The horrible terror attacks in Belgium has further escalated the fears of terror in Europe and policy makers from all over the continent are calling for new measures to fight extremism and populist politicians have been fast to call for closing Europe’s borders. However, the clear risk is that the economic costs of such measures easily could be larger than what can be justified by the actual risks from terror.

The fact is that compared to during the Cold War a lot less people are killed in terror attacks in Europe today than was the case in 1970s or 1980s and even more importantly the actual risk of being killed in a terror attack is extremely small.

In fact in 2011 a report on terrorism from the US National Counter Terrorism Center notes that Americans are just as likely to be “crushed to death by their televisions or furniture each year” as they are to be killed by terrorists. Then compare the risk of being killed in a terror attack with the risk of dying in a traffic accident.

Lets take the most deadly year in terms of terror since 2000. In 2004 nearly 200 people in total died in terror attacks across Europe. 2004 was the year of the Madrid train bomb. Now compare that to the number of killed in traffic accidents. This is the latest statistics – 746 in Belgium (2013), 3268 in France (2013) and 1730 in Spain (2013). Being killed in a traffic accident is quite small, but it is a lot more likely than being killed in a terror attack. Or said in another way – every year more people die in traffic accidents in France than was killed in the 911 attacks in 2001.

Despite of that we hear very few politicians talk about road safety, but basically all European politicians are now screaming about the need to “do something” about the terror threat.

I believe that there are two primary reasons for these “do something” tendencies in European politics (it is not only in the case of terror, but could equally well be applied to for example environmental discussions).

First of all, psychologists have shown that humans in general are not very good at estimating the risk of very infrequent events (such as being killed in a terror attack) and that people psychologically tend to seriously overestimate such risks.

Second, what the American economist Bryan Caplan has termed Rational Irrational Voters. What Caplan means by this is that in the voting process we as voters don’t really have to make rational assessments as the likelihood that our individual vote will mean anything for the outcome of the election is very limited – we are so to speak of rationally irrational, irresponsible and ignorant.

As a result, we are much more likely to give into fears and fantasies in the political process than when we are making a decision to for example buy a car or make an investment. Politicians very well know this and are happy to play on these fears. After all politicians are rarely elected by presenting statistics to the voters.

But we cannot and should not cave into fears – not in our personal life or in our political decisions. The best thing to do is to do as the British are saying – “calm down and carry on”. That does not mean that we should ignore terrorism as a risk to European citizens, but if we give in to fears and let that guide policies then surely the terrorists have won.

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This post was first published as an op-ed in the Icelandic newspaper Frettabladid.

In 2008 Iceland was hit by a massive banking crisis and the economy went into a tailspin. However, the Icelandic economy has since then recovered strongly and continues to grow robustly.

On the other hand Denmark, which was also hard hit by crisis in 2008 has essentially not recovered – at least not if we look at the level of GDP.

The graph below shows the development in real GDP in the five Nordic countries.

What do the two worst performers – Denmark and Finland – have in common? They are linked to the euro – Denmark through a pegged exchange rate regime and Finland as a member of the euro. On the other hand the three best performers Sweden, Iceland and Norway have floating exchange rate regimes.

But that is not really the story I want to tell. Rather I am interested in the importance of monetary policy in the impact on aggregate demand from fiscal policy. And here the difference between Iceland and Denmark is interesting.

The graph below shows the ‘fiscal impulse’ – measured as the %-point change in the structural budget deficit as share of GDP as measured by the IMF in Denmark and Iceland. A negative number is fiscal tightening.

The graph shows the scale of fiscal tightening in Iceland – since 2010 fiscal policy has been tightened by accumulatively nearly 9% of GDP. By any measure this is a very sizable tightening of fiscal conditions. On the other hand there has been no fiscal tightening in Denmark – in fact there is been an accumulative easing of fiscal policy by nearly 1% of GDP in this period.

A lot of things of course explains the difference in growth in the Nordic countries, but I think that the anti-fiscal austerity crowd needs to explain how Iceland has been able to grow faster than any other Nordic country – with the exception of Sweden – while at the same time undertaking massive fiscal austerity.

The answer to me is clear – easing monetary policy has been extremely efficient in Iceland to offset the impact of fiscal austerity and this in my view clearly shows that monetary policy is far from impotent. Hence, you can easily undertake sizable budget consolidation without causing a recession if you have the right monetary policy regime in place.

PS Today it 10 years ago that the “Geyser Crisis”-report, which forecasted doom-and-gloom was published. I of course co-authored that report. It is fair to say the report changed my life.

Yesterday we got the news that the Egyptian central bank had devalued the pound and announced that the country is moving closer to a freely floating exchange rate.

This is from Bloomberg:

Egypt allowed the pound to weaken the most in 13 years as the North African nation became the latest emerging market to ease defense of its currency to conserve reserves and boost competitiveness.

The Central Bank of Egypt devalued the pound by almost 13 percent on Monday to 8.95 per dollar and said in a statement it would adopt a “more flexible exchange-rate” policy. The authority, which currently controls the currency at regular dollar sales, didn’t give details on what mechanism would be adopted. Egyptian stocks jumped the most since 2013 and Eurobonds rallied.

The move was an echo of January 2003, when Egypt let the pound tumble by 14 percent in a single day before allowing a further 13 percent depreciation through the end of the year. The currency will probably trade between 9 and 9.5 per dollar this year as the central bank closely manages its fluctuations, according to Hany Genena, the head of equities strategy at Cairo-based investment bank Beltone Financial.

This is yet another example the the ‘dollar bloc’ is gradually falling apart and countries around the world are moving away from pegging their currencies to the dollar and are moving towards more flexible exchange rate regimes. This in my view certainly is good news.

The big challenge for Egypt will now be what it should be doing next. It would certainly not be a good idea just to continue with a “new peg” to the dollar.

I hope to in the near future to write more on what could be a ‘good’ monetary regime for Egypt.

I am a regular contributor to Geopolitical Information Service (GIS). This is from my latest article at GIS:

The year has not started well for global financial markets. Undoubtedly, one reason that stocks have slumped is that the United States Federal Reserve under Janet Yellen has started to raise interest rates and signaled that more hikes are coming.

The hawkish stance of Ms. Yellen’s Fed not only risks derailing the U.S. economy and throwing it back into recession, but it could also exacerbate the tensions observable for some time within what we have called the “dollar bloc.”

You can read the rest here (pay wall)

Believe it or not – one of my favourite books on the Great Depression is not about monetary policy, but rather wage stickiness in the US labour market and failed labour market policies during the Roosevelt administration. The book is Richard Vedder and Lowell Gallaway’s “Out of Work: Unemployment and Government in Twentieth-Century America”.

A key conclusion in Out of Work is that real wages are strongly countercyclical when the economy is hit by aggregate demand shocks. The mechanism is simple. When a negative demand shock hits the economy the aggregate demand curve shifts to the left causing a drop in inflation (expectations) and as nominal wages typically are stickier than prices this will cause real wage growth to increase. This is in turn will cause unemployment to rise.

This essentially means that there are two elements in the sharp rise in US unemployment during the Great Depression – first of all a monetary contraction and second of all sticky nominal wages. Said in another way the reason US unemployment rose during the Great Depression was the fact that nominal wages failed to drop as much as prices was nominal wages where downward sticky.

In fact, the Roosevelt administration did a lot to curb the necessary downward adjustment of nominal wages for example through first of all the National Industrial Recovery Act (1933) and later that Wagner Act (1935) and the Wage-Hours Act (1938).

Scott Sumner tells exactly story in his new book The Midas Paradox – The Great Depression had two legs: A monetary policy shocks (the negative AD shock) and the government policies to push up nominal wages growth (the negative AS shock).

Repeating history – strongly countercyclical real wage growth post-2008

If we look at what have happen on the US labour market from 2008 the story in many ways is similar to what happened during the Great Depression.

The graph below illustrates this.

When the negative aggregate demand shock – the monetary contraction – hit in 2008 inflation expectations – here illustrated by 5-year/5-year inflation expectations – dropped dramatically. As nominal wages are sticky they failed to drop as much as inflation expectations initially, which in turned caused a sharp rise in real wages. This is the counter-cyclicality of real wages – a negative demand shock causes a rise in real wages. This resulted in a sharp increase in US unemployment in 2008-2009.

However, as the Federal Reserve moved to offset the initial shock inflation expectations rebounded in early 2009, which in turn cause real wage growth to start slowing and as a result US unemployment started to decline from October 2009 – essentially with a six-month lag from when real wage growth again had dropped below the pre-crisis average around 1.5%. Hence, again we see a strong counter-cyclicality – as the Fed moves to boost aggregate demand growth real wages decline, which in turn caused unemployment to drop.

Extremely lacklustre real wage growth       

While the Fed initially moved to offset the initial aggregate demand shock the Fed effectively failed to move nominal aggregate demand growth back to the old growth of 5-5½% nominal GDP growth and rather seems to implicitly has targeted less than 4% NGDP growth since 2009.

As a result, both nominal and real GDP growth have been extremely lacklustre since 2009 and even if we have assumed that the there is a “great stagnation” in US productivity growth (which I really don’t think is the case) then real wage growth has been extremely meagre. This undoubtable is a reflection of the fact that monetary conditions have remained excessively tight since 2009.

However, this also illustrates that nominal wages are not sticky in medium-to-long run and one can hence, conclude that unemployment has come down in the US not only because of Fed monetary easing – in fact monetary policy seems to have been continuously too tight – but rather because the aggregate supply curve has shifted rightwards causing nominal and real wage moderation.

On the positive side even though there have been some political attempts in the US to push up wage growth for example through legislation to increase the minimum wage there measures implemented have been far less draconian and hence less damaging than what the FDR administration pushed through in the 1930s. As a result, we have seen more downward real wage flexibility in the US than was the case during the Great Depression. On the negative side the weak real wage growth in the recent is probably also an important cause of the rise of populist politicians like Donald Trump and Bernie Sanders.

Sharp rise in real wage growth will cause unemployment to rise

So while we during the period of moderate low (but stable) aggregate demand growth from 2010 to 2013-14 saw very weak nominal and real wage growth, which has caused the decline in unemployment the picture has changed rather dramatically since 2014.

Hence, I have earlier argued that the Federal Reserve essentially from mid-2014 has moved to tight US monetary conditions rather significantly (David Beckworth has made a similar point – see for example David latest blog post here).

The tightening of US monetary condition has been very visible inflation expectations, which essentially have been trending downwards for nearly two years.

While nominal wage growth has been fairly low and stable the drop in inflation expectations means that over the past year or so have seen a gradual acceleration in real wage growth.

Paradoxically while is in fact is an indication that US monetary policy becoming too tight and the unemployment likely soon will start to rise Fed Chair Janet Yellen sees rising real wage growth as an indication that inflation soon will rise.

The problem obviously is that Yellen fail to realize that inflation is a monetary phenomena and that real wage growth is counter-cyclical rather than pro-cyclical. As a consequence Yellen seems to completely miss the fact that her overly tight monetary stance is pushing the US economy closer and closer to recession. Some thing also visible is the US yield curve, which has been flattening significantly recently and if Yellen’s Fed continues to insist on interest rate hikes then it becomes very likely that the yield curve will turn inverse – 10-year yields will drop below 2-year yields. That would be a very clear signal that the US is heading for another Fed-induced recession.   

Or as Rudi Dornbusch once said:

“No postwar recovery has died in bed of old age—the Federal Reserve has murdered every one of them.”

Unfortunately, the Fed seems overly eager to prove Dornbush right again.