Friday, 28 September 2012

Reforming democracies

From about a month ago, Buttonwood wrote a good piece at the Economist, addressing this important issue:
"Modern governments play a much larger role in the economy than the ancient Greeks or the founding fathers could have imagined. This makes political leaders a huge source of patronage, in the form of business contracts, social benefits, jobs and tax breaks. As the late political scientist, Mancur Olson, pointed out, these goodies are highly valuable to the recipients but the cost to the average voter of any single perk will be small. So beneficiaries will have every incentive to lobby for the retention of their perks and taxpayers will have little reason to campaign against them. Over time the economy will be weighed down by all these costs, like a barnacle-encrusted ship. The Greek economy could be seen as a textbook example of these problems." [my emphasis]
And if I may add, not only the Greek economy, I can think of a lot of examples that fit this unfortunate scenario.
"One reason was the fear that democratic rule would lead to ruin. Plato warned that democratic leaders would “rob the rich, keep as much of the proceeds as they can for themselves and distribute the rest to the people”. James Madison, one of America’s founding fathers, feared that democracy would lead to “a rage for paper money, for an abolition of debts, for an equal division of property and for any other improper or wicked projects”. Similarly John Adams, the country’s second president, worried that rule by the masses would lead to heavy taxes on the rich in the name of equality. As a consequence, “the idle, the vicious, the intemperate would rush into the utmost extravagance of debauchery, sell and spend all their share, and then demand a new division of those who purchased from them.” 
Even with all these issues, democracies still have an advantage over dictatorships and all other forms of government in creating, sustaining and distributing wealth. The problem is in the between-country institutional differences and rules in the society that make some democracies more extractive than others, even when they both conduct a fair election. 

Should the solution to this problem be to surrender fiscal policy and redistribution to an unelected body of technocrats, like we do with monetary policy and the central banks? After all, the reason monetary policy was taken away from the full power of politicians was precisely the same argument surrounding current debates on fiscal policy and corresponding corruption and cronyism. Politicians used central banks to print money in order to reduce the country's debt. This power was taken away from them by making central banks independent. Now, they are again abusing their powers through skewed forms of fiscal redistribution, serving to interest groups, logrolling etc. 

I'm currently reading a new book by De Mesquita and Smith (two of the four authors of the excellent "Logic of Political Survivor"), called "The Dictator's Handbook: Why Bad Behavior is Always Good Politics". The aim of the book is to discover and portray the self-interested motives of politicians and what they do to usurp and maintain power, the single most important aim of their political career and motivation.

Needless to say, for a political economist, this is an argument I fully align with. I find it remarkable how the authors look at democratic rulers and dictators under the same loop, where both seem to be using similar methods to reach and stay in power. Use of violence is the big and crucial difference, but the idea of building an essential coalition of supporters and relying on this small group of to rule over a large group (the available voters, i.e. the population) is actually no different in Third World countries and Western democracies. However, the authors do point out that democrats find it harder than dictators to stay in power for a long amount of time. In my paper I model how even in democracies rulers can stay in power for longer periods of time provided that they curtail their rent-extraction - the argument is a bit different than the book's thesis, as De Mesquita and Smith seem to think that rulers don't even need to reduce rent-extraction; they only need to maintain their steady support from the essential group that keeps them in power. 

To see this more precisely, De Mesquita and Smith find a striking example of a town in California, called Bell (pop. 35,000). There they had a 'major' (city manager) called Robert Rizzo who governed this town for 17 years. In this time he managed to push a balanced budget every time. However he also managed to pay himself a salary of $800,000 per year (in comparison, the US President earns $400,000), even though the majority of citizens are rather poor. They were poor because Rizzo levied high taxes on the people to pay for his cronies and for keeping himself in power. His winning strategy was to form a group of loyal council members to whom he also gave large salaries by assigning them as board members in city companies. They were happy with their also huge earnings and knew that they will keep getting this by keeping Rizzo in power. As for the elections, even thought they were always fair and subject to the US electoral system, Rizzo and his councilmen were winning since the amount of those who voted was low, and among them it was much easier to pick those who can be influenced to vote the "right" way. 

A story like this happening in America? In the middle of California? Impossible! Now, I'm not saying that things like these happen all around the country. Also the strength of the US institutional system punished the corruption and criminal activities that happened in this town (perhaps a bit late, but justice did prevail). But even the fact that it could happen is worrying and is sending a troublesome picture of how a democracy can be altered to serve self-interest of politicians. 

The next question is how do we reform this? Is the aforementioned fiscal council the proper solution? Or could these bureaucrats be as easily corruptible as politicians. After all fiscal policy isn't the same as monetary policy. Redistribution of the budget to special interest group doesn't have a strong, visible, and immediate negative effect on the economy. Printing money does. 

Perhaps the solution is in the classical problem of rules vs. discretion in policy-making. Charles Wyplosz has a good new paper on this topic. Perhaps if we had strong rules that would guide budgetary redistribution there would be much less scope for interest groups and corruption. If this is true for monetary policy (John Taylor persistently points to the benefits of rules in monetary policy that lower policy uncertainty and lower business cycle volatility - see this paper for example), why wouldn't it be applicable for fiscal policy as well? I'm basically up for any solution that would limit the power of politicians, reduce the influence of various interest groups, and reduce the uncertainty of economic policy decision-making. 

Tuesday, 25 September 2012

An overview of market monetarism

As I briefly mentioned in my last blog post, the credit for Fed’s latest monetary stimulus is given mostly to a group of theoretical monetary economists called market monetarists. This post will recapitulate their main idea and act as a critique of some parts of their arguments.

Market monetarists reject the idea that central banks have lost ‘ammunition’ to stimulate the economy. They, in fact, believe that monetary stimulus is the only thing that can help the economy at this moment. Even under the zero-lower bound (ZLB) constraint. Evidence? A rise in stocks and investor confidence after the news of QE3, QE2, QE1, and fall of Spanish and Italian bond yields after ECB actions (in August 2011, December 2011, and most recent ones in July and September 2012). However, they claim, this isn’t enough, as central banks can do much more in impacting aggregate demand. 

Aggregate demand can, from a monetary perspective, be stimulated in two ways: quantitative easing (or any other way of increasing the money supply), and long-term signalling on easier monetary policy in the future. 

As far as quantitative easing is concerned I agree with a part of their argument; current QE efforts create money for banks that isn’t being released into the real economy. It makes perfect sense for banks to hoard cash and deposit money in central banks overnight when alternative investments over low interest rates are relatively more risky. However, I don’t agree that higher sums of QE would be more helpful to increase demand. I fail to see why this would after some threshold value induce banks to release the money back to the real economy. 

The second favourable idea is to credibly signal long term easier monetary policy, when interest rates are no longer zero. The central argument is that this signal of easier money in the future and expectations of rising demand will induce people to spend more today. This does make sense as businesses would make investments today if they would be certain that these investments would pay off in the future. It’s the uncertainty of today that’s killing off their investments and hiring. So a credible signal of monetary policy would be enough to break the uncertainty surrounding their investment decisions. 

I don’t believe that it’s this simple. First of all it takes a lot of effort for a central bank to influence future expectations. And why would the people react positively to announcements from the central bank? Does a business owner really base his decisions on signals from a central bank? No, he bases his decision on signals from his local bank. So does a consumer. But that’s what this means; the central bank indirectly signals to consumers and businesses that they are fighting uncertainty. The direct signal is being sent to major investors like banks. They are the ones who are supposed to re-start the investment cycle, but banks are being constrained from the regulatory perspective. Investor confidence does tend to increase after these announcements (as I’ve shown in the previous post), but business confidence doesn’t catch up so quickly. Consumer confidence is even slower to respond. The currently available data proves this (see here, here or here). And I predict that neither business or consumer confidence will surge after these announcements by the end of this year. They only way to reach an increase in confidence comes from increasing the disposable income of consumers (higher incomes through more jobs and higher wages, or via lower income taxes) and lowering regulatory uncertainty and the tax burden for businesses.

However, market monetarists still argue that the easiest way to achieve this signalling would be to target nominal GDP growth. The ‘rule of thumb’ target would be 5% (2% inflation plus 3% real GDP growth which is a potential GDP growth path). This implies that if nominal GDP falls to around 2% per year, the Fed should allow for temporary higher inflation to reach the 5% nominal growth target. So depending on which of the two parameters falls, the central bank should allow the other parameter to overshoot in order to reach the target. In periods of low real economic growth (as we have now) this would imply the Fed increasing inflation. Here's from my earlier text on NGDP targeting
"The idea can literary translate to the following: If the Fed prints more money, this drives up prices (the classical causal relation in monetary economics where more money in the economy makes it lose its value and triggers an increase in prices as people now need more currency to buy the same goods as before). Higher prices of goods and services will increase the GDP measured in current prices (nominal GDP). This is an easy way to reach the target without increasing real growth at all. For the current 1% rate of real growth the Fed may pump up inflation to 3,5% in order to reach its target. But this doesn't mean the economy grew at 4,5% - it's real growth is still weak." 
For example, the practice of the Bank of England prior to the crisis was close to this way of conducting monetary policy. They did have formal inflation targeting but were far more willing to allow inflation to overshoot, rather than they would see it undershoot its 2% target. This kept nominal GDP within the 5% mark. 

Scott Sumner texts

In two excellent papers for National Affairs and the Adam Smith Institute (one focused on the US, one on the UK), Scott Sumner summarizes his main points on why NGDP targeting should be favoured as the dominant monetary policy. 

He argues that in the short run nominal and real GDP seem to align closely together while inflation is sticky (prices and wages adjust slower than decisions on production or spending). In the recent recession it was the rapid fall of nominal GDP in 2008 and 2009 that caused the unemployment to rise to above 10%. He argues that action from the Fed can achieve the same shift but in a different direction if it increases nominal GDP, which will push up real GDP. However, this can’t be done in a longer period since boosting nominal GDP via higher inflation will in the long run only result in higher prices, i.e. disaster (no one can print their way into prosperity). That’s why current proposals for NGDP targeting are a strictly short-run monetary stimulus that can be used to get the economy out of a recession and on to its potential output path. 

His critique is mostly focused around the Fed not responding in a timely manner, but I find an error in his argument when he compares the recovery of the 1980s with the current one. He emphasizes that the 1980s recovery, after significant declines in real GDP, saw an upsurge of real and nominal GDP by the end of 1982 (RGDP=7.7%, NGDP=11%), followed by a mild inflation of 3.3%. However, the recovery of nominal GDP at the time wasn’t triggered by higher inflation, as market monetarists call for today; it was triggered by structural reforms initiated by the Reagan administration. These included a multitude of similar reforms required now all across Europe and the US. 

Source: St.Louis Fed, FRED database
Observing the graph above, the inflation rate was decreasing rapidly during the 1980s recovery, so it couldn’t have caused nominal GDP to increase so substantially. Or am I missing something? 

Sumner does make a point that the current policy debate is focused around how we see the problem – is it an aggregate demand shock, or is it a structural problem? I think it’s structural, and that the remedy should be structural reforms. Proponents of fiscal and monetary stimuli think it’s aggregate demand, and that we need to address the short-term issue of poor nominal (or real) GDP growth to prevent the economy from falling further into a depression. And that’s the crucial difference. 


Now I have no problem in using NGDP targeting over inflation targeting as a monetary policy strategy in the long run (I’m particularly intrigued by Sumner’s ideas on an NGDP futures market which would make monetary policy more market-based and remove the ‘central planning’ characteristic of the Fed and make it more supervisory), but I don’t see it effective as a short-run stimulus to start-up a recovery. 

The biggest problem I have with this approach is that it assumes that the crisis was just another aggregate demand shock which can be resolved by short-run stimuli. This perhaps was the case with the 2001 recession (which was initiated by a series of shocks like the 9/11 attacks, dot-com boom, and corporate scandals like Enron), and it may even be applicable today if the shock was being constrained on the housing market alone. But that’s not what happened. The housing market bust was just a trigger for the unsustainable system to fall. The answer cannot be to wait for businesses and consumers to continue what they’ve been doing before, the answer must be in creating and finding new jobs and new patterns of production and labour specialization

The crisis was a signal for entrepreneurs to discover new equilibria in the economy and new patterns and paradigms of growth and development. Patterns that are based on a less extensive role of the state, and based more on innovation, higher productivity and better incentives to create value. 

Market monetarists want the Fed to return nominal GDP to a higher growth path, and want the Fed to commit to this regardless of inflation or unemployment, which is what the current dual mandate of the Fed focuses on. Even if we accept the claims that tight money made the recession much worse, monetary policy didn’t cause the recession. At least not single-handedly. There was a multitude of factors that skewed the financial system where a bubble on the housing market (also induced a great deal through favourable policies) only released the dangers of trying to eliminate risk from the financial system. When this exogenous shock hit the financial system it fully uncovered all the systemic instabilities of an overprotected labour market, overregulated businesses, declining productivity and an underachieving economy. This was true for both US and Europe. Peripheral Europe was even worse as they added corruption and rent-seeking to the whole story. Plus their economies were dependent on consumption and borrowing from abroad. (see the full analysis on the Eurozone here)

Back in the US, a lot of business got outsourced to Asia which made a lot of workers in the West redundant, but no one fired them until it became too costly to keep them on. However this was a natural transition due to a technological change of the new decade. Now there must be a process or rediscovering new skills and new ways to create and sustain value in the West. This is what we should be focused on; creating new jobs, not restoring old ones. Creating a new long-run growth path for the economy, not pegging a target for the old growth path. 

When thinking about how to solve a recession one needs to first understand what caused it. Focusing on monetary policy alone would be wrong. Reforming the welfare state, reforming the financial system, stop bailing out zombie banks, and rediscovering new patterns of production and specialization is the way forward.

Update (30/09/2012): From a recent presentation by James Bullard, President of the St. Louis Fed, I found a couple of interesting facts, but mostly this: 

"In some well-regarded research, Athanasios Orphanides has emphasized that the early 1970s were characterized by a productivity slowdown, but that policymakers at the time did not recognize the slowdown. Policymakers kept policy very easy in response to output and employment growth they regarded as “too slow.” The eventual result was double-digit inflation and double-digit unemployment, simultaneously."

"In my own work with Stefano Eusepi of the New York Fed, we investigated the consequences of a misperceived productivity slowdown... We found that it would take policymakers several years to learn that their policies were inappropriate; in the meantime, about 300 basis points of unintended inflation would be created. The consequences of naïve NGDP targeting, without appropriate adjustment, might be more severe today."

Sunday, 23 September 2012

More on monetary stimuli

I left a few things out in the last week’s post on monetary stimulus. First of all, let me restate what the Fed and the ECB did. 

United States

The Fed proposed purchasing $40bn of mortgage-based securities each month until the labour market improves. They will also continue with existing policies of reinvesting their money from other asset purchases into MBSs, which will increase their holdings of long-term securities by $85bn each month. All this, the Fed hopes, will help put downward pressure on long-term interest rates and support the recovery of the mortgage market. They are now focusing strongly on maintaining their dual mandate; stable prices and low unemployment. That’s why this decision wasn’t a nominal GDP target per se, since the Fed is still sticking to its 2% inflation target. As long as the long run expectations of inflation are intact, the Fed is willing to accept mild inflation now if that would imply an improvement in the labour market. 

However, the Fed doesn’t offer a threshold value of the unemployment rate below which it would cease its open market operations. We don’t even know which variable on the labour market they are looking at; the unemployment rate, nominal wages, rise in employment or the E-P ratio? Also, does this mean that the Fed is targeting real values like unemployment, a potentially dangerous decision in terms of future inflation? 

Either way, market monetarists seem to have rejoiced on the news (see Scott Sumner – the loudest and most enthusiastic supporter of the idea, Lars Christensen, David Beckworth, Bill Woolsey, etc.), and so have the US stock markets (see graph below). 

Source: Bloomberg. The graph shows Dow Jones Industrial (orange),
S&P 500 (green), NASDAQ (yellow) and  NYSE composite index (red)
and their reactions after September 13th and the Fed's new policy decision. 

Market monetarists do tend to get a lot of credit for such a U-turn approach from the Fed, but most of it goes to Michael Woodford, a prominent monetary economist, and his paper on methods of monetary policy accommodation at the zero-lower bound (I haven’t read it yet, but I intend to). 

See his interview for the Washington Post here, where he explains his position. Bottom line, apart from endorsing NDGP targeting his technical paper gives answers to what a central bank can do in times of the zero lower bound. According to him QE (bond buying and increasing the money supply) misses the point. It would be enough for Bernanke simply to say that the Fed is targeting NGDP from now on, since after all, it’s all about expectations. If businesses and consumers expect the interest rates to be low even when the economy starts moving upwards, this means that they will undertake more investments and more loans today. He calls for a policy that would "rely on a combination of commitment to a clear target criterion to guide future decisions about interest-rate policy with immediate policy actions that should stimulate spending immediately without relying too much on expectational channels." Such a clear target criterion would be NGDP targeting, while the immediate policy actions is quantitative easing. 

Woodford also calls for a fiscal stimulus to pair it with NGDP targeting, thereby combining two forms of short-run stimuli, where private sector crowding out or inflation from higher government spending could be prevented. 

There’s so many things wrong here, but I’ll leave it for the second blog post which will follow shortly. I just can’t accept the argument for either monetary or fiscal stimuli in times when a restructuring of the economy is desperately needed. In the blog so far I've been more focused on fiscal stimuli, primarily because this was the loudest wrong policy that has been advocated so far. Now it's time to turn to monetary stimuli.


As for the ECB, they pledged to do “whatever it takes” to save the euro (Draghi’s speech from July 2012), which means buying sovereign debt on secondary markets via the bailout mechanism (details of his intentions from a speech in early September 2012). The reaction of Spanish and Italian 10-year bond yields was swift having them fall from 6.8 (Spain) and 5.7 (Italy) to 5.6 and 5 respectfully (see graph). Not only that, but after the announcements equity markets soared, CDS spreads have tightened, while the euro grew stronger. 

In addition to that on September 12th the German constitutional court allowed Germany to increase its participation in the European Stability Mechanism (ESM), giving a final boost in confidence for the Eurozone recovery. 

Source: Bloomberg. Spanish (orange) and Italian (green) 10-year bond
yields - the reaction to the ECB's announcement of unlimited bond buying. 

The credibility of the ECB should be enough to buy peripheral eurozone countries even more time, just as they did back in December 2011 and previous to that in August 2011. Reminiscing on that, a year has gone by since the ECB (then under Thrichet) has helped Italian and Spanish governments to reach their austerity targets and give them more time to initiate reforms. However, the reforms didn’t start until, what a surprise, the change of governments in both Italy and Spain. 

Now the new mechanism called Outright Monetary Transactions (OMT) is supposed to yield different results. “Insanity is doing the same thing, over and over again, and expecting different results.” said a wise man once. However the difference is that these bond purchases will be unlimited. This means that ECB will make sure that Spanish and Italian bond yields stay low long enough, at least until the effects from structural reforms in these countries, if any, don’t kick in. Essentially this means that the ECB has finally become the lender of last resort to governments, a controversial solution to the Eurozone crisis that was rightly opposed by Germany in fears of moral hazard.

Is there an effect on confidence? 

The argument of the monetary stimulus initiated by the Fed and the ECB (both in different but similar forms) is that it increases business and investor confidence. This is done through expectations of favourable future central bank policies which should induce consumers and investors to spend more money now. However as I've shown back in April, and later in August, similar ECB policies didn’t result in an increase of neither business nor consumer confidence. And this makes perfect sense. The businesses and the consumers haven’t felt the ECB’s policy effects on their pockets. The only ones who did were banks. 

And here arises another crucial problem. As I’ve pointed out many times before the biggest beneficiaries of monetary stimuli were banks who ended up expanding their balance sheets, in times when this wasn’t economically favourable or suggested to them. However this massive expansion of their assets hasn’t been allocated to the real sector at all. The same effect was with the EUR 100bn bailout to Spanish banks, which I have predicted to be senseless and worthless back in June. The money was hoarded to cover the losses on bad loans mostly by zombie banks. 

Bloomberg made an excellent analysis of this issue: 
"European banks pledged last year to cut more than $1.2 trillion of assets to help them weather the sovereign-debt crisis. Since then they’ve grown only fatter. ... They have Mario Draghi to thank. The ECB president’s decision nine months ago to provide more than 1 trillion euros of three-year loans to banks eased the pressure to sell assets at depressed prices. The infusion, designed to encourage firms to lend, succeeded in averting a short-term credit crunch by reducing their reliance on markets for funding. It also may be making European lenders dependent on more central-bank aid." Europe Banks Fail to Cut as Draghi Loans Defer Deleverage, Bloomberg, 18th September 2012

This is normal and expected behaviour from banks in terms of why they hold on liquidity. As Brad DeLong pointed out back in April (a quote I referred to before): 
"The ECB cannot induce banks to make more loans and fund more investment and consumption spending by swapping bonds for reserves as long as the value of pure liquidity is zero and reserves are as good as – nay, better than – short-term bonds."
That’s why for an increase in business confidence I persistently favour structural reforms over any form of short-run stimulus. The causal relationship couldn’t be more clear when businesses are allowed to grow – they are the ones who gain first in confidence (proven by the latest Alesina paper during recoveries), and pull with them consumer confidence by hiring more people and increasing their disposable income. There is no better and more efficient way to increase consumption than via increasing the disposable income of consumers – this can be done in two ways; lowering personal income taxes and creating incentives for the private sector to create jobs. 

QE3 is again misallocating resources towards housing 

Finally, asset purchases designed by the Fed will be dangerous as they attempt to encourage the public to buy more houses and take on more mortgages. Bernanke confirmed it himself, the QE3 is supposed to lower interest rates on mortgage loans in order to induce more mortgage lending. 

I can’t believe that this is happening again. After the misallocation caused by the Fed’s recourse rule made it obvious why creating an artificial demand for housing or mortgage-based securities is dead wrong, the Fed is once again focused on credit allocation policies that seem to be a quick way to combat a recession. Remember that Greenspan in 2001 encouraged mortgage purchases by making banks fill up their balance sheets with MBSs, thereby creating an artificial demand for mortgage loans, and lowering lending standards for those types of loans. Coincidentally, the recourse rule was given effect in 2001. The consequences were dire, but in my opinion necessary in order to reform the unsustainable system. Problem is no one listens, mistakes are being repeated, and quick fixes are wanted to restore old equilibria. 

This is something that the market monetarists, and anyone with common sense for that matter, strictly oppose. 

Thursday, 20 September 2012

Graph (tables) of the week: Who's better for stocks, trade and economic freedom?

Still on the US Presidential election, Forbes asks which potential President is better for stocks? Usually one would infer that stock performance aligns more closely with a Republican, but the following table suggests otherwise:

Perhaps this graph isn't all that accurate in measuring Presidential performance as some good market performance had nothing to do with what a President did in office. They can however be a good indicator of who's better for business, or at least who's better for Wall Street. Btw, contrary to popular belief President Obama seems to be doing pretty good in terms of stock market performance (much better than Bush for example).

However, even with this in mind, I still fear the answer to the question of which of the two candidates is better for the economy, particularly when one looks at their opinions on international trade (see here for Obama's point of view and here for Romney's).

Don Boudreaux gives them both a run around. This is the message for Romney:
"Less forgivable is a campaign promise to break a campaign promise. Your wish to “label China a currency manipulator” means that you seek a pretext to impose (as your website says) “countervailing duties” on imports from China – which is to say, you seek a pretext for raising taxes on Americans who buy goods and services from China. Yet in other episodes of your campaign you promise (as you did here* last month) “I will not raise taxes on the American people. I will not raise taxes on middle-income Americans.”

If you keep your promise to impose countervailing duties on imports from China you will thereby break your promise to not raise taxes on the American people. (Americans who buy imports from China are, after all, American people.) But if you keep your promise to not raise taxes on the American people, you must – as I hope you will – break your promise to punitively tax those many Americans who buy imports from China."
And this is his message for Obama:
… is nearly twice as active as was that of your predecessor at raising Americans’ cost of living by badgering suppliers to hike the prices charged on products such as consumer electronics, furniture, and footwear;
… has doubled-down on the Bush administration’s efforts to raise production costs for the many American producers who buy inputs such as zinc and oil-field-drilling equipment from Chinese manufacturers;
… is two times as likely to pander to the economically ignorant in order to grant special privileges to the politically powerful, all in efforts to prevent Americans from spending their money as they see fit."

In different but related news, the Fraser Institute in association with the Institute of Economic Affairs has published the newest edition of the Economic Freedom Index. What is worrying is that the UK and the US are out of the top 10, while the US is close to being out of the top 20 on its lowest ever 18th place. For two countries that used to pave the way for economic freedom, this is a highly disappointing result. 

Here's the top 30 countries:

The "usual suspects", Hong Kong, Singapore, New Zealand, Switzerland, Australia and Canada are joined in by Bahrain, Mauritius and Chile. I am happy to see Estonia fighting its way to the top, and I'm equally excited for Arab countries such as UAE (11th), Qatar (17th), Kuwait (19th), Oman (20th) and Jordan (23rd). Hopefully other Arab Spring countries will follow these successful examples. I'm also happy for small countries like Malta (25th), Lithuania (28th) or Montenegro (28th) (Luxembourg is a case for itself). This only proves that size doesn't matter; what matters is willingness to achieve economic freedom. And why is freedom important? "Research shows that people living in countries with high levels of economic freedom enjoy greater prosperity, more political and civil liberties, and longer life spans."

Now for the two disappointments, United States and United Kingdom. In the 1980s, US was ranked 3rd, while the UK was 6th. United States deteriorated in the last decade in regulation (17, down from 2), international trade freedom (42, down from 8) and surprisingly legal system and property rights (33, down from no.1 in the world in 1980). In the last category the crucial issues were judicial independence, impartial courts, protection of property rights, and military interference in the rule of law (?! from grade 10/10 to 6.67 - what's happening in this country?). Other worrying parameters were capital controls (international trade category), administrative requirements, hiring and firing regulations, bureaucracy costs and bribes. 

I don't live in the United States, but if this is true, than this is a serious problem for a country that used to be the panacea for property rights, the legal system, and most of all economic freedom. Has crony capitalism took its toll? 

So going back to the first graph, economic performance of Presidents after 1980s and Reagan, and in some parameters after Clinton and the 1990s doesn't seem to explain the deterioration of economic freedom in the US. If I were to evaluate presidential performance I would use economic freedom indices rather than the Dow. 

Whoever does become president will have to do a lot to address this important issue - how to restore economic freedom in the US. Going back to their positions on international trade, I somehow doubt this will be on their list of priorities. 

Wednesday, 19 September 2012

The 47 percent

The US Presidential candidate Mitt Romney held a dinner for his donors from which a hidden camera revealed a statement which was frowned upon by most of the media lately:
"There are 47% of people who will vote for the President no matter what. Alright, there are 47% who are with him, who are dependent on the government, who believe that they are victims, who believe government has the responsibility to care for them, who believe they are entitled to healthcare, to food, to housing!"
Read the full transcript on the NY Times, or hear the video here.

Frankly, I don't know what all the fuss is about. Ok, perhaps there aren't so many Americans that are fully dependent on the government, but I can see what Mr Romney meant when he said that, by looking at either one of these two graphs

Source: Wall Street Journal, Nicholas Eberstadt: "Are Entitlements Corrupting Us? Yes, American Character is at Stake" August 31st 2012.

I however doubt that he had this in mind, which is probably what got some lefties disturbed (and rightly so if I may add):
Source: NPR, "The 47 percent, in one graphic"
This is only one part of the whole story, the other is the total amount of welfare recipients, something I touched upon about a month ago. Not only those in the lowest income groups receive welfare benefits (Btw, if it were up to me, I would significantly increase the threshold of those on lower incomes who aren't paying taxes, making this relative percentage even higher), but many in the upper income levels receive them as well.

What Romney and his campaign really wanted to emphasize, I think, is that dependency has increased during the current administration (I would say even before this one, as this is a generational switch that cannot occur during one President's term - in fact this is what the above graphs point out), and that America has lost the edge it used to have on upward mobility and meritocracy. This is a big problem indeed, particularly for a country that was proud of its independence from big government and which was founded on different historical and cultural principles than the ones in Europe. This is something that has been emphasized by the Occupy movement as well, although from a somewhat different perspective.

The issue is the change in mentality and attitude towards living off benefits. This affects the incentives for upward mobility where the people are changing their attitude towards work and success, thinking that success can only come if you belong to the higher classes. It sets many in a permanent poverty and entitlement trap. Who's fault was that? It's hard to point a finger at anyone in specific, as the change in mentality, or the change of informal institutions is a gradual process which is ignited by the change in formal institutions. It can be inferred from this that the creation of the modern welfare state in America gradually changed the people's mentality and culture, i.e. it changed the US informal institutions. 

I didn't think Americans were that invested in the welfare state, even though more and more data have been pointing that out pretty clearly. For example, the aforementioned text from the Wall Street Journal published couple of weeks ago claims that more and more Americans have switched to welfare in the last 30 years (a 7-fold increase since the 1960s). This comes as an outright surprise compared to the spirit of Americans from the first half of the 20th century, not to mention anything earlier than that. 
"From the founding of our nation until quite recently, the U.S. and its citizens were regarded, at home and abroad, as exceptional in a number of deep and important respects. One of these was their fierce and principled independence, which informed not only the design of the political experiment that is the U.S. Constitution but also their approach to everyday affairs.  
The proud self-reliance that struck Alexis de Tocqueville in his visit to the U.S. in the early 1830s extended to personal finances. The American "individualism" about which he wrote did not exclude social cooperation—the young nation was a hotbed of civic associations and voluntary organizations. [my emphasis] But in an environment bursting with opportunity, American men and women viewed themselves as accountable for their own situation through their own achievements—a novel outlook at that time, markedly different from the prevailing attitudes of the Old World (or at least the Continent).
The corollaries of this American ethos were, on the one hand, an affinity for personal enterprise and industry and, on the other, a horror of dependency and contempt for anything that smacked of a mendicant mentality[my emphasis] Although many Americans in earlier times were poor, even people in fairly desperate circumstances were known to refuse help or handouts as an affront to their dignity and independence. People who subsisted on public resources were known as "paupers," and provision for them was a local undertaking. Neither beneficiaries nor recipients held the condition of pauperism in high regard."
This admirable mentality has obviously changed, and to the worse. And as Nicholas Eberstadt concludes in his text, not only does this change in mentality affect the unsustainability of the public finances, it threatens to change the American character.

Update (20/09/2012): A new MIT working paper by Acemoglu, Robinson and Verdier offers potentially good insights on the subject:
"We show that, under plausible assumptions, the world equilibrium is asymmetric: some countries will opt for a type of “cutthroat” capitalism that generates greater inequality and more innovation and will become the technology leaders, while others will free-ride on the cutthroat incentives of the leaders and choose a more “cuddly” form of capitalism. Paradoxically, those with cuddly reward structures, though poorer, may have higher welfare than cutthroat capitalists; but in the world equilibrium, it is not a best response for the cutthroat capitalists to switch to a more cuddly form of capitalism." [my emphasis] (Abstract)
"This perspective therefore suggests that the diversity of institutions we observe among relatively advanced countries, ranging from greater inequality and risk taking in the United States to the more egalitarian societies supported by a strong safety net in Scandinavia, rather than reflecting differences in fundamentals between the citizens of these societies, may emerge as a mutually self-reinforcing equilibrium. If so, in this equilibrium, we cannot all be like the Scandinavians, because Scandinavian capitalism depends in part on the knowledge spillovers created by the more cutthroat American capitalism.[my emphasis] (pg 36)
The title of the paper is "Can’t We All Be More Like Scandinavians? Asymmetric Growth and Institutions in an Interdependent World?"

Sunday, 16 September 2012

Monetary stimulus advocates are missing the point

Last week the Federal Reserve announced a third round of quantitative easing (QE3), manifested through a series of measures designed to help stimulate economic activity in the US economy: 
"To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. The Committee also will continue through the end of the year its program to extend the average maturity of its holdings of securities as announced in June, and it is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. These actions, which together will increase the Committee’s holdings of longer-term securities by about $85 billion each month through the end of the year, should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative."
They also announced a closer focus on the labour market:
"If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability."
Basically, the Fed is willing to take on a higher temporary inflation in order to lower unemployment and help the mortgage market to recover. It will buy bonds until the recovery becomes robust enough. Such a decision is based on its credibility to keep inflation under control in the future, but it's still careful enough not to adapt new targets or policy rules. It will operate within the existing framework, but with a more dovish look on inflation, at least until the economy and the labour market start recovering. This is something that has been called for by monetary stimulus advocates for a long time. 

FT Alphaville has a good analysis. FOMC's economic projections and quick assessments of the appropriate monetary policy can be found here.

Will it help? 

Both the Fed and the ECB have in the recent month attempted to take a stronger position and a more active role in stimulating the economy. Pressures due to political failures to enable proper fiscal adjustments and initiate structural reforms have mounted over the central bankers and have forced them into more action. 

I still feel the problem is political not monetary. Political inaction in reforming the unsustainable system cannot be replaced by monetary stimulus alone. Policies like QE3 or NGDP targeting (or a fiscal stimulus for that matter) aim to restore nominal GDP to its pre-crisis trend (i.e. to close the gap on the graph below). But the pre-crisis trend was build on an unsustainable welfare state model that needs to be reformed. The boom decade was characterized by political concessions in Europe and an increasing warfare-welfare state in the US (many other things in the financial system went wrong as well, but leave this aside for now). The crisis has revealed the faults of the old growth model. 

A new paradigm has to be rediscovered, new jobs need to be created. This was postponed by the Fed in 2001, after the dot-com bubble, but after a stronger market erupted (the housing market) consequences were much more widespread. The signal isn't to return to what we had before. I can't understand this logic. If what we had before is wrong, why would anyone want to preserve that? Where's the change (we believed in)? 

Old jobs are being replaced by new ones but on a much slower pace. Existing constraints are preventing the restructuring from occurring faster than it should. This apparent private sector inactivity is putting even more pressure on the central banks to step in and at least increase inflation expectations and focus on fixing the unemployment picture. There's a bit of political economy in here too, which is especially being called at in the US, where the Fed decided to engage in the stimulus before the upcoming elections. They defend themselves by claiming that a slow recovery urged them to do something - a sort of a "now or never" argument. For the ECB it was simpler; they've been urged to do something big to the Eurozone for two years now. And they did a similar policy back in January that was short-lived. We are to wait and see will this action have the same short-term effect as the previous ones. My guess is yes, it will. (I'll cover them in a separate post)

Back to reality austerity

Proponents of fiscal and monetary stimuli like to use graphs like these to prove their point and say that quick action is needed (on one or either fronts) to close the output gap. 

However, the big problem is that neither monetary nor fiscal stimulus played a key role in this particular scenario in Sweden in the 1990s. From a previous text on the Swedish structural reform, I come back to this graph: 

Yes, that's what proper fiscal restructuring looks like. And it has a big role in explaining why it closed the output gap by 2001. I wouldn't even call it closing the output gap as that would imply returning to the pre-crisis equilibrium. Sweden reached a new, better equilibrium.

If we want to learn anything from the Swedish example, then the lesson is the following: reform, reform, reform. Start from the labour market, union bargaining, and pensions; then move on to the tax and regulatory system by making them less burdensome to businesses; and finally finish with the entitlement system by adjusting it to the needs and means of the population. This is far from easy, as I've noted many times before, but it's the only road to a new and sustainable equilibrium. 

Thursday, 13 September 2012

Graph(s) of the week: US job recovery

Regular readers of the blog are likely to recognize the following graph depicting a precise estimate of the jobless recovery in the United States, much more precise than the unemployment rate can show: 

Source: St. Louis Fed, FRED database

Or this one, showing the slow pace of adding new jobs:

Source: WSJ, "Jobs Report: Taking a Step Back to View the Big Picture", September 7th 2012
Even if we think of the slow job growth as the "new normal", the upper graph still points to a disturbing picture of all the jobs lost from 2008, where the E-P ratio decreased from an average 63% down to around 58.5%. One can claim that this restructuring was necessary and that there were simply too many unsustainable jobs out there. In other words, all the jobs that got outsourced in the past decade and were kept during the booming decade, are now too costly to keep around. This allowed the business owners to release the artificially preserved jobs. Perhaps this was a necessary restructuring done by the market in order to discover new production techniques. Perhaps the crisis (the creative destruction) served its purpose of enabling a faster trial and error process in the economy? 

Either way, the newest data from last week showed another substantial decrease of job growth in the US, where the economy added only 96,000 jobs in August, down from 141,000 in July. Now this is certainly a large number, but it is weak compared to 8.8 million jobs lost in the recession, while only 4 million were recovered, and it is particularly low when you take it into perspective of the second graph. 

However, last week I ran into another disturbing piece of evidence on the US job market - a comparison of jobs lost in the recession and gained afterwards based on the wage level occupations. This is my graph of the week: 

Source: Real Clear Policy, originally from National Employment Law Project

Here's what the authors have to say:
"During the Great Recession, employment losses occurred across the board, but were concentrated in mid-wage occupations. By contrast, in the recovery to date, employment growth has been concentrated in lower-wage occupations, which grew 2.7 times as fast as mid-wage and higher-wage occupations..."
Here is the distribution based on individual occupations which have created the majority of new jobs:

What does this tell us in terms of the restructuring of the labour market? One thing is certain, the new jobs are taken out of necessity, not out of the need for skills. People who lost their mid-wage occupations are willing to accept lower paying jobs, and jobs below their level of skills. This is more than enough to conclude that the recovery in the labour market is taking a (slow) step in the wrong direction. The private sector is constrained in hiring and investments and is therefore leaving the people with no choice but to accept anything they find. The process of creative destruction hasn't failed in this case; it hasn't been allowed to commence. At least not the 'creative' part. 

Monday, 10 September 2012

Recovery paradigms: Fiscal consolidation or infrastructure spending?

Note: This blog post was published as an article for the Adam Smith Institute, on 13th September 2012. For all my other ASI writings see here.

A new research paper by Alesina, Favero and Giavazzi focuses on measuring the output effect of fiscal consolidations. Basically, the paper repeats some of the points Alesina made in his previous (2009) paper co-written with Silvia Ardagna, and in his numerous texts on VoxEU. Favero and Giavazzi summarize some of the main findings here

The idea is that fiscal consolidations tend to have much more favourable effects on the economy if they are done via spending cuts alone, not via increased taxation (see the graph below), which is actually what austerity is supposed to be.

Here's the abstract:
"This paper studies whether fiscal corrections cause large output losses. We find that it matters crucially how the fiscal correction occurs. Adjustments based upon spending cuts are much less costly in terms of output losses than tax-based ones. Spending-based adjustments have been associated with mild and short-lived recessions, in many cases with no recession at all. Tax-based adjustments have been associated with prolonged and deep recessions.  
The difference cannot be explained by different monetary policies during the two types of adjustments. Studying the effects of multi-year fiscal plans rather than individual shifts in fiscal variables we make progress on question of anticipated versus unanticipated policy shifts: we find that the correlation between unanticipated and anticipated shifts in taxes and spending is heterogenous across countries, suggesting that the degree of persistence of fiscal corrections varies. Estimating the effects of fiscal plans, rather than individual fiscal shocks, we obtain much more precise estimates of tax and spending multipliers."
Source: Alesina, Favero, Giavazzi (2012) "The output effect of fiscal consolidations" Figure 3, pg. 40.
The figure shows the results they got when comparing tax-based and expenditure-based fiscal consolidations, using a sample of 17 OECD economies, over 25 years (1980-2005). It is clear that for every country in the sample, tax increases resulted in a negative or stagnant output, whereas expenditure cuts resulted in an increase of output 2 years after the adjustment. They have also found (not shown in the graphs) that business confidence picks up immediately after the expenditure-based adjustments, unlike consumer confidence for which it takes longer to recover. Finally, the most important finding, in my opinion, is that the "heterogeneity in the effects of the two types of fiscal adjustments is mainly due to the response of private investment, rather than that to consumption growth". 

The findings of the paper are important in trying to explain the process of "right" or "wrong" fiscal adjustments. Using an increased taxation burden combined with spending cuts is a wrong approach since it depresses the economy (loss of public sector jobs leads to a loss of consumption before these people are reemployed), and doesn't offer incentives for it to grow. All the laid off public sector workers that are supposed to find jobs in the private sector are unable to do so since the private sector isn't hiring due to the many existing constraints it is facing. Unemployment starts to go up, supported by an increasing number of graduating youths for whom finding a job is now even more difficult, making the situation look bad for the politicians in power. This means that the politicians, under even more pressure to close the budget deficit, now need to cease spending cuts and stop firing more civil servants and bureaucrats, since they don't want to make the unemployment picture even worse than it already is. In addition, more unemployed would depress consumption even further. So the government then relaxes the spending cuts and public sector reforms and focuses mostly on increasing taxes to close the budget deficit. The government starts running out of options, as further spending cuts become politically unfavourable while increased taxation is needed to continue closing the budget deficit. 

Are public investments the key to recovery? 

This got me thinking further on one of the most popular policies aimed at kick-starting a recovery, one that is especially being advocated in the UK - infrastructure spending. The idea is as follows; the government is suppose to kick-start growth via infrastructure spending by two ways; (1) directly creating jobs, and (2) cutting costs to businesses through improved infrastructure. The first idea implies that hiring more workers in construction who will use their new wages to increase spending, will ultimately boost consumption (the classical demand-side story, followed by a Keynesian government spending multiplier). However, if the idea is to hire more workers to start a demand-side increase in consumption, why not have the government hire 100,000 workers (or more), give them all a job to dig holes around the country, and then fill them up? That's a perfectly meaningless job, but as long as the workers get paid, they will begin the cycle of recovery, right? Wrong! Expectations of temporary income aren't the same as expectations on permanent income: "If people anticipate a rise in tax rebates or any other form of stimuli (this is true for companies as well, not just consumers) to be temporary, they will save this money instead of spend or invest it. But when they anticipate a permanent rise in income (like getting a new or better paid job) they are much more likely to spend or invest now as they anticipate a certain future stream of income." (This was from the text on tax rebates, but the idea is essentially the same.)

The second way is having the newly build infrastructure lower the costs of businesses and help them grow. But how long does it take to build major infrastructure projects like motorways or railways? A long time! Much longer than the average bankruptcy rate for businesses in the UK. And much longer than the current recovery is going to last (hopefully). Full benefits won't be visible in another 10 years, during which time the very same businesses advocating the project will be using old roads and old railways. 

This isn't to say that infrastructure projects aren't important - they are, for long term growth almost definitely, but they cannot be the priority in starting up a recovery. One can argue that major infrastructure projects and things like the New Deal made a big difference during the Great Depression, but the world is much different today than it was 80 years ago. For starters back then information was being distributed either through the radio or word of mouth. In that case the people hearing that the government is ready to do something to help them out was enough to get confidence going. Their knowledge of possible negative effects on public finances was very limited. In the modern age of vast informational availability this is certainly not the case anymore. Particularly among investors, but that's another story. 

To start up a recovery, the priority should be on supply-side reforms aimed primarily at resolving labour market inefficiencies and at reducing the regulatory and taxation burden on businesses. These will decrease costs much faster and much more efficient than any new road or rail-link, no matter how good or fast they could be. 

Friday, 7 September 2012

Marginal Revolution University

Tyler Cowen and Alex Tabarrok, professors at George Mason University and bloggers at the popular and highly regarded Marginal Revolution blog, have started an online University aimed at spreading the word of their "personal vision of economics" to the broader audience. A noteworthy accomplishment which I will be following closely (feel free to sign up to the University here). 

"We think education should be better, cheaper, and easier to access. So we decided to take matters into our own hands and create a new online education platform toward those ends. We have decided to do more to communicate our personal vision of economics to you and to the broader world." 

They described a few principles they intend to follow within their online University: 
"1. The product is free (like this blog), and we offer more material in less time.
2. Most of our videos are short, so you can view and listen between tasks, rather than needing to schedule time for them.  The average video is five minutes, twenty-eight seconds long.  When needed, more videos are used to explain complex topics.
3. No talking heads and no long, boring lectures. We have tried to reconceptualize every aspect of the educational experience to be friendly to the on-line world."
Even before it started their effort has received praises around the blogosphere (here, here or here), and was even introduced at the World Bank.

The first course will be on Development Economics:
"Development Economics will cover the sources of economic growth including geography, education, finance, and institutions. We will cover theories like the Solow and O-ring models and we will cover the empirical data on development and trade, foreign aid, industrial policy, and corruption. Development Economics will include not just theory but a wealth of historical and factual information on specific countries and topics, everything from watermelon scale economies and the clove monopoly to water privatization in Buenos Aires and cholera in Haiti. A special section in this round will examine India. There are no prerequisites for this course but neither is it dumbed down. We think there will be material in Development Economics that will be of interest to high school students in the United States and Bangladesh and also to PhDs in economics, even to those who specialize in this field."
Courses start from 1st October. 

Thursday, 6 September 2012

Graph of the week: global competitiveness

The Economist compares the World Economic Forum's competitiveness index with GDP p/c:

Source: The Economist, 05/09/2012
Switzerland, Singapore, Sweden and Finland top the competitiveness list, which isn't surprising as the same group of countries usually top the freedom index categories as well. The countries that close the top 10 group are Netherlands, Germany, US, UK, Hong Kong and Japan. What is mildly surprising here is the decline of the United States, which has been dropping on the list persistently for the past four years (a quick glance at its productivity shows why). Looking at the Eurozone "periphery", it too is experiencing declining competitiveness which should hardly come as a surprise to anyone. However the reason the "periphery" countries are still above the trend-line is that they are (or at least were) relatively wealthy countries which have experienced a decline in competitiveness and productivity. In the end this amounts to their relative wealth decreasing (i.e. they are becoming poorer). This is not something that happened recently. The crisis only exacerbated their decline, but the productivity problem and the unsustainable welfare state model were present years before.  

Comparing this data to GDP p/c infers that higher competitiveness can bring more wealth, after a certain threshold (in here that would be around 4.5 or even higher, rough estimate). But the real question is, how does one increase competitiveness? The answer: there is no quick fix. If anything, at least try and learn the lessons from successful examples

Monday, 3 September 2012

“Why a collapse of the Eurozone must be avoided”

A Swedish economist Anders Aslund (senior fellow at the Peterson Institute in Washington) wrote an excellent article a few weeks ago on why a collapse of the Eurozone must be avoided under all costs. I recommend you read the whole thing

His point is partially based on a historical comparison of what happened with the break-up of three previous multi-nation currency zones, namely the ones of the Austro-Hungarian Empire, Soviet Union, and Yugoslavia. The structure of these economies differed to a great extent to the structure of the EU today, but some lessons can certainly be applicable.

His view is, and I agree, that too many economists think of a euro break-up as a mere devaluation that would benefit the exiting states. But not too many recognize the possible dire consequences this could bring to exiting countries (mostly everyone is preoccupied with what the effects will be on countries that remain in the Eurozone, or provided there is a full break-up, what will the effects be on the global economy – these predictions are usually very pessimistic). Exiting a currency peg (Argentina) and abandoning a currency are two very different things. Almost every nation that left the Austro-Hungarian, Soviet or Yugoslav currency unions experienced a rapid hyperinflation. In addition, losses of output were even more devastating: 
"The output falls were horrendous and long lasting. The statistics are flimsy, but officially the average output fall in the former Soviet Union was 52%, and in the Baltics it amounted to 42% (Åslund 2007, 60). Five out of twelve post-Soviet countries – Ukraine, Moldova, Georgia, Kyrgyzstan, and Tajikistan – had not reached their 1990 GDP per capita levels in purchasing power parities by 2010. Similarly, out of seven Yugoslav successor states, at least Serbia and Montenegro, and probably Kosovo and Bosnia-Herzegovina, had not exceeded their 1990 GDP per capita levels in purchasing power parities two decades later (World Bank 2011). Arguably, Austria and Hungary did not recover from their hyperinflations in the early 1920s until the mid-1950s. Thus half the countries in a currency zone that broke up experienced hyperinflation and did not reach their prior GDP per capita in purchasing power parities until about a quarter of a century later."
Now some may say that this was in most cases due to recovering from (Austro-Hungary) or engaging into wars (Yugoslavia), or the fact that a hard and painful transition to a market economy characterized by corruption and cronyism took its toll. However, in neither of the cases had exiting the currency union resulted in increasing exports due to a cheaper currency. In fact, exits were surrounded by huge uncertainty, very high borrowing costs, and a painful drop in output and employment. Not the kind of environment that would attract foreign investors, is it? 

Cronyism which characterized the transition made things worse after the initial stabilization. One can arguably say that hyperinflation at the time played a big role in exacerbating corruptive activities. Although the main culprit for that would probably be the inefficient institutions, initialized by the new governments. Nevertheless hyperinflation ate up a huge proportion of the newly formed nations’ wealth, similar to the effect of currency devaluation done in Argentina in 2001

For these reasons (and in fact many more) abandoning a currency is much harder than it appears to be, particularly for an anchor currency like the euro: 
"If one country (Greece) departs from the Eurozone or if its Target2 balances are capped, the current slow bank run from the south will accelerate quickly and become a massive bank run from most banks in southern Europe, and the banking system would stop working. The Eurozone payments system would stop functioning because it is centralized to the ECB. To re-establish a payments system is both politically and technically difficult. In the former Soviet Union, it took three years to do so. Currency controls would arise and a liquidity freeze would occur. If the drachma were reintroduced in the midst of a severe financial crisis, its exchange rate would plummet like a stone by probably 75%-80%. High inflation would result and mass bankruptcies ensue because of currency mismatches. Output would plunge and unemployment soar. Greece would experience a new default and other countries would follow."
Source: Andres, Domenech: "A solution to the euro debt 
crisis:  Back from the future",,  26 June 2012.
Their view is that higher bond yields and worse-off
Target2 balances reinforce each other.  
He addresses the Target2 balance (an inter-bank measurement of the net flows of money across borders in the Eurozone), which was signaled as a rising concern for the German Bundesbank, and some German economists (see the graph below). Aslund's text was essentially a response to the text from Hans-Werner Sinn who proposed capping the Target2 balances in order to end the 'hidden bailout' the Bundesbank has been issuing to peripheral Eurozone members. Aslund made a comparison to the Soviet example where a similar cap put an even quicker end to the currency zone. Note that these large imbalances arose primarily from the current account deficits of the Southern Eurozone countries. For a more interesting analysis, FT's Money Supply blog has a good overview (and a great graph showing the net balances within the Eurosystem): 
Source: Financial Times blogs, Money Supply: "Keeping track of those
Target2 balances"
, 25 May 2012
In conclusion: 
"...the Eurozone should be maintained at almost any cost. All the economic problems in the current crisis can be resolved within the Eurozone...the Eurozone-wide clearing must be maintained in full. The Target2 balances should be resolved by reforms, not by capping national balances. The only reasons for a breakup of the Eurozone would be that Eurozone governance fails completely or that one nation decides to leave. If the breakup starts, it would be better to agree on a complete and speedy dissolution into the old national currencies."