Friday, 7 December 2012

An alternative Neo classical solution to Europe’s Banking Crisis: Universal Default.

I am constantly amazed with the indignant way politicians and media claim that the deflationary and austere measures demanded by the “Troika” consortium are the epitome of “Neo-liberalism”. It is true that some policy-makers have decided that these measures should continue, despite failing to revive the economies (Ireland, Greece, Portugal) that are in trouble. There seems to be the idea that the lack of recovery is due to a lack of sufficient reduction of the price level, and as such they demand ever more austerity and wage and price falls as a method to restore competitiveness of the ailing economies. The result is a downward spiral of GDP disposable income and people in employment, and a weakening of the critical sector for the economy: Banking.

The issue is that idea that just more austerity works is as weakly based on economic principles as most other suggestions heard in the last three years – rather than being “Neo-liberal” and sticking to the Neo classical paradigm of economics, the policy-makers in favour of these ideas choose a pick and mix approach, that totally discredits their efforts. It is not “neo-liberal” economics: it is bad economics, as it violates one of the first principles set by Lucas for modern Macroeconomics: it should be based on solid microeconomic foundations (i.e. it should anticipate the reaction of each individual agent to changes in incentives).

Let look at the three major suggestions of the “Troika” consortium: Government should reduce expenditure, labour laws and prices should be liberalised and fall in order to restore competitiveness, and banks should increase their capital in order to be immune to the effects of a declining economy. Government should borrow to help the banks directly by providing cheap credit/support.  

Yet Neo classical economics has for decades proven that the combination of these three policies would be catastrophic. Irving Fischer wrote a paper in Econometrica in 1933 that proved that such a combination of policies is catastrophic. Although there are other reasons why the above policies are ruinous (which will be subject of latter articles) here we will focus on Fisher’s understanding of the problem and his solution: the real cost of debt and the idea of universal default.

Fischer pointed out that even if prices and wages are flexible and can fall, contracts written in the past are not. Some of the most rigid (and long term) contracts are loans to firms and individuals; although banks can change the interest they charge in most deposits (and face the risk of losing clients), debtors do not have the right to change the interest they get charged.

For Fischer a severe downturn can bring a reduction of prices and wages in an economy, leading to a dramatic increase in the real cost of an existing loan agreement. For example if I bought a house and I used 10% of my past salary to repay the mortgage, the reduction in prices and wages would mean now I have to spend 20% of my current salary to repay that loan. The house is now probably worth less than what I bought it for (and hence I am repaying a loan for more than its current value) and I need to sacrifice more of my shirking income to pay for it.

What are the implications of the above example? If I keep paying the mortgage then there is a large redistribution of wealth from the owner to the bank: the bank is gaining from the lower price level and thus the real interest rate it receives increases. If I stop paying, the bank will go bankrupt: forcefully getting my asset (the house) will not help the bank as the fire-sales of devaluated assets lead to the asset selling for a very low value.

What is Fischer’s policy advice: universal default! Fischer argues that all institutions and agents acknowledge that past contracts are unworkable and universally default and renegotiate to take account of the new wage and price level. Neo classically this idea is ideologically sound and it can be perhaps best explained with a joke:

It is a slow day in a little Greek Village. The rain is beating down and the streets are deserted. Times are tough, everybody is in debt, and everybody lives on credit. On this particular day a rich German tourist is driving through the village, stops at the local hotel and lays a €100 note on the desk, telling the hotel owner he wants to inspect the rooms upstairs in order to pick one to spend the night. The owner gives him some keys and, as soon as the visitor has walked upstairs, the hotelier grabs the €100 note and runs next door to pay his debt to the butcher. The butcher takes the €100 note and runs down the street to repay his debt to the pig farmer. The pig farmer takes the €100 note and heads off to pay his bill at the supplier of feed and fuel. The guy at the Farmers' Co-op takes the €100 note and runs to pay his drinks bill at the taverna. The publican slips the money along to the local prostitute drinking at the bar, who has also been facing hard times and has had to offer him "services" on credit. The hooker then rushes to the hotel and pays off her room bill to the hotel owner with the €100 note. The hotel proprietor then places the €100 note back on the counter so the rich traveller will not suspect anything. At that moment the traveller comes down the stairs, picks up the €100 note, states that the rooms are not satisfactory, pockets the money, and leaves town. No one produced anything. No one earned anything. However, the whole village is now out of debt and looking to the future with a lot more optimism.

Now some will argue that:
a)      Greece and Southern Europe have not seen deflation as measured by the Consumer Price Index (CPI)
b)      As loans as now estimated as a basis points above the ECB base rate, interest payment are flexible and thus there is no need to renegotiate contracts – interest payments of individuals will fall as their wages decline.
I argue that a) is false and b) is theoretically correct but stopped by the Troika measures.

In regards to a), although the CPI of Southern European countries is positive, this is mainly due to the effects on inflation though tax increases raising prices – thus a CPI minus tax increases is close to being deflationary. There is no doubt that the purchasing power of the average Southern European is falling rapidly and this is accepted even by the “Troika” consortium; they argue it is just not falling fast enough.  

As for b), the ECB interest rate is low but as banks are scrambling to gain capital and other secure assets, we do not see a decrease in the interest rate of lending to individuals; if anything we see interest rates to individuals remain at the same levels, while total lending is being dramatically reduced. But this is mainly is due to the policy of increasing banking solvency at a time of lean economic times, a policy agreed by some of the same policy makers which argue for increased austerity. Currently banks borrow from the ECB cheaply and lend to governments less cheaply, while no one is really helping those who defaulted on their loans: Fischer’s idea provides and alternative view, were homeowners and banks reach settlements through a defaults that is across the board.  I suspect the reason Fischer’s alternative idea is not even discussed has more to do with politics and interest groups rather than with economics.

Despite the fact that I think many of the ideas of the “Troika” consortium are rubbish, I do not believe the economic ideas as expounded by SYRIZA can work. Those who accuse the “Neo liberal” policies and provide alternative heterox views also have a poor foundation in economic theory. As a result an implementation of such views will result to unpredictable and disastrous results. The “Troika” policy makers should stop hiding behind economics: the Neo classical worldview is incredibly mixed and varied, and offers alternative ways out of the current crisis which are not discussed due to political rather than economic considerations.

My thanks to Econtalk for the Fischer Article, and Demetris Halios who first asked me about the paradox hidden in the joke,  and the girl in Cave bar who asked me why does the bailout of Cyprus go to the homeowners rather than to the banks.--------------------------------------------------------------------------------------------------- Licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 3.0 Unported License. . You are free to copy content but you must link back to this blog and attribute the work to me (Alexandros Apostolides).. You cannot use my work for commercial purposes and you must share it under the same terms I do.

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