in very grey territory here.

[2] The errors in the Eurosystem’s financial architecture were not a vast conspiracy either, as some readers have mistaken from my piece on Greece. Yes, sovereign lending looked like free money to Eurozone bankers because all Eurosovereigns were risk-free as regulatory matter. But that regulatory choice came from a misguided political decision to treat sovereigns equally and optimistically, in spite of very divergent economics. Bankers did not lobby for the error, they responded to it. That does not absolve them of their bad loans. Bankers’ job is to regulate credit allocation, and if regulators give them rope to hang themselves they still oughtn’t use it, and ought to be held to account for having done. Western banks are institutions in need of fairly wholesale reform, from which they have thus far been spared. But to indulge in hatred of “bankers” as a class is ugly and unfocused. In general, when we hold people to account as we must, we should do so in sadness because it is necessary, not in glee because we are righteous.

Update History:

  • 14-Jul-2015, 6:30 p.m. EEDT: “you a sympathetic” ⇒ “you are sympathetic”; “institutions that demand fairly” ⇒ “institutions in need of fairly”; “the Euro survives, even though I” ⇒ “the Euro survives, although I”
  • 15-Jul-2015, 0:00 a.m. EEDT: “for fairy tales about inherent virtue” ⇒ “for fairy tales about the inherent virtue”
  • 15-Jul-2015, 1:05 a.m. EEDT: “ought to be held account for having done” ⇒ “ought to be held to account for having done”

Banks and Greece’s bailouts

Greece’s 2010 assistance program was largely a bailout of European banks, initiated to prevent a wider banking crisis. I didn’t expect this claim, from the previous post, to be very contentious. But apparently it is, so I’ll overdocument below. Certainly a bank bailout was not the program’s sole purpose — fear of contagion to other indebted Eurosovereigns was also concentrating people’s minds. But the operation was not a huge help to Greece except in the sense replacing private creditors with more generously scheduled official creditors gave the country breathing space.

Commenters have brought up the 2012 program, which is more complicated. It included “private sector involvement”, Eurospeak for getting private creditors to take a haircut on their holdings of Greek debt. That’s a more ambiguous case, and we’ll discuss it below. My view was and remains that the “cramdown” was made possible precisely because the first program helped European banks to reduce their exposures to Greece, both directly by getting paid in full on near-maturity debt, and indirectly by creating time and a window of optimism during which positions could be offloaded without too much impairment. Below, I link some data and and work through an exercise that supports my view, but I certainly don’t claim it is definitive.

Most of this post is going to be documenting stuff. But I want to correct a misperception I fear I may have left with the previous post.

I am not criticizing Europe’s handling of Greece because banks deserved to take a hit and were treated too lightly. It is not the absence of pain and blame that troubles me, but its asymmetry. What was required was a Europe-wide solution to a European problem. What occurred, in my opinion, was the quarantining of a scapegoat. I blame Europe’s leaders for not framing the crisis in a different way, for acting as though it was about alms to Southern miscreants rather than explaining its roots in EU-wide regulatory errors and poor credit allocation incentives, Europe-wide problems that threatened many states. Framed this way, solutions would have looked very different. They would have addressed Germany’s problems and France’s problems as well as those of Greece, Spain, Portugal, Italy, Ireland, and Cyprus. Framed this way, solutions would have been conducive to “ever closer union” one crisis at a time. Instead, leaders chose to inflame national stereotypes. They pretended that there were villains and angels, and that they (and their own constituents, of course) were the angels.

I understand that life happens in real time, people are human, and politicians face pressures and constraints. But if we can admit that of politicians in Brussels, perhaps we might extend the courtesy to politicians in Athens as well. They too inherited their imperfect institutions, and followed paths of less resistance that perhaps were not so virtuous.

2010 Program

The 2010 assistance program was widely understood at the time to be motivated by the need to prevent disruptive write downs at non-Greek banks. The Guardian reported in February 2010 that France and Switzerland had exposures to Greece of €55B each ($119B @ 1.4266 $/€), and Germany €30B ($43B @ 1.4266 $/€), based on BIS data. The Wall Street Journal reported similar values, as does CRS. [1]

In early 2010, it was not the case that the majority of Greek debt was held by Greek banks, as people seem fond of saying. From the same Guardian piece:

Analysts…dismissed as misplaced concerns that Greek banks might be holding all the €300bn of debt in issuance. “Greek banks own around €40bn of the total…implying most Greek debt is sitting on the balance sheets of non-domestic banks,” said Jagdeep Kalsi, an analyst at Credit Suisse.

From Swiss Daily Tagesanzeiger as translated by Ed Harrison:

According to the International Monetary Fund (IMF), about two thirds of the debt of Greece is held by foreign creditors — an above average value.

After the program was announced, European economists (but not politicians) frequently explained it as intended to shore up non-Greek banks. Here’s former IMF staffer Gary O’Callaghan, writing in 2011:

The new Portuguese programme is set to be launched in the context of a continuing lack of market credibility in the other two — the Greek and Irish…

[W]hy are [Eurozone finance ministers] supporting these financial assistance programmes? Because, if they are not implemented, the non-payment of debt — including bank debt — by the nations on the periphery would lead to severe banking crises and a return to recession in the core of the eurozone.

Former Bundesbank head Karl Otto Pöhl, just after the 2010 program for Greece was approved:

Pöhl: …a small, indeed a tiny, country like Greece, one with no industrial base, would never be in a position to pay back €300 billion worth of debt.

SPIEGEL: According to the rescue plan, it’s actually €350 billion …

Pöhl: … which that country has even less chance of paying back. Without a “haircut,” a partial debt waiver, it cannot and will not ever happen. So why not immediately? That would have been one alternative. The European Union should have declared half a year ago — or even earlier — that Greek debt needed restructuring.

SPIEGEL: But according to Chancellor Angela Merkel, that would have led to a domino effect, with repercussions for other European states facing debt crises of their own.

Pöhl: I do not believe that. I think it was about something altogether different… It was about protecting German banks, but especially the French banks, from debt write offs. On the day that the rescue package was agreed on, shares of French banks rose by up to 24 percent. Looking at that, you can see what this was really about — namely, rescuing the banks and the rich Greeks.

Pöhl, by the way, agreed with the now-(in)famous Yanis Varoufakis that from Greece’s perspective, a partial default would have been superior to the 2010 package. Here’s Pöhl again:

Pöhl: …They could have slashed the debts by one-third. The banks would then have had to write off a third of their securities.

SPIEGEL: There was fear that investors would not have touched Greek government bonds for years, nor would they have touched the bonds of any other southern European countries.

Pöhl: I believe the opposite would have happened. Investors would quickly have seen that Greece could get a handle on its debt problems. And for that reason, trust would quickly have been restored. But that moment has passed. Now we have this mess.

Strange bedfellows, perhaps.

If this is all nonsense (as a correspondent alleges) because of errors in the BIS exposures data widely known four years ago, I’m not the only one who’s missed the memo. I’m in pretty good company. Here’s banking scholar Anil Kashyap writing just a few days ago:

By the spring of 2010 the excessive debt problem became unbearable and there was open speculation that Greece would default. The country had done this on four occasions previously since 1800. Much of the government debt was owed to banks outside of Greece, with the largest amounts in France and Germany. So if Greece had stopped paying, the French and German banks would have suffered substantial losses.

Greece was lent new money in 2010, but as Karl Otto Pohl former head of the German central bank observed at the time much of that money was used to repay the obligations owned by the French and German banks. The new lending was advertised by the politicians across Europe as a rescue for Greece. But it was at least as much a deal to buy time for the banks and other owners of Greek debt to avoid a default.

2012 Private Sector Involvement (PSI)

In 2012, private sector creditors were indeed asked to take a hit. As I mentioned in the intro, my view is that “PSI” was undertaken in deference to the politics of creditor moral hazard only when, thanks to the 2010 intervention, non-Greek banks were able to reduce their exposure. I’m hardly alone in that view. Again, Anil Kashyap:

By continuing to allow banks everywhere to use Greek debt as collateral, the ECB also created conditions that supported the trading of Greek debt. By this time the French and German banks had shed their exposure to Greece so that they would no longer be directly harmed if there was a default. So the stealth rescue of the non-Greek banks was completed with little public attention and the narrative that all the problems were self-inflicted by the Greeks became more pronounced.

By June 2011, Greek banks did hold the majority of Greek debt, and other banks’ exposure was small enough that large write-downs would be manageable. (Here’s a spreadsheet, published by the Guardian, with data apparently from UBS.)

According to the best discussion of PSI I’ve found, by Jeromin Zettelmeyer, Christoph Trebesch, and Mitu Gulati, the debt exchange was large, affecting €199B of debt at face-value, with a present value of roughly €130B at the time of the exchange (using a discount rate of 15.3%, see Table 4, p. 23). The authors estimate the total debt relief to Greece from the operation to be €98B. Of that €98B, €15.8B are accounted for by subsidies embedded in two below-market loans from official lenders: €8.2B in underpriced borrowing to buy notes from the EFSF (to be distributed as a “sweetener” to encourage creditors to make the exchange), and €7.6B in the form of an underpriced loan to partially recapitalize Greece’s banks (which would be impaired following their own participation in the write-down). That left a subsidy of €98B – €15.8B = €82.2B which had to have been provided by surrendering €130B in debt, for an average write down of 63.2%.

If we assume that the Guardian/UBS exposures linked above are valued at comparable discount rates, we can compute the distribution of the incidence of this cost-to-debt-holders / subsidy-to-Greece. According to that data, Greek banks would have accounted for 45.3% of the €130B debt exchanged, non-Greek banks would have accounted for 25.3%, and unknown non-European-bank holders would account for an additional 29.4%. In absolute € terms, then, Greek banks representing €58.9B of exposure would have transfered €37.3B; non-Greek banks representing €32.9B of exposure would have transfered €20.8B; and unknown non-European-bank holders representing €38.2B of exposure would have transfered €24.2B.

I’d say that non-Greek European banks got off pretty easy in this exercise. If you believe the Credit Suisse analyst cited by The Guardian above, Greek banks held only 13% of Greece’s debt when the 2010 bailout began. Yet in the 2012 exchange, Greek banks were responsible for substantially more of the debt relief than non-Greek banks, even net of the recapitalization subsidy. (€29.7B vs €20.8B)

There’s lots you can quibble with here. Maybe the Guardian/UBS exposures are valued at a very different discount than our 15.3%. Maybe that data’s no good (it’s just the only data I could find). I’m treating all debt as incurring the same write-down. In fact, the size of the write-downs were maturity sensitive, with short maturities incurring larger haircuts than longer maturities, and there’s no reason to think the maturity profile of our three subgroups was identical. Maybe the assumptions beneath the pieces I’m borrowing from Zettelmeyer, Trebesch, and Gulati are wrong. Maybe I’m just screwing something up. (Let me know! Trashy spreadsheet!) But this is about the best I can do on the evidence we actually have. And, tentatively, it doesn’t look like Greece’s pre-2010 bank creditors had it very rough at all, especially when compared to 2010 BIS exposures.

Profile of Greece’s overall finance, 2010 – 2012

There’s a wonderful analysis at Greek Default Watch of Greece’s sources and uses of external finance from 2010 – 2012. It seems like a good way to conclude this piece:

The Greek government needed €247 billion in the period from 2010—2012. Of that, a mere 7.7% went to finance the government’s deficit—the rest went for other purposes. Around 15.4% went to pay interest on debt—this money went to both domestic and foreign investors. Another 12.3% went to repay Greek investors who held government bonds that were expiring in that period. A full 24.3%, the largest item, went to repay foreign holders of Greek government bonds—in sum, almost €60 billion. Around 18% went to recapitalize banks, 14% went to support the PSI (such as buying back debt) and 8.6% went for other operations.

In other words, more than 50% of the money that Greece needed in that period was to deal with the country’s excessive debt burden (interest on debt and repaying residents and non-residents). Given that the bank recapitalization and PSI were both, ultimately, linked to the country’s debt, almost 84%, or €206 billion, was ultimately devoted to Greece’s debt—which, at year-end 2009, was €299 billion. Importantly, however, a large sum (€60 billion) went to bailout foreign banks and other investors. So this operation was minimally about covering the current profligacy of the Greek state—it was mostly about covering its pass excesses.

I think that covers it.


Notes

[1] By Twitter, Dave Rabinowitz disputes these values, citing 2011 data and some earlier not-so-accessible investment bank research. It’s not disputed, I think, that exposures were much lower by 2011. That’s much of what buying time with a bailout would be intended to enable. (If Rabinowitz does have better information than the BIS on exposures at the time of the program, and what policymakers at the time would have understood those exposures to be, I hope that he’ll provide it. I’d be glad to offer links in an update.)

Greece

Greece is a remarkable country full of wonderful people, but along dimensions of development and governance, the place is plainly pretty fucked up. It has been fucked up that way for a long time, for decades at least. This has never been secret. Anyone who has visited Athens knows it has far more in common with Bucharest or Istanbul than with orderly Western European capitals. In the run up to Greece’s joining the Euro, everyone who wanted to know knew that Greece’s qualifications to join the Eurozone were, shall we say, ambitious. Mainstream establishment banks “helped” Greece and other Southern European countries with accounting fudges that, while perhaps obscure, were not secret even at the time. Despite protestations when these deals hit the news in 2010 that officials were “shocked, shocked”, they were explicitly blessed by the agency that compiles the statistics on which Eurozone entrance was based in 2002 and Greece’s gaming was extensively reported in 2003 (ht Heidi Moore, both cites). The Euro was and ought to be primarily a political enterprise. In order to sell the common currency to Northern European elites, its architects required Eurozone members to meet strict “convergence criteria” and especially the requirements of the Stability and Growth Pact. But in practice, those criteria have always been interpreted flexibly. Most Eurozone members have broken their promises at one point or another, including both Germany and France. The Euro was a unification project, and erred (not unreasonably, I think) on the side of building a big tent.

Germany and France may have missed their Stability and Growth commitments now and again, but they are not fucked up like Greece is. Greek governments — not the current, much maligned Syriza, but decades of its predecessors — treated the state like a teat from which clients and friends of electoral victors might suck. The Greek state has been a shady, opportunistic borrower, no doubt, the kind of character no one would lend money to with any great expectation of seeing it back.

And yet, that’s precisely what bankers in the relatively not-fucked-up Eurozone countries did! These people were not naïfs. They knew the Greek state was sketchy. But precisely because it was sketchy, prior to the financial crisis its debt paid slightly higher interest rates than that of safer Eurozone sovereigns. European banking regulations attached zero risk weights to all EU sovereigns, rendering it nearly costless for banks to simply manufacture deposits to purchase sovereign debt. Eurozone sovereigns were default-risk-free as a regulatory matter and currency-risk-free from the perspective of Eurozone banks. The European financial system was architected to make lending to Greece — and Spain and Portugal and Italy — a money machine for bankers with little career risk over a medium term. Sketchy credits tend to punch above their weight in terms of volume of issuance, so there was a lot of nice paper to buy. The bankers who lent to these states understood perfectly well that there was in fact a long-term risk, an uncertainty, a constructive ambiguity. They lent anyway, and took home very nice salaries and bonuses for doing so. It was conventional to lend, the mainstream consensus was that credit risk was over and worry warts were old-fashioned, Europe was strong and would work this out. If the worry warts turned out to be right, it was likely years away, IBGYBG.

When the game was up, when the global house of credit cards collapsed in the late Aughts, European leaders had a choice. They had knowingly and purposefully brought weak states into the Eurozone, because they genuinely, even nobly, wished to build a large, strong, United Europe. When they did so, they understood there would be crises. A unified Europe, they had always claimed, would be forged one crisis at a time. The right thing to have done for Europe at this point would have been to point out the regulatory errors and misaligned incentives that encouraged profligate lending and enabled corruption and waste among borrowers, and fix those. Banks that had made bad loans would acknowledge losses. The banks themselves would have to be restructured or bailed out.

But “bank restructuring” is a euphemism for imposing losses on wealthy creditors. And explicit bank bailouts are humiliations of elites, moments when the mask comes off and the usually tacit means by which states preserve and enhance the comfort of the comfortable must give way to very visible, very unpopular, direct cash flows.

The choice Europe’s leaders faced was to preserve the union or preserve the wealth, prestige, and status of the community of people who were their acquaintances and friends and selves but who are entirely unrepresentative of the European public. They chose themselves. The formal institutions of the EU endure, but European community is now failing fast.

It is difficult to overstate how deeply Europe’s leaders betrayed the ideals of European integration in their handing of the Greek crisis. The first and most fundamental goal of European integration was to blur the lines of national feeling and interest through commerce and interdependence, in order to prevent the fractures along ethnonational lines that made a charnel house of the continent, twice. That is the first thing, the main rule, that anyone who claims to represent the European project must abide: We solve problems as Europeans together, not as nations in conflict. Note that in the tale as told so far, there really was no meaningful national dimension. Regulatory mistakes and agency issues within banks encouraged poor credit decisions. Spanish banks lent into overpriced real estate, and German banks lent to a state they knew to be weak. Current account imbalances within the Eurozone — persistent and unlikely to reverse without policy attention — implied as a matter of arithmetic that there would be loan flows on a scale that might encourage a certain indifference to credit quality. These were European problems, not national problems. But they were European problems that festered while the continent’s leaders gloated and took credit for a phantom prosperity. When the levee broke, instead of acknowledging errors and working to address them as a community, Europe’s elites — its politicians and civil servants, its bankers and financiers — deflected the blame in the worst possible way. They turned a systemic problem of financial architecture into a dispute between European nations. They brought back the very ghosts their predecessors spent half a century trying to dispell. Shame. Shame. Shame. Shame.

Until the financial crisis, people like, well, me, were of two minds about the EU’s famous “democracy deficit”. On the one hand, I believe that good governance requires accountability to and participation of the broad public. On the other hand, before the crisis, I was willing to cut the Euro-elite a lot of slack. I’m an American born in 1970, but my life is largely framed and circumscribed by events in Europe during the Second World War. I grew up on a diet of “never again”. I am writing these words from my grandfather’s villa on the Romanian Black Sea, which my mother worked doggedly to recover in an act of sheer vengeance for what this continent’s history did to her father. I was inclined to support Europe’s democratic fudges when they were about diminishing and diffusing the still palpable possibility here of reversion to ethnonational conflict. To see European institutions deployed precisely and with great force in the service polarization across national borders has radicalized and made a populist of me (as have analogous betrayals among the political leadership of my own country). If I were Greek, I would surely be a nationalist now.

With respect to Greece, the precise thing that European elites did to set the current chain of events in motion was to replace private debt with public during the 2010 first “bailout of Greece”. Prior to that event, it was obvious that blame was multipolar. Here are the banks, in France, in Germany, that foolishly lent. Not just to Greece, but to Goldman’s synthetic CDOs and every other piece of idiot paper they could carry with low risk-weights. In 2010, the EU, ECB, and IMF laundered a bailout of mostly French and German banks through the Greek fisc. Cash flowed into Greece only so it could flow out to rickety banks. Now, suddenly, the banks were absolved. There were very few bad loans left on the books of European lenders, everyone was clean, no bad actors at all. Except one. There were the institutions, the “troika”, clearly the good guys, so “helpful” with their generous offer of funds. And then there was Greece. What had been a mudwrestling match, everybody dirty, was transformed into mass of powdered wigs accusing a single filthy penitent (or, when the people with their savings in just-rescued banks decide to be generous, a petulant misbehaving child). [antidote]

Among creditors, a big catchphrase now is “moral hazard”. We cannot be too kind to Greece, we cannot forgive their debt with few string attached, because what kind of precedent would that set? If bad borrowers, other sovereigns, got the idea that they can overborrow without consequence, if Spanish and Portuguese populists perceive perhaps a better deal is on offer, they might demand that. They might continue to borrow and expect forgiveness, and where would it end except for the bankruptcy of the good Europeans who actually produce and save?

The nerve. The fucking nerve. Lenders, having been made nearly whole on their ill-conceived, profit-motivated punts, now fear that if anybody is nice to somebody who doesn’t deserve it, where will it end? I’d resort to that cliché about chutspa, the kid who murders his parents then seeks leniency ‘cuz he’s an orphan. But it’s really too cute for the occasion.

For the record, my sophisticated hard-working elite European interlocutors, the term moral hazard traditionally applies to creditors. It describes the hazard to the real economy that might result if investors fail to discriminate between valuable and not-so-valuable projects when they allocate society’s scarce resources as proxied by money claims. Lending to a corrupt, clientelist Greek state that squanders resources on activities unlikely to yield growth from which the debt could be serviced? That is precisely, exactly, what the term “moral hazard” exists to discourage. You did that. Yes, the Greek state was an unworthy and sometimes unscrupulous debtor. Newsflash: The world is full of unworthy and unscrupulous entities willing to take your money and call the transaction a “loan”. It always will be. That is why responsibility for, and the consequences of, extending credit badly must fall upon creditors, not debtors. There is one morality tale that says the debtor must repay, or she has sinned and must be punished. There is another morality tale that says the creditor must invest wisely, or she has stewarded resources poorly and must be punished. We get to choose which morality tale we most use to make sense of the world. We do, and surely should, use both to some degree. But if we emphasize the first story, we end up in a world full of bad loans, wasted resources, and people trapped in debtors’ prison, metaphorical or literal. If we emphasize the second story, we end up in a world where dumb expenditures are never financed in the first place.

But don’t the Greeks want to borrow more? Isn’t that what all the fuss is about right now? No. The Greeks need to borrow money now only because old loans are coming due that they have to pay, and they have been trying to come to an agreement about that, rather than raise a middle finger and walk away. The Greek state itself is not trying to expand its borrowing. Greece’s citizens and businesses would like to expand the country’s borrowing indirectly, by withdrawing Euros from Greek banks that the Greek banks won’t be able to come up with unless they are allowed to expand their borrowing from the ECB. That is, Greece’s citizens are in precisely the place France’s citizens and Germany’s citizens were in 2010, at risk that personal savings maintained as bank deposits will not be repaid. Something was worked out for French and German citizens. Other than resorting to the ethnonational stereotypes that European elites have now revived in polite company, what is the justification for a Greek schoolteacher losing her savings that wouldn’t have applied just as strongly to a French schoolteacher five years ago? Because Greeks are responsible, as individuals, for what the governments they elect do? Well, then I deserve to be killed for what my government has done in Iraq and elsewhere. Is that where we want to go?

If citizens aren’t going to be held responsible for their governments’ bad debts, how will sovereigns borrow at all? Well, how do firms raise equity, when an equity claim makes no promise whatsoever that any cash will be returned? People invest in shares not because they have any sword of Damocles to hold over the enterprise, but because they believe the firm will engage in activities sufficiently productive that throwing some cash back to investors will not be burdensome, and because firms know repayment enhances access to continued finance. The same is true of sovereigns like the United States or the UK, which borrow easily in currencies they can print any time. Nothing prevents the US from conjuring $100T USD and handing it out to citizens, engineering a one-time inflation that leaves outstanding bonds nearly worthless. It wouldn’t even constitute a default. But the US has organized itself in ways that persuade creditors that their funds will be treated reasonably. Inflexible debt sows seeds of coercion and enmity between borrower and lender. Equity-like arrangements, including “debt” denominated in securities issuable at will by the debtor, require and encourage trust and collaboration. Sovereign debt in particular should always look like the latter, not the former, given the regularity with which government borrowings are disbursed into insiders’ bank accounts rather than used to aid the publics who might be pressured to foot the bill.

Greece should see its debts forgiven, pretty much wholesale. That forgiveness should be understood as a default, with future investors warned. Insured deposits in Greek bank accounts should be made whole, uninsured deposits should be “bailed in”, Greece’s banking system should be integrated into a much more carefully regulated European banking system that eschews investment in individual sovereigns entirely, Germany as much as Greece. Let sovereigns sell securities to the market, where incentives for careful credit allocation are sharper than they are within banks. Let European banks hold only claims against the ECB when they want a risk-free instrument. If Spain or Portugal or Italy wish to haircut or repudiate their existing debt, let them, at cost of future market access. Sovereigns have an option to default full stop. Investors in sovereign securities must price that. If perceived credit risk leaves public finance too expensive Europe-wide, then the EU should develop a mechanism whereunder states are permitted to sell equity securities to the ECB up to a fixed limit, set uniformly across Europe in per capita terms.

I’ll end this ramble with a discussion of a fashionable view that in fact, the Greece crisis is not about the money at all, it is merely about creditors wresting political control from the concededly fucked up Greek state in order to make reforms in the long term interest of the Greek public. Anyone familiar with corporate finance ought to be immediately skeptical of this claim. A state cannot be liquidated. In bankruptcy terms, it must be reorganized. Corporate bankruptcy laws wisely limit the control rights of unconverted creditors during reorganizations, because creditors have no interest in maximizing the value of firm assets. Their claim to any upside is capped, their downside is large, they seek the fastest possible exit that makes them mostly whole. The incentives of impaired creditors are simply not well aligned with maximizing the long-term value of an enterprise.

If it were 2009, I might have been persuaded that the corporate bankruptcy analogy is poor, that Europe’s interest in the development and cohesiveness of its empire would substitute for narrow economic incentives (which should in any case be blunted, since they are the incentives of 27 different fiscs). If the past five years had not happened, I might be open to the argument made here (ht platypus) that, having extended the maturity of a large quantity of debt far into the future, creditors’ position is more like equity, since the fraction of face value creditors eventually recover is dependent upon Greece’s long-term growth.

But we have had five years to observe creditors’ tender ministrations, under governments that complied with creditors’ every demand. This has been the result:

Greekovery
[Graph via David Ruccio, via Frances Coppola, originally due to Robin Wigglesworth I think]

Euroelite apologists cite the small upturn at the very end of the graph to say, “See! Things were going swimmingly until the five-month old Syriza government screwed it all up. They just had to stick with the program! It was working! The darkest hour comes before the dawn!” These people, they are sophisticated highly educated people. You can trust them. Check out this track record:

troika-forecasts-large
[Graph via Felix Salmon, via Zero Hedge evidently]

The fact of the matter is no country, not Germany, not France, would voluntarily put up with the sort of “adjustment” that has been forced on Greece, for the good reason that gratuitous great depressions are not actually helpful to an economy. Creditors have had five years to mismanage Greece and they’ve done a startlingly effective job. Syriza has had five months to object. However much you may dislike their negotiating style, however little you think of their competence, Greece’s catastrophe was not Syriza’s work. If creditors respond to Syriza’s “intransigence” with maneuvers that cause yet more devastation, that will be on the creditors. Blaming victims for having insufficiently perfect leaders is standard fare for apologists of predation. Unfortunately, understanding this may be of little comfort to the disemboweled prey.

Europe’s creditors are behaving exactly as one might naively predict private creditors would behave, seeking to get as much blood from the stone as quickly as possible, indifferent to the cost in longer-term growth. And that, in fact, is a puzzle! Greece’s creditors are not nervous lenders panicked over their own financial situation, but public sector institutions representing primarily governments that are in no financial distress at all. They really shouldn’t be behaving like this.

I think the explanation is quite simple, though. Having recast a crisis caused by a combustible mix of regulatory failure and elite venality into a morality play about profligate Greeks who must be punished, Eurocrats are now engaged in what might be described as “loan-shark theater”. They are putting on a show for the electorates they inflamed in order to preserve their own prestige. The show must go on.

Throughout the crisis, European elites have faced a simple choice: Acknowledge and explain to electorates their own mistakes, which do not line up along national borders of virtue and vice, or revert to a much older playbook and manufacture scapegoats.

Such tiny, tiny people.

Update History:

  • 4-Jul-2015, 11:45 a.m. EEDT: Capitalize S in “Black Sea”, “then” ⇒ “than”
  • 4-Jul-2015, 7:15 p.m. EEDT: “The brought back” ⇒ “They brought back”; add apostrophe to “debtors’ prison”.

Dear Senator Feinstein (re “Fast Track”, TPP, etc.)

The following is the text of a note I just sent to Dianne Feinstein, my US Senator, via the Senator’s “e-mail” comment form. For what it’s worth, you can read it too. I’ve edited out some embarrassing typos.


Dear Senator Feinstein,

As a constituent, I felt betrayed by your vote in favor of 3-6 year, no-supermajority “fast track” for TPP and other trade-related deals negotiated by the executive branch. On procedural grounds, “fast-tracks” should always be supermajoritarian. The usual checks and balances that block or at least shave the edges off of bad law are not present under a straight up-or-down vote on an externally prepared text. To counterbalance that, any fast track should require a much stronger consensus than 50% plus 1 vote. 50-50 fast tracks are just bad political engineering.

On substantive grounds, given what that has been released about TPP, TTIP, and TISA, you should frankly be ashamed to have once endorsed a procedure that realistically makes their passage extremely likely. “Free trade” in the abstract is a good thing, and there are many trade deals I would support. Maximalist intellectual property law and “elimination of nontrade barriers” that in practice means submitting democratic choices about governance to review of unelected corporate arbitration panels are not free trade at all. They are harbingers of the sort of post-democracy that we see operating already in the European Union. They are instruments of plutocracy.

The most cynical argument in favor of these trade deals is the geopolitical argument. “If we don’t write the rules, then China will!” If we don’t write good rules, then maybe China should. The United States should wield global authority not merely because it is our team. The United States should wield global authority because it exercises that authority for the good. Not for the good of well-connected interest groups within the United States, not even just for the good of US and its citizens, but, if we are to exercise global authority, for the world. From the bits that ordinary citizens have been able to learn about the contents of the various deals under negotiation by USTR, we have fallen down badly on the job. Good for well connected interest groups, foreign and domestic? Check. Good for US citizens or the world broadly, no.

I urge you not to betray me and the vast majority of your constituents once again with a vote in favor of fast-track without the “sweetener” of trade adjustment assistance. TAA is a nice idea, but in practice it has never remotely been effective at ameliorating the sometimes troubling distributional effects of trade deals, and would not in this instance either. Still, it is at least a token.

Please undo your first misbegotten endorsement of “fast track” by voting “no” on the mulligan that has been arranged in the Senate after so many of us worked so hard to halt this terrible train in the House. Unbetray us.

Many thanks,
      Steve Randy Waldman

Bernanke on monetary policy and inequality

Ben Bernanke has a new post discussing the relationship between monetary policy and inequality. It is characteristically thoughtful and there is much to recommend it. Unlike some monetary policy cheerleaders, Bernanke is candid that “[m]onetary policy is a blunt tool which certainly affects the distribution of income and wealth”. And he correctly points out that monetary policy operations provoke complex and countervailing distributional effects, rendering simplistic stories hard to judge. Yes, Bernanke acknowledges, monetary easing raises the value of financial assets held almost entirely by upper quintiles and disproportionately by the very wealthy. But “easier monetary policies promote job creation as well as increases in asset prices. A stronger labor market—more jobs at better wages—obviously benefits the middle class, and it is the best weapon we have against poverty.” Bernanke reminds us that, “[a]ll else equal, debtors tend to benefit (and creditors lose) from higher inflation, which reduces the real value of debts. Debtors are generally poorer than creditors, so on this count easier monetary policy again reduces inequality.” To which I can only say, hear, hear!

Some of Bernanke’s protestations are less persuasive. Yes, easy money supports housing prices and “more than sixty percent of families own their home”. But asset price gains are proportionate to value, and the distribution of real-estate value is highly skewed. Plus, the divergence of homeowners and nonhomeowners marks one of the main socioeconomic cleavages in America today, and the whole constellation of housing-price-supportive policies (of which easy money is just one part) have made the chasm ever more risky and difficult to traverse. Because of the wide dispersion of real-estate value, the small, highly leveraged equity positions that are counted as “homeownership”, and the diffuse claims of individual members of households against that equity, citing the gross homeownership rate as a measure of diffusion of housing price gains is misleading.

But the big lacuna in Bernanke’s defense of post-crisis monetary ease (such as it was, pace Scott Sumner) is the unstated counterfactual. Was monetary ease worse along dimensions of distribution than a counterfactual in which tight money, no fiscal support, and a collapse of financial intermediation created a prolonged collapse of output and employment? Surely not, we can agree. But the actual post-crisis policy apparatus was not the only possible configuration of support. Bernanke correctly notes that “if fiscal policymakers took more of the responsibility for promoting economic recovery and job creation, monetary policy could be less aggressive.” Although Bernanke doesn’t state it explicitly, it follows from his discussion that a more fiscal, less monetary, approach to macro stabilization could have retained inequality-reducing employment gains with less inequality-expanding asset price inflation. Bernanke and me and just about everyone else on the planet can join in a big round of Kumbaya tsk-tsk-ing the dysfuction of the United States’ legislative branch.

Less comfortable for Bernanke are counterfactuals of financial intermediation, which touch aspects of crisis policy directly prosecuted or strongly influenced by the former Fed chair. The Bernanke Fed was extraordinarily creative in absorbing private sector risk onto its own balance sheet in order to support and stabilize financial sector incumbents whose prior activity was the proximate cause of the crisis. That was and remains disagreeable on moral hazard grounds. It was also disagreeable on distributional grounds. As recent research reminds us (see Matt O’Brien’s summary), inequality of labor income is largely driven by inequalities of pay between firms and sectors, and compensation in the financial sector is extreme. [See update] Of course, others would have been harmed along with highly compensated finance employees, if we had allowed losses to be realized within financial sector incumbents according to ex ante norms. Stakeholders who would directly have taken losses were disproportionately wealthy creditors and asset holders. The capitalist system itself might have corrected its “long-term trend [towards inequality], one that has been decades in the making”. (Bernanke’s words)

Of course, that italicized directly is quite a caveat. A collapse of financial intermediation would have devastated the entire economy, not just imposed financial losses on disproportionately wealthy creditors. Again, the question is the counterfactual, and the Bernanke Fed itself demonstrated that another counterfactual was on offer. Rajiv Sethi explains:

The main justification for these extraordinary measures in support of the financial sector was that perfectly solvent firms in the non-financial sector would have been crippled by the freezing of the commercial paper market. But as Dean Baker has consistently argued, had the Fed’s intervention in the commercial paper market been more timely and vigorous, it might been unnecessary to provide unconditional transfers to insolvent financial intermediaries. While I do not subscribe to Baker’s view that Ben Bernanke “deliberately misled” Congress in order to gain approval for TARP, his main point still stands: if the Fed can increase credit availability to non-financial businesses and households by direct purchases of commercial paper, than why is any financial institution too big to fail?

It’s a question that the most ardent defenders of the bailouts would do well to address. The impressive numerical estimates of the effects of these policies on output and employment rely on a comparison with a “scenario based on no financial policy responses.” But this is obviously not the proper benchmark. If output and employment could have been stabilized by direct support of the non-financial sector, then we would currently be faced with a different distribution of claims to this output, as well as a different distribution of financial practices.

The case for conventional monetary ease post-crisis, and even for unconventional measures like QE, is easy to make on distributional as well as other grounds, if we presume sensible fiscal policy to be politically unattainable. However, the Fed worked assiduously to prevent a break in the United States’ inequality trend by choices it made with respect to stabilizing the financial sector. There were (and were widely discussed at the time) alternative approaches, some of which the Bernanke Fed itself proved practical with its aggressive and creative support of credit markets via special purpose vehicles in the heat of the crisis. We could relitigate questions of what would have been legal or practical, argue over the costs and benefits and risks of paths taken vs paths not taken. Regardless, it is incontrovertibly the case that policymakers including most emphatically Ben Bernanke chose a path that validated and sustained inequalities that had expanded on the back of very questionable financial activities over alternatives that might have clipped those inequalities dramatically.

This question of counterfactuals is one Bernanke in particular should not be permitted to escape. His widely quoted quip, “If we don’t do this tomorrow, we won’t have an economy on Monday” — where “it” was the extraordinarily finance friendly TARP — deserves a place among the most egregious examples of an expert civil servant wresting control from elected policymakers by presenting a constrained menu of options. TARP, you will recall, was not a spontaneous, last-minute response to the aftershocks of Lehman’s bankruptcy. As Phillip Swagel reported, “The options that later turned into the TARP were first written down at the Treasury in March 2008: buy assets, insure them, inject capital into financial institutions, or massively expand federally guaranteed mortgage refinance programs to improve asset performance from the bottom up.” After months of barely contained crisis between the collapse of Bear Stearns and the bankruptcy of Lehman, the fact that TARP and Meltdown were the only options Bernanke and his colleague at Treasury Henry Paulson had to present policymakers speaks a great deal about their perspectives and priorities.

Finally, all of this talk of the crisis and monetary policy response to the crisis elides the role played by monetary policy in the “very long-term trend…decades in the making”. Prior to the crisis, during the so-called “Great Moderation”, widening inequality was accompanied by an ever diminishing share of output going to labor. That was also the era of “opportunistic disinflation“, under which inflation-obsessed monetary policymakers intentionally clipped employment recoveries to lock-in “disinflationary gains”, um, enjoyed? during recessions. Further, during the Great Moderation, the touchstone of “inflationary threat” in Fed circles, the event most sure to provoke monetary tightening, was an increase in unit labor cost. Unit labor cost is a very dirty measure of inflation. It is, quite precisely, an admixture of the price level and labor’s share of output. Put simply, as a matter of technocratic procedure, the Great Moderation Fed interpreted any increase in labor bargaining power as an event demanding a contractionary response, even if it was not accompanied by an acceleration of the overall price level. Expansions in the cost of capital provoked no similar response. This practice, embedded in an arcane and technical policy regime, helped support the expansion of inequality over the period. (I’ve made this case in more detail here.)

The expansion of inequality since 1980 is a devil with many fathers. But it was not an inexorable fact of nature. It was the product of politics and policy and institutional arrangements that stripped US workers of bargaining power, and stripped US capital of tax obligations and ties to community. The Fed played a role in those arrangements, and not an unimportant role. Yes, post-crisis, post-TARP, in the context of a dysfunctional Congress, easy money has been the best available policy, even on distributional grounds. Yes, the Fed should continue to err on the side of monetary ease, despite the harm done by asset price inflation to social cohesion and to the information content of financial markets. If anything, the Fed’s policy ought to have been even easier, as it would have been under a wiser NGDP level target, for example.

But monetary policy prior to the crisis, and decisions made at the Fed during the event, are not remotely innocent of the catastrophic stratification we face today. Bernanke judges himself and his former institution too narrowly and too generously.

I do wish Ben Bernanke all the best in his new jobs at Citadel and PIMCO and Brookings. I’m sure his new employers have a different perspective on decisions taken during the financial crisis than my own.


Update: The “recent research” arguing that inter- rather than intra- firm changes in pay have driven labor income inequality has sparked a lively debate and some important critiques. See, for example, Matt Bruenig, Nick Bunker, J.W. Mason, and Larry Mishel. Many thanks to Rob Napier for pointing this out. [2015-06-16]: See also Sampling Bias In “Firming Up Inequality” by Marshall Steinbaum.

Update History:

  • 3-Jun-2015, 7:45 a.m. PDT: Added bold update with links to discussion of the Song et al paper cited in the piece.
  • 6-Jun-2015, 3:40 a.m. PDT: “a an expert civil servants servant wresting control”
  • 16-Jun-2015, 1:45 a.m. PDT: Added link to Marshall Steinbaum’s critique of the Song et al paper.

There is a name for this

I’m reading a lot of crap about riots in my hometown. Fuck you all and your firehose of useless, self-serving, careerist punditry, your giant spotlight that cares not a whit about all the things it pretends to illuminate but will blather with equal earnestness and concern about the next thing tomorrow just like it did about the last thing yesterday and hope to get paid or praised for it all. Fuck me for adding to the noise, I barely have the stomach for it anymore.

I don’t live in Baltimore now. I’m writing this from Silicon Valley. Does that even count as being alive? I feel like I’ve been uploaded into the singularity already. I never felt that way in Baltimore. Baltimore is inevitably described by lazy writers as “gritty”. Something like that.

Anyway, I interrupt your punditry to tell you that all your commentary about riots is bullshit and confused and tendentious and fuck off. And that economists, God bless ‘em (no, not really), have a name for this.

Politically motivated riots are a form of altruistic punishment. Look it up. Altruistic punishment is a “puzzle” to the sort of economist who thinks of homo economicus maximizing her utility, and a no-brainer to the game theorist who understands humans could never have survived if we actually were the kind of creature who succumbed to every prisoners’ dilemma. Altruistic punishment is behavior that imposes costs on third parties with no benefit to the punisher, often even at great cost to the punisher. To the idiot economist, it is a lose/lose situation, such a puzzle. For the record, I’m a fan of the phenomenon.

Does that mean I’m a fan of these riots, that I condone the burning of my own hometown? Fuck you and your tendentious entrapment games and Manichean choices, your my-team “ridiculing” of people you can claim support destruction. Altruistic punishment is essential to human affairs but it is hard. It is mixed, it is complicated, it is shades of gray. It is punishment first and foremost, and punishment hurts people, that’s its point. Altruistic punishment hurts the punisher too, that’s why it’s “altruistic”. It can’t be evaluated from the perspective of winners or losers within a direct and local context. It is a form of prosocial sacrifice, like fighting and dying in a war. If you write to say “they are hurting their own communities more than anyone” you are missing the point. Altruistic punishment is not a pissing match over who loses most. The punisher disclaims personal gain, accepts loss, sometimes great loss, in the name of a perceived good or in wrathful condemnation of a perceived evil.

So you want to evaluate riots, then, as tactic. Surely these rioters can’t imagine that this — this — will reduce the severity of policing, bring jobs to the inner city, diminish the carceral state. By the way, have I told you, fuck you? Altruistic punishment is generally not tactical. Altruistic punishment is emotional. The altruism in altruistic punishment is not pure, not saintly. The soldier takes pleasure even as he takes wounds exacting revenge for a fallen comrade on another human who was not, as an individual, his friend’s killer. The looter takes a pair of shoes, because why the fuck not? If you perceive the essence of the riots in the shoes you are an idiot. Altrustic punishment is not tactical, it is emotional, and it is sometimes but not always functional. It functions, sometimes, to change expectations about what is possible or desirable or acceptable. In economist words, people’s propensity for altruistic punishment changes the expected payoffs associated with nonaltruistic behavior by those punished directly and, more importantly, by third parties who observe the unpleasantness. Changes in expected payoffs change the equilibria that ultimately prevail, in ways which may be beneficial for some groups or for “society as a whole”, however you define the welfare of that entity. Of course, there are no guarantees. Changes in expected payoffs can alter equilibria in undesirable directions as well. Drones anybody? This is a risky business.

Even if it is possible that events like rioting can do some good, surely there are better ways? Yes, surely there are. Why haven’t they happened? If you feel entitled to tut-tut the rioters, I hope you have organized against police brutality, marched all peacefully like the GandhiMartinLutherJesus you manufacture to condemn the very people whose cause those idols championed. Have you borne costs to engage politically to ensure economic security and social inclusion for all? You have you say? Well good for you, though I don’t believe you and it doesn’t matter because this isn’t about you. As a society, we have not done these things. On the contrary, we have done the opposite, we have in practical terms increased the distance between the kind of people who lobby congress or write articles and the kind of people who are forcing the Orioles to play for empty bleachers. In theory, a peaceful political process is absolutely the right way to solve the problems of brutality and exclusion. In practice, it hasn’t happened, it isn’t happening, there is no sign that it will happen. Blame the fucking victims for not producing a Dalai Lama if you want, it doesn’t matter, they don’t have one, at least not one likely to be effective, and even if they did, the limited success of the real Martin Luther Kings of the world may have had something to do with the threat of riot and rebellion, with the horde of angry sinners barely held back by those saints whom we bugged and harassed in actual practice.

So I am condoning the riots, really, right? Fuck you. Can you go to hell, really, right now? I am not condoning, I am not condemning, I don’t care if you think that’s mealy-mouthed, this isn’t about me or pissing matches within the high IQ professional idiocracy.

Riots do severe, immediate, harm, they are an escalation, they are violent, they are prima facie bad. Yet the fact that rioting sometimes happens, the uncomfortable possibility of it, has historically and may again create urgency and motivate political change that is ultimately good. Or, it might pull the velvet glove from the iron fist of our hyperstratified ever less democratic police state. That is a possibility too, though it would be costly to elites who gain real satisfaction from pretending that the society that has elevated them is reasonably just and virtuous.

We don’t know the counterfactuals. But I will say this. Although it is not thought out into policy papers, it is not tactical, it is emotional and impure and corrupt, it provokes and sustains war, and it puzzles a certain kind of economist, human affairs would be intolerable without altruistic punishment. In small matters, the fact that people will bear disproportionate costs to protest small ripoffs is essential to the integrity of everyday commerce. In larger affairs, the human propensity to altruistic punishment means we all bear costs of perceived injustice, we all have a stake in finding some mix of society and legitimating ideology under which outcomes are perceived as broadly right. We’ve been doing a bad job of that lately.

Tangles of pathology

Trilemmas are always fun. Let’s do one. You may pick two, but no more than two, of the following:

  • Liberalism
  • Inequality
  • Nonpathology

By “liberalism”, I mean a social order in which people are free to do as they please and live as they wish, in which everyone is formally enfranchised by a political process justified in terms of consent of the governed and equality of opportunity.

By “inequality”, I mean high dispersion of economic outcomes between individuals over full lifetimes. [1]

By “nonpathology”, I mean the absence of a sizable underclass within which institutions of social cohesion — families (nuclear and extended), civic and religious organizations — function poorly or at best patchily, in which conflict and violence are frequent and economic outcomes are poor. From the inside, a pathologized underclass perceives itself as simultaneously dysfunctional and victimized. From the outside, it is viewed culturally and/or morally deficient, and perhaps inferior genetically. Whatever its causes and whomever is to blame, pathology itself is a real phenomenon, not just a matter of false perception by dominant groups.

This trilemma is not a logical necessity. It is possible to imagine a liberal society that is very unequal, in which rich and poor alike make the best of their circumstances without clumping into culturally distinct groupings, in which shared procedural norms render the society politically stable despite profound quality of life differences between winners and losers. But I think empirically, no such thing has existed in the world, and that no such thing ever will given how humans actually behave.

It’s easy to find examples of societies with any two of liberalism, inequality, and nonpathology. You can have inequality in feudal or caste-based societies without pathology. The high castes may well perceive the low castes as inferior, and the low castes may regret their circumstances. But with the hierarchy sustained by overt force and a dominant ideology of staying in place, there is no need for pathology. Families and religious organizations in the lower castes might be strong, there may be little internal conflict, and no perception inside or outside the low status group that they are violating the norms of their society. There are simply overt and customary relations of domination and subordination. This was the situation of slaves in the American South prior to emancipation. They faced an unhappy and unjust circumstance, but a straightforward one. Whatever instabilities of family life or institutional deficiencies slaves endured were overtly forced upon them, and cannot reasonably be attributed to pathologies of the community, particularly given the experience of early Reconstruction. (More on this below.)

Contemporary Nordic countries do a fair job of combining liberalism and nonpathology. But that is only possible because they constitute unusually equal societies.

The United States today, of course, chooses liberalism and inequality, and so, I claim, it cannot survive without pathology. Why not? In a liberal society, humans segregate into groups based on economic circumstance. Economic losers become geographically and socially concentrated, and are not persuaded by the gloats of economic winners that outcomes were procedurally fair and should be quietly accepted. Unequal outcomes are persistent. As an empirical matter we know there is never very much rank-order economic mobility in unequal societies (nor should we expect or even wish that there would be). That should not be surprising, because the habits and skills and connections and resources that predict economic success will be disproportionately available within the self-segregated communities of winners. So, even if we stipulate for some hypothetical first generation that outcomes were procedurally fair, outcomes for future generations will be very strongly biased towards class continuity. Equality of opportunity cannot coexist with inequality of outcome unless the political community forcibly and illiberally integrates winners and losers (and perhaps not even then). But an absence of equality of opportunity is incompatible with the political basis of liberal society. If numerous losers are enfranchised and well-organized, they will seek and achieve redress (redistribution of social and economic goods and/or forced integration), or else the society must drop its pretense of liberalism and disenfranchise the losers, or at least concede the emptiness of any claim to legitimacy based on equality of opportunity.

Pathology permits a circumvention of this dilemma. It enables a reconciliation of equal opportunity with persistently skewed outcomes by claiming that persistent losers simply fail to seize the opportunities before them, as a result of their individual and communal deficiencies. Conflict within and between communities and the chaos of everyday life reduce the likelihood that even a very numerous pathologized underclass will effectively dispute the question politically. Conflict and “broken institutions” also serve as ipso facto explanations for sub-par outcomes. If the losers are sufficiently pathologized, it is possible to reconcile a liberal society with severe inequality. If they are not, the contradictions become difficult to paper over.

This may seem a very functional and teleological, some might even say conspiratorial, account of social pathology. It’s one thing to argue that it would be convenient, from an amoral social stability perspective, for the losers in an unequal society to behave in ways that appear from the perspective of winners to be pathological and that prevent losers from organizing to press a case the might upset the status quo. It’s another thing entirely to assert that so convenient a pathology would actually arise. After all, humans flourish when they belong to stable families, when they participate in civic and professional organizations, and when their communities are not riven by conflict and violence. Why would the combination of liberalism, inequality, and pathology be stable, when the underclass community could simply opt out of behaving pathologically?

Individual communities can opt out. Some do. But unless those communities embrace norms that eschew conventional socioeconomic pecking orders and/or political engagement with the larger polity (e.g. the Amish), it is entirely unstable for those nonpathological communities to remain underclass in a liberal polity. Suppose there were a community constituted of stable, traditional families. Its members were diligent, forward-looking, and hardworking, pursued education and responded to labor market incentives. And suppose this community was politically engaged, pressing its perspective and interests in government at all levels. In a liberal polity, it is just not supportable for such a community to remain a socioeconomic underclass. One of two things may happen: the community may press its case with the liberal establishment, identify barriers to the success of its members and work politically to overcome them, and eventually integrate into the affluent “middle class”. But if all underclass communities were to succeed in this way, there could be no underclass at all, there would be a massive decrease in inequality. Nonpathology requires equality. Alternatively, if severe inequality is going to continue, then there must remain some sizable contingent of people who are socioeconomic losers, who will as a matter of economic necessity become segregated into less-desirable neighborhoods, who will come to form new communities with social identities, which must be pathological for their poverty to be stable. Particular communities can opt out of pathology, but it is a fallacy of composition to suggest that that all communities can opt out of pathology in a polity that will remain both liberal and unequal.

If a society is, at a certain moment in time, deeply unequal, then pathology among the poor is required if status quo winners are to preserve their place, which, under sufficient dispersion of circumstance, can become a nearly existential concern for them. Consider the perspective of a liberal and well-intentioned member of the wealthy ruling elite of a poor, developing country. To “live as ordinary citizens live” would entail renouncing civilized life as she understands it. It would entail becoming a kind of barbarian. I don’t think the perspective of elites in less extreme but still unequal developed countries is all that different. Liberal elites need not and do not set about intentionally manufacturing pathology. They simply manage the arrangement of political and social institutions with a shared, tacit, and perfectly natural understanding that their own reduction to barbarism would count as a bad policy outcome and should be avoided. The set of policy arrangements consistent with this red line just happens to be disjoint from the set of arrangements under which there would not exist pathologized communities. Elite non-barabarism depends upon inequality, upon a highly skewed distribution of consumption and of the insurance embedded in financial claims, which must have justification. Elite non-barbarism may also depend very directly on the availability of cheap, low-skill labor. Liberal elites may be perfectly sincere in their handwringing at the state of the pathologized poor, laudable in their desire to “discover solutions”. Consider The Brookings Institution. But, under the constraints elites tacitly place on the solution space, the problems really are insoluble. The best a liberal policy apparatus can do is to resort to a kind of clientism in which the pathology of the underclass is handwrung and bemoaned, but nevertheless acknowledged as the cause and justification for continued disparity. Instruction (however futile) and a stigmatized means-tested “safety net” are sufficient to signal elites’ good intentions to themselves and absolve them of any need to revise their self-perceptions as civilized and liberal.

If pathology is necessary, it is also easy to get. Self-serving (mis)perceptions of pathology by elites of a poor community become self-fulfilling. Elites fearful of a “pathological” community will be more cautious about collaborating with their members economically, or hiring them. Privately, employers will subject members of the allegedly pathological community to more monitoring, impose more severe punishments based on less stringent evidence than they would upon members of communities that they trust. Publicly, concern over a community’s perceived pathology will translate to more intensive policing and laws or norms that de facto give authorities a freer hand among communities perceived to be pathological. Holding behavior constant, police attention creates crime, and a prevalence of high crime is ipso facto evidence of pathology. Of course, as pathology develops, behavior may not remain constant. Intensive monitoring (public and private) and the “positives” resulting from extra scrutiny justify ever more invasive monitoring and interference by authorities, which leads the monitored communities to very reasonably distrust formal authority. Cautiousness among employers contributes to economic precarity within the monitored community. Communities that distrust formal authority are like tiny failed statelets. Informal protection rackets arise to fill roles that formal authority no longer can. If no hegemon arises then these protection rackets become competitive and violent — “gangs!” — which constitute yet more clear evidence of pathology to outsiders. Economic precarity and employment disadvantage render informal and illicit economic activity disproportionately attractive, leading mechanically to more crime and sometimes quite directly to pathology, because some activities are illicit for a reason (e.g. heroin use). The mix of economic precarity and urban density loosens male attachment to families, a fact which has been observed not only recently and here but over centuries and everywhere, which increases poverty among women and children and engenders cross-generational pathology. Poverty itself becomes pathology within communities unable to pool risk beyond direct, also-poor acquaintances. Behavior that is perfectly rational for the atomized poor — acquiescence to unpleasant tradeoffs under conditions of crisis — appear pathological to affluent people who “would never make those choices” because they would never face those circumstances.

About a year ago, there was a rather extraordinary conversation between Ta-Nehisi Coates and Jonathan Chait. [1, 2, 3, 4, 5, 6, 7, 8, 9, 10] At a certain point, Chait argues that the experience of white supremacy and brutality would naturally have left “a cultural residue” that might explain what some contemporary observers view as pathology. Coates responds:

What about the idea that white supremacy necessarily “bred a cultural residue that itself became an impediment to success”? Chait believes that it’s “bizarre” to think otherwise. I think it’s bizarre that he doesn’t bother to see if his argument is actually true. Oppression might well produce a culture of failure. It might also produce a warrior spirit and a deep commitment to attaining the very things which had been so often withheld from you. There is no need for theorizing. The answers are knowable.

There certainly is no era more oppressive for black people than their 250 years of enslavement in this country. Slavery encompassed not just forced labor, but a ban on black literacy, the vending of black children, the regular rape of black women, and the lack of legal standing for black marriage. Like Chait, 19th-century Northern white reformers coming South after the Civil War expected to find “a cultural residue that itself became an impediment to success.”

In his masterful history, Reconstruction, the historian Eric Foner recounts the experience of the progressives who came to the South as teachers in black schools. The reformers “had little previous contact with blacks” and their views were largely cribbed from Uncle Tom’s Cabin. They thus believed blacks to be culturally degraded and lacking in family instincts, prone to lie and steal, and generally opposed to self-reliance:

Few Northerners involved in black education could rise above the conviction that slavery had produced a “degraded” people, in dire need of instruction in frugality, temperance, honesty, and the dignity of labor … In classrooms, alphabet drills and multiplication tables alternated with exhortations to piety, cleanliness, and punctuality.

In short, white progressives coming South expected to find a black community suffering the effects of not just oppression but its “cultural residue.”

Here is what they actually found:

During the Civil War, John Eaton, who, like many whites, believed that slavery had destroyed the sense of family obligation, was astonished by the eagerness with which former slaves in contraband camps legalized their marriage bonds. The same pattern was repeated when the Freedmen’s Bureau and state governments made it possible to register and solemnize slave unions. Many families, in addition, adopted the children of deceased relatives and friends, rather than see them apprenticed to white masters or placed in Freedmen’s Bureau orphanages.

By 1870, a large majority of blacks lived in two-parent family households, a fact that can be gleaned from the manuscript census returns but also “quite incidentally” from the Congressional Ku Klux Klan hearings, which recorded countless instances of victims assaulted in their homes, “the husband and wife in bed, and … their little children beside them.”

This, I think, is a biting takedown of one theory of social pathology, that it arises as a sort of community-psychological reaction to trauma, an explanation that is simultaneously exculpatory and infantilizing. The “tangle of pathology” that Daniel Patrick Moynihan famously attributed to the black community did not refer to people newly freed from brutal chattel slavery in the late 1860s. It did not refer even to people in the near-contemporary Jim Crow South, people overtly subjugated by state power and threatened with cross-burnings and lynchings. No, the Moynihan report referred specifically to “urban ghettos”, mostly in the liberal North. The black community endured, in poverty and oppression but largely without “pathology”, precisely where it remained oppressed most overtly. For a brief period during Reconstruction, the contradictions between imported liberalism, non-negotiable inequality, and a not-all-at-pathological community of freedman flared uncomfortably bright. But before long (after, Coates points out, literal coups against the new liberal order), the South reverted to the balance it had always chosen, sacrificing liberalism for overt domination which permitted both inequality and a black community that lived “decently” according to prevailing norms but was kept unapologetically in its place.

Social pathology may be pathological for specific affected communities, but it is adaptive for the societies in which it arises. Like markets, pathology constitutes a functional solution to the problem of reconciling the necessity of social control with liberalism, which disavows many overt forms of coercion. A liberal society is a market society, because if identifiable authorities aren’t going to tell people what to do and force them, if necessary, to act, then a faceless, quasinatural market must do so. A liberal, unequal society “suffers from social pathology”, because the communities into which its losers collect must be pathological to remain so unequal. No claims are made here about causality. It is possible that some communities of people are, genetically or by virtue of some preexisting circumstance, prone to pathology, and pathology engenders inequality. It is possible that dispersion of economic outcomes is in some sense “prior”, and then absence of pathology becomes inconsistent with important social stability goals. Our trilemma is an equilibrium constraint, not a narrative. Whichever way you like to tell the story, a liberal society whose social arrangements would be badly upset by egalitarian outcomes must have pathology to sustain its underclass. The less consistent the requirements of civilized life among elites are with egalitarian outcomes, the greater the scale of pathology required to support the dispersion. That, fundamentally, is what all the handwringing in books like Coming Apart and Our Kids is about.


[1] We’ll be more directly concerned with “bottom inequality”, or “relative poverty” in OECD terms, rather than “top inequality” (the very outsized incomes of the top 0.1% or 0.001%).

relative-inequality-kersbergen-vis

The figure is from Comparative Welfare State Politics by Kerbergen and Vis.

Broadly speaking, top inequality is most relevant with respect to political and macroeconomic aspects of inequality (secular stagnation, plutocracy), while bottom inequality most directly touches social issues like family structure, labor market connectedness, social stratification, etc. Top and bottom inequality are obviously related, though the connection is not mechanical in a financial economy in which monetary claims can be created ex nihilio and the connection between monetary income and use or acquisition of real resources is loose.

Surge!

So-called “surge pricing” is not the main thing to worry about with Uber. Investors who value the ethically challenged firm at an astonishing $40B have made a cynical (also ethically challenged) bet that “network effects” will permit the firm to basically own the 21st century successor to the taxi industry. Our main concern should be to ensure investors do not win that bet. In particular, public policy should focus on encouraging “multihoming”, where drivers advertise availability over several competing platforms (Uber, Lyft, Sidecar, etc.) simultaneously. Municipalities might also consider requiring that ride-sharing platforms support standard APIs that would enable Kayak-like metaplatforms to emerge. Or municipalities might offer such applications to the public directly. As usual, the question here is not “regulation” vs “deregulation”, but smart regulation to ensure a high-quality competitive marketplace. Fortunately, the right of municipalities to regulate transportation services is well established, so it should be straightforward for cities to impose conditions like nonexclusivity and publication of fares in standardized formats.

I don’t care all that much about Uber’s “surge pricing” — its practice of increasing its usual fare schedule by multiples during periods of high demand. I do, however, care about the damage done by a kind of idiot dogmatism that hijacks the name “economics”. Uber’s surge pricing may or may not serve Uber’s objectives of profit maximization and world domination. It may or may not increase “consumer welfare”. But it is not unambiguously a good practice, either from the perspective of the firm or as a matter of economic analysis. Its pricing practices impose tradeoffs that must be addressed with reference to actual, on-the-ground circumstances. Among prominent academic economists there may well be a (research-free) consensus that surge pricing promotes consumer welfare (ht Adam Ozimek), but that reflects the crude selection bias of the profession much more than actual analysis of the issue. The dogmatism which has arisen in support of Uber’s surge pricing is quite analogous to the case of urban rent regulation, a domain in which there is incredible heterogeneity across localities and nations, both of circumstance and policy, and a wide range of legitimate values that conflict and must be reconciled. (Here’s an interesting case in the news today, in Spain, ht Matt Yglesias.) Almost as a rite of passage, economists drone in every intro course that rent controls are bad. By preventing price signals from working their magicks, they prevent the explosion of real-estate supply that a truly free market would deliver. This is stated as uncontroversial fact even while economists who research and opine prominently on housing policy have endlessly documented that housing supply is not in fact price-elastic in the prosperous cities where rent controls are typically imposed. None of this is to say that rent controls are good or bad, or that non-price barriers to construction are good or bad. These are complex questions involving competing values textured by local circumstance. They deserve bespoke analysis, not pat dogma imposed by distant central planners economics professors.

Anyway, surge. The excellent Tim Lee grapples with the miserable dogmatism that surrounds the subject here:

The thing Lyft customers seem to hate the most about Uber is surge pricing. That’s when Uber automatically raises prices during periods of high demand…

The economic argument for surge pricing is impeccable: varying prices helps to balance supply and demand, ensuring that people who really need a ride can always get one. But businesses have to take customer preferences into account whether or not they’re rational. So it might make sense for Uber to adopt Lyft’s softer approach to demand-based pricing.

As in the case of rent control, the stereotyped economist’s case for surge pricing is based on a conjectured elasticity of supply. With higher prices, the reasoning goes, more drivers will hit the road, more customers will be served, and the world will be better off. And that’s a good case, as far as it goes. But it doesn’t go very far, without some empirical analysis. It doesn’t justify Uber’s actual practice of surge pricing, which is far from the transparent auction our stereotyped economist seems to imagine. It doesn’t account for the trade-offs imposed by price-rationing (as opposed to time- or lottery- rationing), both between customers and for the public at large.

First, how price elastic is driver supply? If we presume that Uber is a Walrasian auctioneer, a disinterested matchmaker of supply and demand, apparently supply is not very elastic. Uber surges prices by multiples, two, three, even four times “typical” pricing in periods of high demand. That’s extraordinary! If supply were in fact elastic, small increases in price would lead to large increases in supply. The supply-centered case for dynamic pricing is persuasive in direct proportion to actual elasticity of supply. Uber’s behavior suggests that the supply-based case is not so strong. Of course, we cannot make very strong inferences about driver supply from Uber’s behavior, because they are not in fact a disinterested Walrasian auctioneer. When Uber surges, it dramatically raises its own prices and earns a lot more money per ride, whether ride supply increases not at all, or whether it spikes so much that drivers end up competing heavily for riders and suffer long vacancies. As a profit maximizer, Uber’s incentives are to impose surges primarily as a function of demand, and say nice things about supply to con economists and journalists.

Suppose, then, that supply is not elastic. Is there any problem with Uber “charging what the market will bear”? Even for inelastically supplied goods, the stereotyped Econ 101 professor recommends price-rationing, as that should ensure that the scarce supply goes to those who most value it. Unfortunately, the argument for price-rationing (as opposed to lottery-rationing, or queue-rationing) of goods as being welfare-maximizing depends (at the very least) upon a rough equality of wealth so that interpersonal dollar values can stand in for interpersonal welfare comparisons. In an unequal society, price rationing ensures disproportionate access by the rich, even when they value a good or service relatively little. There is no solid case that price-rationing is optimal or even remotely a good idea when dispersion of purchasing power is very large. I’ve written about this, as has Matt Yglesias very recently. Matt Bruenig has two excellent posts relating this point to Uber specifically (as well as another post on ethical claims about Uber’s pricing). For a deep dive into how distributional concerns affect welfare-economic intuitions under perfectly orthodox economic analysis, I’ll recommend my own welfare economics series. It’s easy to write-off Uber controversializing as a masturbatory first-world problem among hipsters, rather than a pressing question of wealth and poverty. That’s a mistake. There’s little question that “app-mediated” car provision will soon replace conventional taxis, because it is a much higher quality product. Poor people are in fact one of the main clienteles of traditional taxis in the US, since nonpoor households typically own cars and use taxis primarily when traveling. As the industry transitions, poor people will be hit very immediately by whatever practices become standard. In an unequal society, distributional effects are a first-order concern.

Suppose you just don’t care about distribution and you favor price-rationing of scarce goods over alternative schemes full stop. Then you should still be troubled by Uber’s surges, because Uber itself is a cartel. The actual service providers are individual drivers. When Uber “surges”, it raises prices across its whole fleet of drivers. Yes, Uber faces competition, from traditional cabs, and (depending on the city) from other startups. But between perfect competition and monopoly, there are a lot of degrees of pricing power. In many cities, Uber already has a lot of pricing power, and that may increase over time, depending on how today’s competitive battles shake out. Like any potential monopolist, Uber’s incentives will be to “surge” to a price that is higher than the output-maximizing price that would obtain in a competitive market. There is no technical reason why Uber needs to be organized like a cartel. In fact, one of its competitors, Sidecar, allows each driver to set her own price, encouraging competition within the service. Like Sidecar, Uber claims to be a “platform”, and disavows any employment relationship with or liability for the actions of its drivers. Fine. It makes a market for independent contractors. Then why on earth do “free market economists” applaud when it forces those contractors to coordinate price increases? Why would antitrust laws even tolerate that?

Finally, we need to consider questions of economic calculation. In macroeconomics, we sometimes face tradeoffs between an increasing and unpredictably variable price-level and full employment. Wisely or not, our current policy is to stabilize the price level, even at short-term cost to output and employment, because stable prices enable longer-term economic calculation. That vague good, not visible on a supply/demand diagram, is deemed worth very large sacrifices. The same concern exists in a microeconomic context. If the “ride-sharing revolution” really takes hold, a lot of us will have decisions to make about whether to own a car or rely upon the Sidecars, Lyfts, and Ubers of the world to take us to work every day. To make those calculations, we will need something like predictable pricing. Commuting to our minimum wage jobs (average is over!) by Uber may be OK at standard pricing, but not so OK on a surge. In the desperate utopia of the “free-market economist”, there is always a solution to this problem. We can define futures markets on Uber trips, and so hedge our exposure to price volatility! In practice that is not so likely. For many people, time-uncertainty may be more tolerable than price-uncertainty in making future plans. If this weren’t the case, congestion pricing of roads would be much more popular than it is. Just as we leave home early now to account for the time we’ll spend parked on the expressway, we can summon a ride early to ensure we arrive on time even when there is no car immediately available.

It’s clear that in a lot of contexts, people have a strong preference for price-predictability over immediate access. The vast majority of services that we purchase and consume are not price-rationed in any fine-grained way. If your hairdresser or auto mechanic is busy, you get penciled in for next week. She doesn’t tell you she’ll fit you in tomorrow at double her usual rate. There are, as far as I know, no regulatory or technological impediments to more dynamic pricing schemes for everyday services. Even in the antediluvian, pre-app world, less routine sorts of service provision like hotels did price dynamically. People seem to tolerate dynamic prices of services they consume sporadically or as a discretionary luxury, but prefer price predictability and time uncertainty for services they consume routinely. You’d think economists of all people would “mark their beliefs to market”, but the stereotyped practitioners who define what Tim Lee calls “impeccable” economics are in fact wide-eyed utopians. They look past actual preferences that consumers express in purchasing behavior, and that providers reflect in pricing behavior, to a hypermarketized alternative reality where interactions are governed in a very fine-grained way by price-signals and market incentives. It’s not clear that very many humans actually want to live in their world. Lee expresses the incoherence of the “impeccable” economist very well when he writes, “businesses have to take customer preferences into account whether or not they’re rational.” In theory, of course, customer preferences can be inconsistent, but they can never be irrational. Economics as a discipline takes human preferences as given, and defines rationality as action that maximizes the degree to which those preferences are satisfied. But the “impeccable” economist so privileges stereotyped market mechanisms as analyzed in a deracinated fictional theoryworld that any preferences not consistent with means chosen a priori get deemed irrational. That way of thinking may be “impeccable”, but it is the opposite of good economics.

I don’t want to be too negative. As I said at the start, surge pricing per se is really not the major concern with Uber. Our efforts should be devoted to ensuring that no single price-coordinating “platform” dominates the nascent on-demand transportation industry. There is a solid case for using price to incentivize ride supply, or even to ration relatively fixed supply. Price-rationing may be welfare maximizing, among the options available to a firm like Uber. But there is also a solid case against, for preferring predictable pricing and lottery- or time-rationing. Even if we stipulate that price rationing is best, it’s hard to think of any consumer-welfare rationale for Uber-style fleet-wide surge pricing rather than a Sidecar-style competitive auction among drivers. Sidecar’s competitive provision is less prone to consumer-welfare-destructive monopoly rent extraction than Uber’s coordinated pricing. Sidecar’s system also permits heterogeneous strategies among drivers, allowing the market to decide and perhaps segment, as some users pay up for immediacy, while other users reward drivers who hew to stable prices by preferring them even when demand is slack.

Update History:

  • 30-Dec-2014, 11:15 p.m. EST: “to ensure that investors”; “over several competing platforms”; ” while the economists who research and opine most prominently on housing policy have endlessly documented the fact that”; “encouraging competition within the platform service“; “defines rationality as action that maximizes the degree to which those preferences are met satisfied“; “it’s hard to think of a any consumer-welfare rationale”
  • 31-Dec-2014, 10:15 a.m. EST: Added link to Dempsey paper, both as related academic work and as cite for claim that taxis significantly used by the poor.
  • 31-Dec-2014, 10:30 a.m. EST: Added link to third Matt Bruenig post on Uber.
  • 18-Jan-2015, 7:05 a.m. PST: “right rite of passage”, thanks Bob Jansen and commenter Bruce