Note: see update below

Paul Krug­man has a recent post about how the coun­try of Esto­nia is appar­ently pissed at him over his objec­tions to the asser­tion that Estonia’s austerity-policy has been a stun­ning suc­cess. It’s a fas­ci­nat­ing story that holds a num­ber of rel­e­vant lessons for the conun­drum the globe finds itself in at the moment.

The gist of Krugman’s argu­ment is that the Esto­nia recov­ery hasn’t actu­ally been all that great: A 20% drop in GDP from 2007–2009 fol­lowed by rebound that’s brought Esto­nia back up to around 92% of its peak 2007 GDP. While this may be true, the austerity-defenders make the case that this is really all a mat­ter of selec­tive data-manipulation and the government’s aus­ter­ity poli­cies. Plus, Krug­man really pissed off Toomas Hen­drik Ilves, the pres­i­dent of Esto­nia. And, appar­ently, a lot of the rest of Esto­nia:

Busi­ness Week
Krug­menistan vs. Esto­nia
By Bren­dan Gree­ley on July 20, 2012

In May 2009, months after the pas­sage of a $787 bil­lion stim­u­lus pack­age in the U.S., Estonia’s gov­ern­ment took the oppo­site tack: the hard line. It did not dip into the country’s reserves or bor­row money. Min­is­ters say they never even con­sid­ered devalu­ing what was then Estonia’s cur­rency, the kroon, which would have derailed a 10-year plan to adopt the euro. To main­tain the country’s bal­anced bud­get, a tra­di­tion it had hon­ored since the end of the Soviet occu­pa­tion, Estonia’s gov­ern­ment froze pen­sions, low­ered state salaries by about 10 per­cent, and raised the value-added tax by 2 per­cent. The gross domes­tic prod­uct dropped more than 14 per­cent that year.

...

On June 6, in a blog post titled “Eston­ian Rhap­sody,” Krug­man took on what he called “the poster child for aus­ter­ity defend­ers.” In his post, he graphed real GDP from the height of the boom to the first quar­ter of this year to show that, even after a recov­ery, Estonia’s econ­omy is still almost 10 per­cent below its peak in 2007. “This,” he wrote, “is what passes for eco­nomic triumph?”

“It was like an attack on Eston­ian peo­ple,” says Palmik, in an office above his plant, sur­rounded by blue­prints for his new pro­duc­tion line. “These times have been very dif­fi­cult. Peo­ple have kept together. And this Krug­man took all these facts that he wanted.”

Over the course of a week’s visit to three cities in Esto­nia, I met only two peo­ple who didn’t know what Krug­man wrote about their recov­ery. This is not because Esto­nia is a coun­try of blog-obsessed ama­teur econ­o­mists. It’s because Toomas Hen­drik Ilves picked a fight.

Ilves is the pres­i­dent of Esto­nia. The night Krug­man wrote his post, Ilves was in Riga, on a state visit to Latvia. He gave a talk to the city’s busi­ness com­mu­nity, offer­ing what he calls “moral sup­port” for Latvia’s own aus­ter­ity pol­icy. He went to a recep­tion on a boat, then returned to his hotel and pulled out his iPhone. “I read some­where ‘Krug­man attacks Esto­nia,’ and I thought, well, let’s look at his blog,” says Ilves. “I said ‘What the f …’” Ilves does not com­plete the word.

Estonia’s pres­i­dent has lit­tle for­mal power. As in the U.K., the prime min­is­ter runs the gov­ern­ment. Like the Queen of Eng­land, Ilves has only a bully pul­pit. On June 6, stand­ing in front of the Riga Radis­son, he linked to Krugman’s post and wrote five tweets in 73 minutes.

8:57 p.m. Let’s write about some­thing we know noth­ing about & be smug, over­bear­ing & patron­iz­ing: after all, they’re just wogs
9:06 p.m. Guess a Nobel in trade means you can pon­tif­i­cate on fis­cal mat­ters & declare my coun­try a “waste­land.” Must be a Prince­ton vs Colum­bia thing
9:15 p.m. But yes, what do we know? We’re just dumb & silly East Euro­peans. Unen­light­ened. Some­day we too will under­stand. Nos­tra culpa.
9:32 p.m. Let’s sh*t on East Euro­peans: their Eng­lish is bad, won’t respond & actu­ally do what they’ve agreed to & reelect govts that are respon­si­ble.
10:10 p.m. Chill. Just because my country’s pol­icy runs against the Received Wis­dom & I object doesn’t mean y’all gotta fol­low me.

The tweets made the Eston­ian papers and the inter­na­tional press. The next morn­ing Jür­gen Ligi, the country’s finance min­is­ter since 2009, had to com­ment on them at a press con­fer­ence. “Maybe the style can be argued,” he tells me. “For exam­ple, the reac­tion was really sen­si­tive, blam­ing Krug­man, but the gen­eral idea was right. Krug­man was clearly wrong. He clearly doesn’t under­stand dif­fer­ences of choices between Amer­ica and in a small econ­omy. By a Nobelist, it was a shame.”

...

Since inde­pen­dence, Esto­nia has focused on becom­ing part of the West. It joined NATO, the Coali­tion of the Will­ing, and the Euro­pean Union. Mart Laar, Estonia’s first post-Soviet prime min­is­ter, likes to say that when he was elected, he had read only one book on eco­nom­ics, Mil­ton Friedman’s Free to Choose. The coun­try is open, effi­cient, and wired. On the World Bank’s Ease of Doing Busi­ness Index, it ranks 24th out of 183. Esto­nia speaks a lan­guage close to Finnish, and its strongest trade ties are with Fin­land and Swe­den. At the Kadri­org, Ilves pro­duces a col­ored map rank­ing the most com­pet­i­tive economies in the Euro­pean Union. Esto­nia sits in the sec­ond tier, behind the Nordic coun­tries, grouped with Ger­many and the United Kingdom.

...

Note that Esto­nia isn’t the the only for­mer Eastern-Bloc coun­try to embrace laissez-faire eco­nom­ics with a fer­vor in the last two decades. Accord­ing to this piece by George Mason Uni­ver­sity pro­fes­sor Peter Boet­tke, the writ­ings of econ­o­mist Mil­ton Fried­man played a role in the col­lapse of the Soviet Union. Now, since Boet­tke is Boet­tke is an Austrian-school econ­o­mist and direc­tor of the Koch-founded/funded Mer­ca­tus Cen­ter, we shouldn’t be sur­prised by the Friedman-oriented enthu­si­asm. Ok, we should be kind of sur­prised. But gen­er­ally speak­ing, think of Fried­man as the leader of right-wing “Chicago School” counter-attack against Key­ne­sian­ism in the lat­ter half of the 20th cen­tury (and you can think of the Aus­trian School as the crazy aunt liv­ing in the attic that went mad from her gold obses­sion).

Skip­ping down in the article...

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Ilves divides Europe into coun­tries that fol­low the rules and coun­tries that don’t. And he has started wor­ry­ing about a new kind of pop­ulism in Europe: peo­ple who play by the rules and are unwill­ing to help those who didn’t. Ilves points to Fin­land, where the True Finns party has won votes by reject­ing bailouts, and to Slo­va­kia, where the prime min­is­ter lost a con­fi­dence vote last year for her sup­port of Europe’s bailout fund.

Esto­ni­ans, in their own eyes, have always fol­lowed the rules, and in 2009 took their lumps to do so. Ilves says Estonia’s aver­age salary is 10 per­cent below the min­i­mum salary in Greece. He says pen­sions are also much lower, and civil ser­vants retire 15 years later. “You can imag­ine why there might be some frus­tra­tion,” Ilves says.

...

The point made by Estonia’s pres­i­dent about the frus­tra­tions Esto­ni­ans feel over the per­ceived unfair­ness of the euro­zone bailouts is a crit­i­cal aspect the entire euro­zone cri­sis, and the Esto­ni­ans aren’t the only ones that share this sense of resent­ment. They did indeed “take their lumps”, vol­un­tar­ily. All three Baltic nations were still issu­ing their own cur­ren­cies when the cri­sis hit (Esto­nia joined the euro in 2011), and so all three had the option of devalu­ing their cur­ren­cies instead of embrac­ing the “inter­nal devaluation”/austerity approach. All three of the “Baltic Tigers” choose aus­ter­ity and it hurt. A lot. In addi­tion Latvia and Lithua­nia both had national debts under 20% of their GDP debt and Esto­nia has had a bal­anced bud­get for two decades and almost no pub­lic debt at all. Humans are wired to per­ceive and dis­like inequal­ity. Researchers were appar­ently able to insti­gate a strike in a capuchin mon­key com­mu­nity sim­ply by shift­ing from a fair to unfair rewards sys­tem. We’re wired to per­ceived unfair­ness. It makes us tricky crit­ters to rule: we can sense injustice.

The sen­ti­ment that “we took our lumps for our suc­cess and now you’re ask­ing us to bailout a bunch of layabouts!?” is a very real sen­ti­ment across much of EU right now and it’s under­stand­able. And since the Baltic tigers have seen their economies rebound in the last cou­ple of years after swal­low­ing the bit­ter pill of wage cuts, there’s also the under­stand­able sen­ti­ment that the eurozone’s ail­ing economies (the PIIGS) should sim­ply learn the lessons of the suc­cess of the Baltic states’ exper­i­ment with crash course aus­ter­ity. Unfor­tu­nately, even when a pop­u­lace pays dearly in terms of aus­ter­ity the lessons drawn from their col­lec­tive expe­ri­ences may not be entirely applic­a­ble to a neigh­bor­ing nation also under­go­ing an eco­nomic cri­sis. Many of the same lessons that apply in the Baltics may also apply in the dis­tressed eco­nom­ics of Spain and Italy too. But a lot lessons don’t apply across dif­fer­ent economies. So the “we’ve paid, so should they”, sen­ti­ment is both an under­stand­able state­ment, but also a mis­guided sen­ti­ment. Under­stand­ably mis­guided sen­ti­ments are a big part of con­tem­po­rary pol­i­tics and policy-making:

Finan­cial Times
Myths and truths of the Baltic aus­ter­ity model
June 28, 2012 12:16 pm by Neil Buckley

...

Latvia and its Baltic neigh­bours Esto­nia and Lithua­nia suf­fered the world’s steep­est eco­nomic con­trac­tions in 2009 amid swinge­ing aus­ter­ity mea­sures. But now they find them­selves in the front­line of the debate over aus­ter­ity ver­sus growth as the best way to tackle the eurozone’s debt problems.

Even before Ms Lagarde’s com­ments, the Baltics were the talk of the eco­nomic blo­gos­phere after a spat between Paul Krug­man, the Nobel eco­nom­ics lau­re­ate and aus­ter­ity critic, and Eston­ian pres­i­dent Toomas Ilves.

Ilves called Krug­man “smug, over­bear­ing and patro­n­is­ing” on twit­ter after a Krug­man blog ques­tioned whether Estonia’s “incom­plete” bounce­back from a Depression-level slump should be con­sid­ered an “eco­nomic triumph”.

So are the Baltics really a model for, say, Greece or Spain? The answer is prob­a­bly not – though they may pro­vide lessons. And that makes the Baltic states’ achieve­ments no less extraordinary.

The three for­mer Soviet states binged on cheap cap­i­tal in the 2000s, hop­ing to nar­row the eco­nomic gap with west­ern Europe in double-quick time. They became heav­ily reliant on short-term exter­nal financ­ing. When Lehman Broth­ers’ col­lapse cut off inter­na­tional liq­uid­ity, their economies – and tax rev­enues – hit the wall.

Com­pet­i­tive­ness, mean­while, had been sharply eroded by hefty pre-crisis wage increases. All three had also pegged their cur­ren­cies to the euro. They were des­per­ate to avoid a mon­e­tary deval­u­a­tion, tor­pe­do­ing their chances of join­ing the sin­gle currency.

So they pio­neered the “inter­nal” deval­u­a­tion – low­er­ing real wages and costs – that Ger­many, in par­tic­u­lar, is pre­scrib­ing for way­ward euro­zone economies. They slashed pub­lic sec­tor spend­ing, wages and jobs, while car­ry­ing out struc­tural reforms.

Con­sump­tion col­lapsed. Latvia, the most extreme case – and the only Baltic coun­try to receive an IMF bailout – saw its econ­omy con­tract, peak to trough, by a quar­ter, and by 18 per cent in 2009 alone. Unem­ploy­ment tripled in three years to 21 per cent. Lithuania’s econ­omy shrank nearly 15 per cent in 2009, Estonia’s 14 per cent.

But all three returned to growth dur­ing 2010, and last year Estonia’s 7.6 per cent, Lithuania’s 5.8 per cent and Latvia’s 5.5 were the fastest growth rates among EU economies.

This recov­ery appears more than a “dead cat bounce”, instead reflect­ing a gen­uine recov­ery in com­pet­i­tive­ness. From spring 2010 to autumn 2011, the three saw year-on-year growth in total exports run­ning at above 20 per cent. Esto­nia and Lithua­nia expe­ri­enced peak export growth of a stun­ning 45 per cent in the first quar­ter of 2011, notes Anders Aslund of the Peter­son Insti­tute for Inter­na­tional Economics.

But the Baltics’ expe­ri­ence may not be trans­fer­able, or entirely rel­e­vant, to euro­zone periph­ery countries.

First, the Baltics were not, like Greece, strug­gling under a moun­tain of debt – which their big falls in GDP would have made, pro­por­tion­ally, an even big­ger bur­den. Each had gov­ern­ment debt below 20 per cent of GDP in 2008 – Estonia’s was in low sin­gle dig­its.

The Baltic states also expe­ri­enced far more explo­sive pre-crisis growth than, say, Greece. In 2005–2007, Latvia’s econ­omy grew by a third; salaries dou­bled. The eco­nomic crash took it back only to 2005.

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Unions, too, are much weaker than in, say, Greece. That made street protests against spend­ing cuts, thought not entirely absent, much more muted.

And finally, emi­gra­tion has played a huge role as a safety valve. Latvia’s pop­u­la­tion has shrunk about 10 per cent since 2000, to 2m. True, peo­ple were seek­ing better-paid jobs abroad even dur­ing the pre-2008 boom. But Mihails Haz­ans, Latvia’s biggest expert on the sub­ject, says emi­gra­tion rose sharply after aus­ter­ity was launched, and increas­ingly involved entire fam­i­lies. Some esti­mates sug­gest Lithuania’s pop­u­la­tion has declined by at least as much.

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As the above excerpt indi­cates, there are a num­ber of dif­fer­ences between the eco­nomic sit­u­a­tion fac­ing the Baltic states and the PIIGS but it’s impor­tant to keep in mind that nearly ALL the of the EU’s ail­ing economies had num­ber of big things in com­mon. For starters, they nearly all had a major hous­ing boom (Por­tu­gal being an excep­tion). And it was a hous­ing boom that fueled a pri­vate — not pub­lic — debt binge in the years lead­ing up to the finan­cial melt­down:

Busi­ness Week
Krug­menistan vs. Esto­nia
By Bren­dan Gree­ley on July 20, 2012

...

In the 1990s, Estonia’s labor costs were low, and the work­force was skilled and edu­cated, so the Finns moved south and started busi­nesses. In a way, Esto­nia was Finland’s East Germany—close, cheap, and cul­tur­ally famil­iar. Around 2004, Swedish and Finnish banks began to com­pete aggres­sively to sell mort­gages in Esto­nia, and Esto­ni­ans began to build new houses. Var­blane lists what he calls the “dread­ful devel­op­ments” of the boom years. Pri­vate debt increased from 10 per­cent to 100 per­cent of GDP. As debt flowed into the coun­try, work­ers left man­u­fac­tur­ing for more lucra­tive jobs in con­struc­tion. Wages grew rapidly, and pro­duc­tiv­ity growth flat­tened out. Man­u­fac­tur­ing became more expen­sive. Domes­tic debt began to crowd out for­eign investment.

The crash was nec­es­sary, says Finance Min­is­ter Ligi, “to cor­rect our under­stand­ing about growth potential.”

...

It’s inter­est­ing to note that the coun­tries with the high­est rates of home own­er­ship in Europe tend to be amongst the poor­est nations and vice versa. Keep in mind that the hous­ing bust didn’t just wipe out the pri­vate wealth of Europe’s poor­est nations. It was also the cat­a­lyst for the sub­se­quent spike in pub­lic debt. It was clas­sic hous­ing bub­ble in action: as the con­struc­tion of new houses freezes and exist­ing home val­ues fall a nation won’t find itself only with col­laps­ing tax base. But there’s also the bailouts. Bub­bles pretty much always involve exces­sive lend­ing by the banks. So when that bub­ble bursts, home­own­ers and spec­u­la­tive investors default on their loans. And when enough bor­row­ers default, the banks default...at least if it’s a smaller bank. If the bank is BIG enough (i.e. too-big-to-fail BIG), it’s gets bailed out. And THAT’S REALLY EXPENSIVE.

So have the Baltics fol­lowed this strange dynamic of a private-sector/debt-fueled boom and bust? In addi­tion to the self-imposed aus­ter­ity mea­sures, did the Baltic nations also have bank­ing crises fol­low­ing their hous­ing crashes that lead to a pub­lic bailout of their banks? Was an expe­ri­ence like that part of what’s led to resent­ment in the Baltic nations over the ongo­ing bailouts in the PIIGS? Well...sort of:

Esto­nia avoided a cri­sis with its bank­ing sys­tem in large part because its bank­ing sys­tem “is mostly dom­i­nated by Nordic banks”, and the Nordic banks are doing just fine. Mostly. So while pri­vate debt lev­els are still high rel­a­tive to the low per-capita incomes, the Eston­ian bank­ing sys­tem isn’t fac­ing a risk of insol­vency because that sys­tem is, in effect, a sub­sidiary of the Nordic banks.

Lithua­nia and Latvia also have bank­ing sys­tems dom­i­nated by their Nordic neigh­bors, but they haven’t been quite as for­tu­nate as Esto­nia. In Decem­ber 2008, Latvia received a 7.5 bil­lion euro “bailout” in the form of an emer­gency loan with lots of austere-strings attached. This was fol­low­ing a run on the nation’s sec­ond largest bank, Parex, the prior month. The run was only quelled after the Lat­vian gov­ern­ment stepped in and pur­chased a 51% share in the bank and assumed it(and did some other stuff). In 2009, Parex got a sec­ond round of “state cap­i­tal injec­tions”.

In Decem­ber last year both Lithua­nia and Lativa got to expe­ri­ence a new bank run. Or, more pre­cisely, an ATM-run. This was fol­low­ing the col­lapse and state takeover of Lithuania’s 5th largest bank, Sno­ras, and its Lat­vian sub­sidiary. The cost of this bailout, 1 bil­lion euros, is enough to raise Lithunia’s pub­lic debt from 33% to 40% of GDP. And the cause of this col­lapse? Good ol’ bad ol’ greed and fraud per­pe­trated by a con­stel­la­tion of for­eign and domes­tic oli­garchs.

So the Baltic states are very much in a posi­tion to under­stand how much it sucks to have to bail out a bunch of banks that made for­tunes in the build up of the bub­ble and/or fraud. Its under­stand­able that there might be an expec­ta­tion that other coun­tries ALSO bail out their banks using pub­lic debt. Any­thing else would be unfair.

Now, if the Baltic Tigers had to endure years of aus­ter­ity while also foot­ing the bill for the bailout of pri­vate banks, why shouldn’t the same be asked of the PIIGS? It’s a rea­son­able ques­tion for austerity-weary mem­bers of the pub­lic to ask, even if its cou­pled to an unrea­son­able demand. So why shouldn’t the PIIGS also just shrink their economies through “inter­nal devaluation”(austerity) and export their way back to eco­nomic health? Well, this gets us back to some of the main sim­i­lar­i­ties and dif­fer­ences between the sit­u­a­tions fac­ing a nation like Esto­nia and, say, Spain and Italy.

First, the sim­i­lar­i­ties: The Baltic nations may have still had their own cur­ren­cies when the cri­sis hit (recall that Esto­nia didn’t join the euro until last year), but their cur­ren­cies were/are being pegged to the euro as a pre­req­ui­site for even­tu­ally join­ing the euro. Sim­i­larly, the PIIGS are all euro­zone mem­bers. So Baltic Tigers and the PIIGS all shared the same under­ly­ing cur­rency and the same conun­drum of being unable to devalue their cur­ren­cies in the face of a cri­sis. And cur­rency deval­u­a­tion is one of the basic tools in the financial-crisis tool­box. All of the coun­tries we’re talk­ing about lack that basic tool. Sim­i­larly, all of the coun­tries in ques­tion lack a sec­ond pri­mary tool that nor­mally exists for coun­tries with a cen­tral bank: the abil­ity to sim­ply print more money. Newly cre­ated printed money can be invalu­able in the midst of an eco­nomic cri­sis. It can finance emer­gency stim­u­lus spend­ing via the ind, it can buy up gov­ern­ment debt...generically speak­ing, the abil­ity of a cen­tral bank to print cre­ate more money sim­ply allows a gov­ern­ment to do some­thing in an emer­gency. But this isn’t an option for the euro­zone mem­bers or those aspir­ing to join the euro­zone. Sim­i­larly, instead of print­ing more money a gov­ern­ment could just bor­row more and spend it on a stim­u­lus. But if you’re a mem­ber of the the euro­zone (or an aspir­ing mem­ber like the Baltics), that option is sim­ply no longer there. This is why the “inter­nal devaluation”/austerity pro­to­col that the Baltic Tigers com­mit­ted them­selves to in the wake of their hous­ing bub­bles sort of seemed like the default option for the entire euro­zone: once you take the option of print­ing new money, bor­row­ing more, stim­u­lus spend­ing, and cur­rency deval­u­a­tion off the table, aus­ter­ity really is one of the only options left.

Now, obvi­ously, an econ­omy can’t just print its way to pros­per­ity. Part of the rea­son the eurozone’s top policy-makers are so adamantly opposed to the non-austerity path out cri­sis for the PIIGS is because the only cen­tral bank that could print that new money is the Euro­pean Cen­tral Bank (ECB). All of the indi­vid­ual euro­zone nations still have their own cen­tral banks, but they can’t just print new euros. Only the ECB can do that. And the ECB was set up with strict con­trols on how much it could expand the money sup­ply. Now why would the euro­zone mem­bers have done such a strange thing? Well, in large part its because the eurozone’s most influ­en­tial mem­ber, Ger­many, has a pow­er­ful national mem­ory of how out of con­trol gov­ern­ment money cre­ation led to hyper­in­fla­tion in the 1920’s and the sub­se­quent hor­rors of the 1930’s. Granted, his­to­ri­ans actu­ally point towards the defla­tion­ary poli­cies of the 30’s as the real cat­a­lyst of the eco­nomic calamity of the early 30’s that led to the rise of Hitler, but mem­ory can be a weird thing. As is the case with the Baltics, this hyper­fear of hyper­in­fla­tion may be a mis­un­der­stand­ing, but it’s an under­stand­able misunderstanding.

Of course, other than print­ing more money or “inter­nal deval­u­a­tion”, there’s also the option an exter­nal bailout. It’s a famil­iar sce­nario at this point: call the IMF, ask for a bailout, get bailed out but with a bunch of aus­ter­ity mea­sures and pri­va­ti­za­tions of state assets as part of the agree­ment (e.g. “struc­tural reform”), and declare suc­cess. It’s pretty much the tem­plate for the euro­zone bailouts and that shouldn’t be a sur­prise since the IMF is one third of the “troikas” we now find run­ning run­ning Greece, Ire­land, and Por­tu­gal. And, of course, a county can find itself in a sit­u­a­tion where it can print more money, devalue the cur­rency, get an IMF bailout, and still end up default­ing. It’s a sit­u­a­tion Rus­sia found itself in back in 1998, with a num­ber of rel­e­vant lessons for today:

NY Times
The Euro in 2010 Feels Like the Ruble in 1998
By ANDREW E. KRAMER
Pub­lished: May 12, 2010

MOSCOW — As the finan­cial mar­kets try to absorb news of a res­cue pack­age for Greece and other tee­ter­ing euro-zone economies, some bankers and econ­o­mists see par­al­lels to Russia’s default in 1998.

A decade ago Rus­sia was walk­ing in the same shoes as Greece is today, striv­ing to restore con­fi­dence in gov­ern­ment bonds by seek­ing a huge loan from the Inter­na­tional Mon­e­tary Fund and other lenders. Then, as now, the debt cri­sis was roil­ing global finan­cial mar­kets. And hopes were pinned on a bailout — one that in Russia’s case did not work.

“Greece cre­ates a remark­able sense of déjà vu,” Roland Nash, the head of research for Renais­sance Cap­i­tal invest­ment bank in Moscow, wrote in a recent note to investors. The 1998 bailout designed for Rus­sia, in the form of a res­cue pack­age offered by the Inter­na­tional Mon­e­tary Fund, had the effect of fore­stalling but not pre­vent­ing Russia’s default­ing on its for­eign debt.

Dur­ing the month between the announced res­cue and that default, Russ­ian and West­ern banks fran­ti­cally cashed out of short-term debt as it matured, changed the rubles into dol­lars and spir­ited the money out of Russia.

The bailout propped up the exchange rate through this process, enrich­ing those bond­hold­ers who got out early and leav­ing the embit­tered Russ­ian pub­lic hold­ing the debt and hav­ing to pay back cred­i­tors, includ­ing the I.M.F. By Aug. 17, 1998, when the gov­ern­ment announced a de facto default on Russia’s for­eign debt and said it would allow the ruble to float more freely against the dol­lar, the World Bank and mon­e­tary fund had dis­bursed about $5.1 bil­lion of the bailout money.

Some ana­lysts say that if a sim­i­lar pat­tern takes hold in the euro-zone res­cue, it could be Euro­pean tax­pay­ers pay­ing for the bailout while investors in Greek debt are largely made whole.

In Russia’s case, the mon­e­tary fund, spurred to action by the Clin­ton administration’s wor­ries about the polit­i­cal con­se­quences in Rus­sia of a finan­cial col­lapse, cob­bled together an aid pack­age that was enor­mous by the stan­dards of the day.

The mon­e­tary fund and other lenders first pro­posed $5.6 bil­lion, but then raised it to $22.5 bil­lion, includ­ing pre­vi­ous com­mit­ments — the equiv­a­lent of $29.5 bil­lion in today’s dollars.

In Greece, the fund and Euro­pean Union ini­tially pro­posed a bailout of 110 bil­lion euros, or $139 bil­lion, last week. After mar­kets reacted skep­ti­cally, Euro­pean finance min­is­ters met over the week­end and pro­posed a nearly $1 tril­lion finan­cial sup­port pack­age for Greece and other weak euro zone economies. They pro­posed form­ing an invest­ment fund guar­an­teed by the gov­ern­ments of richer Euro­pean Union coun­tries like Ger­many and France that would also draw on mon­e­tary fund money.

With Rus­sia, the suc­ces­sive bailout pro­pos­als were quickly judged by the mar­kets as too lit­tle, too late — as hap­pened with the Greek cri­sis before the lat­est announcement.

“You need speed to put out a for­est fire,” Ana­toly B. Chubais, who was the lead Russ­ian nego­tia­tor with the Inter­na­tional Mon­e­tary Fund in the 1998 cri­sis, said in writ­ten responses to ques­tions about the Greek bailout.

Edmond S. Phelps, a Nobel lau­re­ate and Colum­bia Uni­ver­sity econ­o­mist, in a tele­phone inter­view cited a les­son from the 1998 bailout: lenders should announce their high­est num­ber as quickly as pos­si­ble, to keep inter­est rates down and lower the cost of a bailout. Inter­na­tional lenders, he said, need to go in “with all their guns blazing.”

Mr. Nash, in his investor note, wrote that bond investors ana­lyz­ing the sit­u­a­tion in Greece and the other weak south­ern Euro­pean economies may be doing what bond investors did dur­ing the Rus­sia cri­sis — siz­ing up under­ly­ing neg­a­tive finan­cial forces so potent that many investors bet against even the big­ger bailout package.

Back then, as now, a global eco­nomic cri­sis had ren­dered local economies uncom­pet­i­tive at the exist­ing exchange rates. Rus­sia at the time had pegged the ruble to the dol­lar, Greece today is locked into the euro zone.

In Russia’s case, the prices for the country’s main­stay petro­leum exports had plum­meted the pre­vi­ous year because the eco­nomic con­trac­tion in Asia in 1997 had dimin­ished demand. The ruble was under pres­sure to fol­low this trend down­ward. For many months, though, the Russ­ian cen­tral bank kept the ruble pegged to the dol­lar — a dol­lar that was gain­ing strength as global investors sought a safe harbor.

Only after the Russ­ian cen­tral bank finally did devalue the ruble in August 1998, which plunged by 70 per­cent within a month, did the Russ­ian econ­omy begin to recover. The turn­around was faster than any­body imag­ined. Within a year, Russia’s econ­omy had recov­ered to pre­cri­sis lev­els and a decade of rapid growth fol­lowed. Banks rushed back to do busi­ness in Russia.

Russia’s oil woes back then may be anal­o­gous to the gap today between Greece’s and South­ern Europe’s low pro­duc­tiv­ity and the high salaries its work­ers receive in euros. But the fix may be harder to achieve.

“Greece, fun­da­men­tally, does not have a debt prob­lem,” Mr. Nash wrote. “It has an econ­omy which is not com­pet­i­tive at the pre­vail­ing exchange rate and which lacks the struc­tural flex­i­bil­ity to become competitive.”

...

Yes, Rus­sia, in the end, faced a sit­u­a­tion with a num­ber of par­al­lels to what coun­tries like Greece or the Baltics face: a cur­rency pegged to a stronger inter­na­tional stan­dard (the dol­lar in Russia’s case, the euro EU case) was sup­posed to give for­eigner investors the kind of con­fi­dence in the coun­try that would spur long-term invest­ments and a dynamic econ­omy. But when a cri­sis hits — a hous­ing crash in the EU and the Asian finan­cial cri­sis of 1997 for Rus­sia — that com­mit­ment to an arti­fi­cially strong cur­rency can become a lia­bil­ity. And those efforts to main­tain that arti­fi­cial strength can end up sim­ply pro­vid­ing the for­eign investors a “get out of jail free” card, so to speak. The bailout props up the cur­rency dur­ing a time when for­eign lenders are all tempted to head for the exits.

As the com­men­ta­tors in the above arti­cle pointed out, the man­age­ment of a finan­cial cri­sis isn’t sim­ply a mat­ter of tech­no­cratic manip­u­la­tion of this or that inter­est rate. It’s closer to psy­cho­log­i­cal war­fare: the cen­tral bank and gov­ern­ment in cri­sis has to con­vince for­eign investors that the whole house of cards isn’t going to burn down. THAT’s why the abil­ity abil­ity of a cen­tral bank to print its own money at will and in unlim­ited amounts is such a sharp double-edge sword: When used appro­pri­ately, a cen­tral bank can assure mar­kets that there won’t be a “liq­uid­ity event”. That’s what hap­pens when the mar­ket for some­thing freezes up when, for instance, you have tons of sell­ers and no buy­ers. When that hap­pens for a com­mod­ity or stock the price tends to plunge in a panic. But when it hap­pens to a government’s sov­er­eign debt mar­ket the entire econ­omy freezes. Liq­uid­ity events in any of the key mar­kets, like short-term gov­ern­ment debt, is how economies die, so the ability/threat of a cen­tral bank to print unlim­ited amounts of cash and use it to buy a crit­i­cal secu­rity (usu­ally gov­ern­ment debt) is a very pow­er­ful tool to use ward of a liq­uid­ity event. But once that spigot really is turned on, it’s not espe­cially easy to turn off and it really can poten­tially over­whelm a country’s money sup­ply. In other words, you don’t really want to turn on the unlimited-money fire hose unless there’s really a fire. But if you’re going to use that fire hose, use it early and use it over­whelm­ingly. Rus­sia and the IMF had that fire hose in 1998 but didn’t use it in time and ended up default­ing any­ways (a 70% deval­u­a­tion in their cur­rency within an month was basi­cally a default).

So, if cur­rency deval­u­a­tion — like Rus­sia drop­ping the ruble’s cur­rency peg to the dol­lar — is effec­tively a default, and defaults are to be avoided at all cost, how does cur­rency deval­u­a­tion avoid spook­ing for­eign investors? Well, once again, one of the pri­mary jobs (and tools) of a cen­tral bank is the man­age­ment of the psy­chol­ogy of the mar­ket­place. When investors or spooked, cen­tral banks are sup­posed to step in and pre­vent a panic. When investors get overly exu­ber­ant and move into “bub­ble” ter­ri­toriy, cen­tral banks are sup­posed to step in and “remove the punch bowl”. And when investors are REALLY spooked over about the long-term via­bil­ity of a nation’s econ­omy, a cen­tral bank’s job is con­vince investors that there really is a future for this coun­try. Cur­rency deval­u­a­tion is one of the main tools that can give the world a sense that a coun­try really does have a future. When a coun­try can export again, that light at the end of a tun­nel might not look so much like an oncom­ing train, and noth­ing helps a coun­try export more than a cur­rency deval­u­a­tion. Think of the abil­ity of a cen­tral bank to print unlim­ited money as one of the pri­mary tools avail­able for deal­ing with imme­di­ate liq­uid­ity crises, whereas the abil­ity to devalue a cur­rency is sort of a long-term solu­tion. In a finan­cial panic, you need both short term AND long term solu­tions and you need them simultaneously.

Now, if the Baltics were able to rebound suc­cess­fully (well, ok, that depends on you who ask to define “suc­cess­fully”), why can’t nations like Spain, and Italy just fol­low that same model? Well, now we return to the sim­i­lar­i­ties and dif­fer­ences between and economies like Spain and Italy, and one like Esto­nia. One obvi­ous dif­fer­ence between the two nations is that Spain and Italy are sim­ply much much larger than any of the Baltics. If they’re going to export their way back to health some­one else has to buy all those exports. That’s a lot eas­ier to do in tiny economies like the Baltics where much of the eco­nomic growth of the past decade involved for­eign man­u­fac­tur­ers mov­ing in and set­ting up fac­to­ries for export. In other words, if you’re already an export-oriented econ­omy, export­ing your way back to health is just a lot eas­ier to do. And if you’re a tiny export-oriented econ­omy with wealthy neigh­bors, it’s that much easier.

Nearly every­one agrees that Spain and Italy need more exports, but can they just “inter­nally devalue” and export to the rest of the world in place of the nor­mal currency-devaluation? Well, in the­ory, and over a long period of time. Aus­ter­ity mea­sures could remain, unem­ploy­ment could lan­guish at high rates and wages could con­tinue to fall. But here’s the prob­lem: unlike a cur­rency deval­u­a­tion, which sort of has the effect of uni­formly bring­ing down everyone’s wages in a nation (at least with respect to the out­side world), “inter­nal deval­u­a­tion” doesn’t rely a nice smooth mech­a­nism like cur­rency deval­u­a­tion. Instead, it relies on folks just tak­ing a big pay cut. As many folks as pos­si­ble. And here’s the prob­lem: wages are “sticky”. Unem­ploy­ment may rise, but that doesn’t smoothly trans­late into lower wages. Instead, what we’ve seen in Spain and Italy is sim­ply high unem­ploy­ment, but with lit­tle improve­ment in over­all “com­pet­i­tive­ness” because wages haven’t fallen. And nei­ther should we expect them to unless a coun­try sub­mits to some sort of cen­tral­ized wage author­ity. That’s just the messi­ness of real life inter­fer­ing with eco­nomic the­ory. Even Esto­nia, a coun­try that con­sciously embrace “inter­nal deval­u­a­tion”, wages did even­tu­ally fall, but they were still pretty “sticky”:

Busi­ness Week
Krug­menistan vs. Esto­nia
By Bren­dan Gree­ley on July 20, 2012

...
Krug­man was right about one thing: Wages were sticky. But they weren’t glued. They declined slightly in 2009 and 2010. They have grown since, but the larger wage trend since 2007 is flat. Anec­do­tally, some indus­tries reported wage cuts of as much as 30 per­cent. Pro­duc­tiv­ity, in the mean­time, recov­ered. And both look roughly where they’d be now had there been no hous­ing boom. As hoped, Estonia’s growth in 2010 and 2011 came from exports. The gov­ern­ment points proudly to Ericsson’s (ERIC) recent deci­sion to build a plant near Tallinn. Estonia’s politi­cians seem relieved that the coun­try has resumed its right­ful place in the world: man­u­fac­tur­ing, exports, and sobriety.

...

So why can’t this work for Spain and Italy? Well, it could work...in the long run. Once a country’s spirit and econ­omy is suf­fi­ciently bro­ken, those wages will even­tu­ally fall. But why can’t this work in the short run? Well, once again, it could...in a dif­fer­ent world. More specif­i­cally, it could poten­tially work in a world that had the global demand to buy all those newly com­pet­i­tive Span­ish and Italy exports. That’s a very dif­fer­ent world from the one we live in today and that brings us to one of the cen­tral prob­lems with the entire austerity/“internal deval­u­a­tion” approach to solv­ing these kinds of sov­er­eign debt crises: “inter­nal deval­u­a­tion” might increase exports and reduce imports, but it comes at an enor­mous cost that isn’t nearly as costly when cur­rency deval­u­a­tion is used instead: “inter­nal deval­u­a­tion” breaks the inter­nal econ­omy:

Newsweek
Spain is More Com­pet­i­tive than You Think
Jun 18, 2012 1:00 AM EDT
Author
Fiona Bravo

You know Spaniards are depressed when Coca-Cola broad­casts a tele­vi­sion com­mer­cial encour­ag­ing cit­i­zens to “go get ’em.” The spot cuts away from for­eign com­men­ta­tors pre­dict­ing Spain’s immi­nent col­lapse to show­case the country’s strengths: engi­neers, high-speed trains, and, of course, soc­cer. In the midst of a cur­rency cri­sis, steep credit down­grades, and a 100 bil­lion euro bailout of its bank­ing sys­tem, it’s easy to be pes­simistic about Spain. But there are some grounds for optimism.

Start with exports. While Span­ish wages rose much faster than the euro zone aver­age dur­ing the pre-crisis years, large exporters kept costs under con­trol, allow­ing them to stay rel­a­tively com­pet­i­tive. Mean­while Span­ish employ­ers with more than 250 work­ers stayed just as pro­duc­tive as their Ger­man, Ital­ian, and French coun­ter­parts, accord­ing to BBVA, Spain’s No. 2 bank.

Con­se­quently, despite Asia’s rise, Spain has man­aged to hang on to its global mar­ket share of exports. That puts it in a league with Ger­many and well ahead of most of the euro zone. Indi­tex, the apparel group best known for its Zara retail chain, is a poster child of Span­ish com­pet­i­tive­ness. It shrugged off the Euro­pean finan­cial cri­sis and even deliv­ered a sharp rise in first-quarter profits.

The catch is that exports, which account for about 30 per­cent of Spain’s GDP, can’t com­pen­sate for the steep drop in demand at home. Yet some com­pa­nies are doing well inside Spain. Mer­cadona, the largest purely domes­tic gro­cer, boosted sales by 8 per­cent last year, to 17.8 bil­lion euros. Its unique busi­ness model is stud­ied in the class­rooms of top Amer­i­can busi­ness schools.

...

Spain’s emblem­atic com­pa­nies show that this can be done. But their suc­cess has been despite, not because of, the country’s politi­cians and rigid employ­ment laws. Spain has already imple­mented painful reforms, par­tic­u­larly in the labor mar­ket, but they will take time to feed into the econ­omy. The bank bailout may even­tu­ally ease the ongo­ing credit crunch, but in the short term the country’s spi­ral­ing bor­row­ing costs will make it harder for Span­ish entre­pre­neurs to finance their busi­nesses. In the mean­time, the hope in Madrid is that the country’s national soc­cer team, win­ner of the last World Cup, will pro­vide some respite from the doom and gloom.

As the above arti­cle high­lights, one of the fun­da­men­tal prob­lems with the “inter­nal deval­u­a­tion” approach is that any boost to exports comes at a pretty sig­nif­i­cant cost to the inter­nal econ­omy: If the Key­ne­sian solu­tion to a fis­cal cri­sis involves more infla­tion (in the form of cur­rency deval­u­a­tion and more pub­lic debt), the “aus­te­rion” solu­tion is more unem­ploy­ment. And in the infla­tion vs unem­ploy­ment debate, the unem­ploy­ment approach rarely seems to work. One of the main rea­sons the eco­nomic rebound of the Baltic nations has been pointed out as an excep­tional exam­ple of the power of aus­ter­ity is because suc­cess with aus­ter­ity alone is excep­tion­ally rare. It just doesn’t help a coun­try to break its non-export-oriented econ­omy. This is partly do to fact that sov­er­eign debt cri­sis are vir­tu­ally never only about long-term con­cerns over the eco­nomic via­bil­ity of a nation. There is always a short-term com­po­nent to the cri­sis, and the closer a nation gets to default the greater those short-term con­cerns become in the minds of inter­na­tional investors. And if there’s one thing those inter­na­tional investors don’t want to see in a coun­try fac­ing a debt cri­sis it’s a surge in debt cou­pled with a col­lapse in con­fi­dence. Remem­ber, cen­tral bank­ing is as much about wag­ing psy­cho­log­i­cal war­fare as it is a task of man­ag­ing the econ­omy. If a surge in debt is used in a large pro-stimulus man­ner that cre­ates real con­fi­dence that the gov­ern­ment is seri­ous about address­ing the eco­nomic prob­lems both in the short, medium, and long-run, the mar­kets will be will­ing to accept that surge in debt and a cri­sis can be averted. But if a surge in debt is tak­ing place amidst aus­ter­ity mea­sures due to a col­laps­ing inter­nal econ­omy AND this is all tak­ing place in a col­laps­ing inter­na­tional economy...well, that’s just a recipe for dis­as­ter. Exactly the kind of dis­as­ter we’ve been see­ing across the euro­zone. Aus­ter­ity is, at best, a long-run solu­tion. Finan­cial pan­ics are short-term traps that may or may not involve long-term con­cerns. But regard­less of whether or not long-term “com­pet­i­tive­ness” con­cerns are part of what’s dri­ving the panic, any solu­tion that requires long-term patience on the part of inter­na­tional investors is pretty much doomed to fail.

So why is Ger­many, leader of the euro­zone, so adamant about aus­ter­ity as the only model? Well, partly because Ger­many tried aus­ter­ity less than a decade ago and it worked...sort of. Ger­many may have imple­mented its own ver­sion of austerity/“internal deval­u­a­tion” in 2005, but that’s also not a great exam­ple of the value of aus­ter­ity in the midst of a sov­er­eign debt cri­sis. Ger­many wasn’t in the midst of finan­cial panic and the global econ­omy was still growing...it was a very dif­fer­ent sit­u­a­tion from what Spain and Italy find them­selves in today (Plus, the Ger­mans had some “help” that cush­ioned the blow). But it’s also impor­tant to keep in mind that the wage cuts expe­ri­enced Ger­man work­ers in the mid 2000’s were real and painful. One again, the desires of the Ger­man pub­lic to see the PIIGS pay for their bailout might be mis­guided, but it’s under­stand­ably mis­guided. But that just explains the mass psy­chol­ogy of the gen­eral pub­lic. The behav­ior of Germany’s politi­cians, on the other hand, is less under­stand­able. It’s actu­ally pretty per­plex­ing:

The Irish Times — Fri­day, July 20, 2012
Bun­destag gives back­ing for bailout of Span­ish banks

DEREK SCALLY in Berlin

GERMAN FINANCE min­is­ter Wolf­gang Schäu­ble will add Berlin’s sup­port for bail­ing out Span­ish banks today after receiv­ing the back­ing of a large Bun­destag major­ity yes­ter­day evening.

Some 473 MPs voted in favour of con­tribut­ing almost €30 bil­lion in Ger­man loans and guar­an­tees to the Span­ish pack­age of up to €100 bil­lion, run­ning over 18 months.

But oppo­si­tion was more marked than in pre­vi­ous bailout votes: some 97 of a total of 620 MPs opposed the move, includ­ing 22 from the coali­tion ranks, with a total of 13 abstentions.

The gov­ern­ment failed to get an absolute, so-called “chan­cel­lor” major­ity, though six coali­tion politi­cians were miss­ing from the mid­sum­mer par­lia­men­tary recall.

Before the vote, Mr Schäu­ble said finan­cial mar­kets had “doubts” about Spain’s eco­nomic health and the bailout would help Madrid buy time to com­plete cut­backs and reforms already under way.

“Spain is on the right path to solid state finances but this progress is endan­gered by inse­cu­rity over its finan­cial sec­tor,” he said.

“We have a strong inter­est in allow­ing Spain to con­tinue to reform.”

He assured MPs that full lia­bil­ity for all loans lay with the Span­ish state, dis­miss­ing spec­u­la­tion in some quar­ters that recap­i­tal­is­ing euro zone banks would let states off the hook for liability.

Mr Schäu­ble denied this was the case with the Spain bailout, insist­ing Euro­pean lead­ers would dis­cuss this issue only after a Euro­pean bank­ing reg­u­la­tor was in place and oper­at­ing to everyone’s satisfaction.

“Any­one who talks about imme­di­ate, direct refi­nanc­ing of banks through the ESM (bailout fund) or of col­lec­tive lia­bil­ity for banks in the euro sys­tem is shoot­ing his mouth off,” he said, a dig at euro zone bailout chief Klaus Regling.

Oppo­si­tion leader Frank Wal­ter Stein­meier, par­lia­men­tary head of the Social Democ­rats (SPD), said his party would sup­port the bailout for euro zone sta­bil­ity – but as a show of sup­port for the euro zone and not for the government.

He accused Angela Merkel’s coali­tion of unset­tling vot­ers by spin­ning a “fairy tale” of fis­cally pru­dent Ger­mans sur­rounded by fis­cally reck­less neighbours.

“Ger­many is no blessed isle. The cri­sis will hit even export-driven coun­tries [such as Ger­many] and, as one export mar­ket after another hits the skids, we can­not rule out that we will be dragged down,” he said.

Mr Stein­meier put the gov­ern­ment on notice that the SPD would not con­tinue to sup­port euro zone bailouts for banks unless cred­i­tor involve­ment was agreed.

...

OK, first off, kudos to SPD leader Frank Stein­meier. By call­ing out Merkel for sell­ing Ger­man vot­ers on a fairy tale of “lazy South­ern­ers” we might be see­ing a sign that the power of the pol­i­tics of per­ceived inequal­ity is fad­ing in Ger­many. Now let’s hope the same hap­pens in Fin­land. Soon. Far-right polit­i­cal gains aren’t just being seen in the crisis-hit euro­zone mem­bers. Fin­land, with one of the strongest economies in europe, saw the far-right True Finns party surge to 19% of the vote in last year’s elec­tions based on anti-bailout sen­ti­ment. And that sen­ti­ment hasn’t sub­sided since then as the south­ern economies con­tinue to erode. In fact, Fin­land man­aged to extract a spe­cial con­ces­sion in exchange for its sup­port of the lat­est Span­ish bank bailout: col­lat­eral val­ues at ~40% of its share of the loans to Spains banks. The syn­er­gis­tic rela­tion­ship between the euro­zone cri­sis and the rise of rad­i­cal polit­i­cal groups is a grow­ing and most trou­bling phe­nom­ena.

So what are we see­ing here with the Ger­man par­lia­ment demand­ing that Spain’s pub­lic accept the full lia­bil­ity for a 100 bil­lion euro bailout of Spain’s banks? Isn’t that just going to exac­er­bate the under­ly­ing sov­er­eign debt cri­sis? Well yes, but we’re not just see­ing the pol­i­tics of bailout-resentment on dis­play here. One way to look at it is we’re see­ing an attempt to do the unprece­dented: cen­tral bank­ing doesn’t really have prece­dent for deal­ing with finan­cial pan­ics using the austerity-only approach. The accepted par­a­digm for quelling a panic is for the cen­tral bank to act as a “lender of last resort”. In other words, the cen­tral bank needs to threaten to do what­ever it can to stop the panic. Stim­u­lus spend­ing, buy­ing debt, print­ing money, any­thing. It may not be a per­fect approach but it does have a track record of work­ing. But in our brave new world of the euro­zone, the only cen­tral bank in the euro­zone with the power to buy bonds and issue euros is the ECB. And not only does the ECB not want to use its power of lender of last resort. It’s man­dated to do one thing only: main­tain “price-stability”. That’s a fancy way of say­ing “avoid infla­tion at all costs”. Defla­tion is fine, though...you can’t have “inter­nal deval­u­a­tion” with­out defla­tion. And the spe­cial funds set up to help “bailout” the PIIGS (the EFSF and the ESM) can’t actu­ally buy sov­er­eign debt them­selves. At least not unlim­ited amounts. Only the ECB could tech­ni­cally engage in these activ­i­ties and be a “lender of last resort” but it’s man­dated not to do so:

Thurs­day, July 5, 2012
Mar­shall Auer­back: All Roads Lead to the ECB

By Mar­shall Auer­back, a hedge fund man­ager and port­fo­lio strate­gist. Cross posted from New Eco­nomic Perspectives

We’ve always been a fan of Pro­fes­sor Paul De Grauwe from Uni­ver­sity of Leu­ven, who has con­sis­tently pointed out the struc­tural flaws inher­ent in the orig­i­nal struc­tures of the EU. Recently, Pro­fes­sor de Grauwe wrote an excel­lent analy­sis explain­ing why the lat­est “res­cue plan” cob­bled together by the Euro­zone author­i­ties is des­tined to fail.

The key points:

1) ECB is not cur­rently a ‘lender of last resort’. The ECB was set up with fun­da­men­tal flaws, where “… one of the ECB’s main con­cerns is the defense of its bal­ance sheet qual­ity. That is, a con­cern about avoid­ing losses and show­ing pos­i­tive equity– even if that leads to finan­cial insta­bil­ity.” This is a pro­foundly mis­con­ceived idea. As we have noted many times, a pri­vate bank needs cap­i­tal – clearly because there are pru­den­tial reg­u­la­tions requir­ing that – but because it can become insol­vent. It has not currency-issuing capac­ity in its own right. While the ECB has an elab­o­rate for­mula for deter­min­ing how cap­i­tal is from the national mem­ber banks at an intrin­sic level, it has no need for cap­i­tal. It could oper­ate for­ever with a bal­ance sheet that if held by a pri­vate bank would sig­nal insol­vency. There are no com­pa­ra­ble con­cepts for a cur­rency issuer and a cur­rency user in terms of sol­vency. The lat­ter is always at risk of insol­vency the for­mer never, so the ECB’s focus on prof­itabil­ity is not only mis­guided, but lead­ing to inad­e­quate pol­icy responses.

2) The cre­ation of the Euro­pean Finan­cial Sta­bil­ity Facil­ity (EFSF) and the ESM has been moti­vated by the over­rid­ing con­cern of the ECB to pro­tect its bal­ance sheet and to avoid engag­ing in “fis­cal pol­icy”. The prob­lem again goes back to the cre­ation of the euro: no supra­na­tional fis­cal author­ity to go with a supra­na­tional cen­tral bank, which means that the only entity that can con­ceiv­ably carry out “fis­cal trans­fers” of the sort exem­pli­fied by a bond buy­ing oper­a­tion is the ECB. Sure, the actual fis­cal trans­fers can be ’sub­con­tracted” to the EFSF and ulti­mately the ESM, but it can only work if the latter’s bal­ance sheet is linked to the ECB’s, giv­ing it the same unlim­ited capac­ity to buy up the bonds and thereby deal with the insol­vency issue. As things stand now, per de Grauwe: “The enlarged respon­si­bil­i­ties that are now given to the ESM are to be seen as a cover-up of the fail­ure of the ECB to take up its respon­si­bil­ity of the guardian of finan­cial sta­bil­ity in the Euro­zone; a respon­si­bil­ity that only the ECB can fulfill”.

3) Related to this prob­lem is the fact that the ESM has been given only finite resources as per Germany’s stip­u­la­tion the minute it begins. It is cap­i­talised at 500bn euros. And it’s unclear that Ger­many can go much fur­ther, given that there are cur­rently 3 con­sti­tu­tional chal­lenges which the ESM is now fac­ing within Germany’s courts. This will delay rat­i­fi­ca­tion of the vote taken last week by Germany’s par­lia­ment to rat­ify the ESM’s exis­tence, as well as lim­it­ing its fire­power going for­ward. The ESM’s “bazooka” is in effect a pop-gun. Con­se­quently, as de Grauwe argues, “Investors will start fore­cast­ing the moment when the ESM will run out of cash. They will then do what one expects from clever peo­ple. They will sell bonds now rather than later.”

As is clear from every FX cri­sis in the past, “A cen­tral bank that pegs the exchange rate and has a finite stock of inter­na­tional reserves to defend its cur­rency against spec­u­la­tive attacks faces the same prob­lem. At some point, the stock of reserves is depleted and the cen­tral bank has to stop defend­ing the cur­rency. Spec­u­la­tors do not wait for that moment to hap­pen. They set in motion their spec­u­la­tive sales of the cur­rency much before the moment of deple­tion, trig­ger­ing a self-fulfilling crisis. “

Until Europe’s author­i­ties have this fig­ured out, the cri­sis will con­tinue. All roads lead back to the ECB.

Once again, the ECB sim­ply isn’t allowed do what the Fed­eral Reserve of Bank of Japan can do because the ECB’s man­date is lim­ited to one thing: “price sta­bil­ity”. Fight­ing infla­tion is pretty much it’s one and only pri­or­ity. And not sur­pris­ingly, that’s also the only man­date of the Bun­des­bank. As the Bun­des­bank goes, so goes the ECB. The night­mare of the Weimar Repub­lic lives on, but in reverse and in neigh­bor­ing countries.

So what is this new par­a­digm that we’re see­ing here? What is the les­son for the world that the ECB (Bun­des­bank) has in store for the rest of us? Well, in some ways this an unprece­dented approach to cen­tral bank­ing and eco­nomic man­age­ment. In other ways it’s old school. Aus­trian old school:

Slate
The Hang­over The­ory
Are reces­sions the inevitable pay­back for good times?
By Paul Krugman|Posted Fri­day, Dec. 4, 1998, at 3:30 AM ET

A few weeks ago, a jour­nal­ist devoted a sub­stan­tial part of a pro­file of yours truly to my fail­ure to pay due atten­tion to the “Aus­trian the­ory” of the busi­ness cycle—a the­ory that I regard as being about as wor­thy of seri­ous study as the phlo­gis­ton the­ory of fire. Oh well. But the inci­dent set me thinking—not so much about that par­tic­u­lar the­ory as about the gen­eral world­view behind it. Call it the over­in­vest­ment the­ory of reces­sions, or “liq­ui­da­tion­ism,” or just call it the “hang­over the­ory.” It is the idea that slumps are the price we pay for booms, that the suf­fer­ing the econ­omy expe­ri­ences dur­ing a reces­sion is a nec­es­sary pun­ish­ment for the excesses of the pre­vi­ous expan­sion.

The hang­over the­ory is per­versely seductive—not because it offers an easy way out, but because it doesn’t. It turns the wig­gles on our charts into a moral­ity play, a tale of hubris and down­fall. And it offers adher­ents the spe­cial plea­sure of dis­pens­ing painful advice with a clear con­science, secure in the belief that they are not heart­less but merely prac­tic­ing tough love.

Pow­er­ful as these seduc­tions may be, they must be resisted—for the hang­over the­ory is dis­as­trously wrong­headed. Reces­sions are not nec­es­sary con­se­quences of booms. They can and should be fought, not with aus­ter­ity but with liberality—with poli­cies that encour­age peo­ple to spend more, not less. Nor is this merely an aca­d­e­mic argu­ment: The hang­over the­ory can do real harm. Liq­ui­da­tion­ist views played an impor­tant role in the spread of the Great Depression—with Aus­trian the­o­rists such as Friedrich von Hayek and Joseph Schum­peter stren­u­ously argu­ing, in the very depths of that depres­sion, against any attempt to restore “sham” pros­per­ity by expand­ing credit and the money sup­ply. And these same views are doing their bit to inhibit recov­ery in the world’s depressed economies at this very moment.

The many vari­ants of the hang­over the­ory all go some­thing like this: In the begin­ning, an invest­ment boom gets out of hand. Maybe exces­sive money cre­ation or reck­less bank lend­ing dri­ves it, maybe it is sim­ply a mat­ter of irra­tional exu­ber­ance on the part of entre­pre­neurs. What­ever the rea­son, all that invest­ment leads to the cre­ation of too much capacity—of fac­to­ries that can­not find mar­kets, of office build­ings that can­not find ten­ants. Since con­struc­tion projects take time to com­plete, how­ever, the boom can pro­ceed for a while before its unsound­ness becomes appar­ent. Even­tu­ally, how­ever, real­ity strikes—investors go bust and invest­ment spend­ing col­lapses. The result is a slump whose depth is in pro­por­tion to the pre­vi­ous excesses. More­over, that slump is part of the nec­es­sary heal­ing process: The excess capac­ity gets worked off, prices and wages fall from their exces­sive boom lev­els, and only then is the econ­omy ready to recover.

Except for that last bit about the virtues of reces­sions, this is not a bad story about invest­ment cycles. Any­one who has watched the ups and downs of, say, Boston’s real estate mar­ket over the past 20 years can tell you that episodes in which overop­ti­mism and over­build­ing are fol­lowed by a bleary-eyed morn­ing after are very much a part of real life. But let’s ask a seem­ingly silly ques­tion: Why should the ups and downs of invest­ment demand lead to ups and downs in the econ­omy as a whole? Don’t say that it’s obvious—although invest­ment cycles clearly are asso­ci­ated with econ­o­my­wide reces­sions and recov­er­ies in prac­tice, a the­ory is sup­posed to explain observed cor­re­la­tions, not just assume them. And in fact the key to the Key­ne­sian rev­o­lu­tion in eco­nomic thought—a rev­o­lu­tion that made hang­over the­ory in gen­eral and Aus­trian the­ory in par­tic­u­lar as obso­lete as epicycles—was John May­nard Keynes’ real­iza­tion that the cru­cial ques­tion was not why invest­ment demand some­times declines, but why such declines cause the whole econ­omy to slump.

Here’s the prob­lem: As a mat­ter of sim­ple arith­metic, total spend­ing in the econ­omy is nec­es­sar­ily equal to total income (every sale is also a pur­chase, and vice versa). So if peo­ple decide to spend less on invest­ment goods, doesn’t that mean that they must be decid­ing to spend more on con­sump­tion goods—implying that an invest­ment slump should always be accom­pa­nied by a cor­re­spond­ing con­sump­tion boom? And if so why should there be a rise in unemployment?

Most mod­ern hang­over the­o­rists prob­a­bly don’t even real­ize this is a prob­lem for their story. Nor did those sup­pos­edly deep Aus­trian the­o­rists answer the rid­dle. The best that von Hayek or Schum­peter could come up with was the vague sug­ges­tion that unem­ploy­ment was a fric­tional prob­lem cre­ated as the econ­omy trans­ferred work­ers from a bloated invest­ment goods sec­tor back to the pro­duc­tion of con­sumer goods. (Hence their oppo­si­tion to any attempt to increase demand: This would leave “part of the work of depres­sion undone,” since mass unem­ploy­ment was part of the process of “adapt­ing the struc­ture of pro­duc­tion.”) But in that case, why doesn’t the invest­ment boom—which pre­sum­ably requires a trans­fer of work­ers in the oppo­site direction—also gen­er­ate mass unem­ploy­ment? And any­way, this story bears lit­tle resem­blance to what actu­ally hap­pens in a reces­sion, when every industry—not just the invest­ment sector—normally contracts.

As is so often the case in eco­nom­ics (or for that mat­ter in any intel­lec­tual endeavor), the expla­na­tion of how reces­sions can hap­pen, though arrived at only after an epic intel­lec­tual jour­ney, turns out to be extremely sim­ple. A reces­sion hap­pens when, for what­ever rea­son, a large part of the pri­vate sec­tor tries to increase its cash reserves at the same time. Yet, for all its sim­plic­ity, the insight that a slump is about an excess demand for money makes non­sense of the whole hang­over the­ory. For if the prob­lem is that col­lec­tively peo­ple want to hold more money than there is in cir­cu­la­tion, why not sim­ply increase the sup­ply of money? You may tell me that it’s not that sim­ple, that dur­ing the pre­vi­ous boom busi­ness­men made bad invest­ments and banks made bad loans. Well, fine. Junk the bad invest­ments and write off the bad loans. Why should this require that per­fectly good pro­duc­tive capac­ity be left idle?

The hang­over the­ory, then, turns out to be intel­lec­tu­ally inco­her­ent; nobody has man­aged to explain why bad invest­ments in the past require the unem­ploy­ment of good work­ers in the present. Yet the the­ory has pow­er­ful emo­tional appeal. Usu­ally that appeal is strongest for con­ser­v­a­tives, who can’t stand the thought that pos­i­tive action by gov­ern­ments (let alone—horrors!—printing money) can ever be a good idea. Some lib­er­tar­i­ans extol the Aus­trian the­ory, not because they have really thought that the­ory through, but because they feel the need for some pres­ti­gious alter­na­tive to the per­ceived sta­tist impli­ca­tions of Key­ne­sian­ism. And some peo­ple prob­a­bly are attracted to Aus­tri­an­ism because they imag­ine that it deval­ues the intel­lec­tual pre­ten­sions of eco­nom­ics pro­fes­sors. But mod­er­ates and lib­er­als are not immune to the theory’s seduc­tive charms—especially when it gives them a chance to lec­ture oth­ers on their failings.

...

Keep in mind that Paul Krug­man wrote the above cri­tique of the Aus­trian School of eco­nom­ics in 1998, a decade before the cur­rent cri­sis. It’s also an amaz­ingly pre­dic­tive cri­tique. What Krug­man wrote about the Aus­trian approach to eco­nom­ics is pretty much what has hap­pened: a finan­cial cri­sis was turned into a moral­ity play and the ensu­ing austerity-policies ended up tak­ing down entire national economies. And with Krug­man now the biggest oppo­nent of this neo-Austrian School of eco­nom­ics, it’s no sur­prised that we end up see­ing lots of fan­fare over the “Krug­menistan vs Esto­nia” story. After all, if the ECB was to suc­cess­fully save the euro­zone with aus­ter­ity alone, that would send a pow­er­ful mes­sage to all future economies around the globe that aus­ter­ity works. What’s we’re see­ing here isn’t Krug­menistan vs Esto­nia. It’s Krug­menistan vs Aus­te­ria. It’s the ulti­mate moral­ity play where the final moral of the story is that gov­ern­ment social spend­ing doesn’t work and only leads to dis­as­ter. We are being taught that cen­tral banks shouldn’t step in to act as the lender of last resort. That will only put off the nec­es­sary pain required for proper reform. One can see how this is an emo­tion­ally com­pelling approach to macro­eco­nom­ics. And if you’re look­ing at the con­se­quences of this approach, one can see how it’s also a giant blun­der. An under­stand­able giant blun­der, sure, but still a giant blun­der. The Aus­trian School of eco­nom­ics isn’t just a piece of our past: it’s intended to be our future too. Our blun­der­ous future.

So how is the euro­zone sup­posed to pro­ceed for­ward and not con­tinue on as a giant fis­cal trap for its denizens? Well, one approach would be for the ECB to drop the moral­ity play and act like a real cen­tral bank. We just got a sign today that the ECB may do just that when ECB head Mario Draghi announced that the ECB is ready to start buy­ing sov­er­eign bonds again. As he put it, “these are not empty words now”. Then again, he also said that the ECB must still act within it’s mandate...the sin­gle man­date of fight­ing infla­tion. So these may, once again, be empty words. Still, it’s progress.

But ECB bond buy­ing is still only a short-term solu­tion. The euro­zone needs a long-term solu­tion and tit-for-tat aus­ter­ity really isn’t going to cut it. If the euro­zone mem­ber nations end up view­ing each other as either moochers or cruel aus­ter­ity freaks it’s just not going to work. So here’s a free tip bor­rowed from a bil­lion­aire: the euro­zone needs to remem­ber the birth lot­tery. It’s a sim­ple con­cept pop­u­lar­ized by bil­lion­aire War­ren Buf­fett and it’s one most use­ful best ideas the guy has ever had. Think of it like this: We don’t con­trol where we’re born, who our par­ents are, what our nat­ural traits might be (phys­i­cally, IQ, etc), and really much else. At least not until we get older and begin to make our own way in the world. And even once we become adults there is still an immense amount of our world that is well beyond our indi­vid­ual con­trol. So with that in mind, if you were a hypo­thet­i­cal future cit­i­zen of the euro­zone but you couldn’t con­trol any­thing about which coun­try you were born in and any of your other nat­ural traits, how would you want that euro­zone to be structured?

Here’s a sec­ond tip: Part of the Aus­trian School involves a fix­a­tion on the going back to the gold stan­dard. There are a lot of prob­lems with the gold stan­dard, but as is the case with austerity-politics there’s just an immense amount of emo­tional pull to the idea of a “hard” cur­rency. Now, since human­ity is fac­ing an immi­nent nat­ural resource cri­sis, per­haps the aspir­ing Aus­trian School econ­o­mists could start focus­ing their men­tal efforts on some­thing much more use­ful: an vital nat­ural resources stan­dard. As they say, you can’t eat gold. Fresh water and top soil, on the other hand, really help with eat­ing. A mean­ing­ful nat­ural resources stan­dard would no doubt have a num­ber of prob­lems, but at least it’s not a dead end like gold. We’re all dead in the long run, but human­ity is dead if we don’t get this resource crunch under con­trol. That’s real austerity.

Here’s a final tip, although it’s not really for the euro­zone. It’s for Mitt Rom­ney. And it’s not really a tip. It’s more of a dec­la­ra­tion: Mit­tens, you have some messed up friends.

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Update
Well, I guess we know whether of not the ECB’s recent change of heart is real or not. It’s not:

Bun­des­bank pours cold water on ECB bond buy hopes

FRANKFURT | Fri Jul 27, 2012 6:38am EDT

(Reuters) — Germany’s Bun­des­bank damp­ened expec­ta­tions for fur­ther action by the Euro­pean Cen­tral Bank on Fri­day by uphold­ing its resis­tance to the ECB buy­ing bonds, a day after ECB Pres­i­dent Mario Draghi raised expec­ta­tions such a move could be on the cards.

Draghi sent a strong sig­nal to mar­kets on Thurs­day that the ECB was prepar­ing fur­ther pol­icy action, say­ing that the ECB was ready, within its man­date, to do what­ever it takes to pre­serve the euro, refer­ring also to inflated bor­row­ing costs, which some saw as a hint the bank could revive its bond pur­chase program.

The Bun­des­bank, which opposes the ECB’s Secu­ri­ties Mar­kets Pro­gram (SMP) because it treads too close to the cen­tral bank’s ulti­mate taboo of state financ­ing, said on Fri­day it was still not in favor of such a step.

“The Bun­des­bank con­tin­ues to view the SMP in a crit­i­cal fash­ion,” a Bun­des­bank spokesman said “The mech­a­nism of bond pur­chases is prob­lem­atic because it sets the wrong incentives.”

The ECB has spent more than 210 bil­lion euros on gov­ern­ment bonds, hav­ing bought them in the sec­ondary market.

...