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The very unpleasant echo from the 1930s

I am trying very hard not to become alarmist, but I must admit that I see very little positive news at the moment and I continue to see three elements – monetary policy failure/weak growth, the rise of extremist politics (Trump, Orban, Erdogan, Putin, ISIS etc) and sharply rising geopolitical tensions coming together to a very unpleasant cocktail that brings back memories of the 1930s and the run up to the second World War.

It has long been my hypothesis that the contraction in the global economy on the back of the Great Recession – which in my view mostly is a result of monetary policy failure – is causing a rise in political extremism both in Europe (Syriza, Golden Dawn, Orban etc) and the US (Trump) and also to a fractionalization and polarization of politics in normally democratic nations.

That is leading to the appeal of right-wing populists like Donald Trump, but equally to the appeal of islamist groups like ISIS among immigrant youth in for example France and Belgium. Once the democratic alternative loses its appeal extremists and populists will gain ground.

The geopolitical version of this is Ukraine and Syria (and to some extent the South China Sea). With no growth the appeal of protectionism and ultimately of war increases.

Unfortunately the parallels to the 1930s are very clear – without overstating it try to look at this:

  • Syrian war vs Spanish civil war: Direct and indirect involvement of authoritarian foreign regimes (Stalin/Hitler vs Erdogan/Putin)
  • Euro  zone vs the gold standard
  • The rise of populists and extremists: Communists, Nazis and Fascists vs Syriza, Golden Dawn, Jobbik, Orban, regional separatism in Europe, anti-immigrant sentiment, Trump and ISIS (in Europe) etc.
  • The weakening (failure?) of democratic institution: Weimar Republic vs the total polarization of politics across Europe – weak and unpopular minority governments with no “political muscle” for true economic reforms across Europe.

Maybe this is too alarmist, but you would have to be blind to the lessons from history not to see this. However, that does not mean that history will repeat itself – I certain hope not – but if we ignore the similarities to the 1930s things will only get worse from here.

PS if you are looking for more empirical evidence on these issues then have a look at Manuel Funke, Moritz Schularick and Christoph Trebesch’s recent very good post on voxeu.org on The political aftermath of financial crises: Going to extremes.

HT Otto Brøns-Petersen.

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

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We need a mechanism for sovereign debt crisis resolution

In the future I will be writing a weekly column for the Danish business daily Børsen. The first column appears in today’s edition of the newspaper (you can read the article in Danish here). International news outlets and newspapers interested a syndication deal on my new weekly column are welcome to contact me (lacsen@gmail.com).

On this occasion I here share the English translation of the article:

We need a mechanism for sovereign debt crisis resolution

Recently nearly all the news flow in the financial media has been about the risk of a Greek sovereign default. But Greece is not the only country, which is currently in serious risk of a default. The same is the case for Ukraine, Venezuela and Puerto Rico. Thus, if we are unlucky, we might get 3-4 sovereign defaults within the next 1-2 months.

It is quite obvious that a possible Greek or Ukrainian sovereign default is something that contributes to the uncertainty surrounding especially the European economy and it is clear that this is contributing to increasing volatility in global financial markets.

The main source of uncertainty in relation to sovereign default is uncertainty about when it happens and what creditors that will be affected.

If we compare a sovereign default with a company or a bank going bankrupt, then it is the case that we in most developed economies in the world have relatively clear rules on how a possible bankruptcy should be handled in legal terms.

It is usually the case that a company in financial trouble under certain conditions can go into receivership, while trying to see if the company can be rescued. And if this rescue attempt fails then there will be quite clear rules about what creditors are first in line when the estate is made up.

Such mechanisms mostly ensure that an orderly and controlled restructuring or liquidation of the company can take place and at the same time ensure the greatest possible transparency about who will bear any losses.

Unfortunately we don’t have similar rules and mechanisms when it comes to sovereign defaults. As a result even a minor risk of a possible sovereign default creates unnecessary volatility in the global financial markets.

This, however, need not be the case and one may wonder why we in the EU hardly have discussed the possibility of organizing a mechanism within the EU, or at least within the euro area, which can ensure a more transparent and proper handling of threatening sovereign defaults.

In 2010, the four economists – including the former chief economist of the World Bank Anne Krueger – put forward a concrete proposal for “A European mechanism for sovereign debt crisis resolution”. The plan for example included a proposal for a special European court to oversee the process of debt negotiations and debt restructuring. Such a court and clear rules on debt restructuring would greatly help to make the handling of the sovereign debt crises much less politicized than it is today.

Unfortunately, the proposal has not received much attention among European decision-maker, and one can only fantasize about how much easier the handling of the Greek debt crisis would have been if we had such rules and mechanism for orderly debt restructuring in place in recent years.

Companies go bankrupt. And so does governments. We therefore urgently need to set up institutions and mechanisms to handle sovereign defaults.

Adam Tooze’s great insights into the history of Europe

I spend the weekend with my family in the Christensen vacation home in Skåne (Southern Sweden). I didn’t do any reading, but I had time to watch a fantastic lecture series on YouTube with one of my absolute favourite historians Adam Tooze.

Tooze did the lectures last year at Stanford University’s Europe Center. Watch the great lectures here:

“Making Peace in Europe 1917-1919: Brest-Litovsk and Versailles”
“Hegemony: Europe, America and the problem of financial reconstruction, 1916-1933”
“Unsettled Lands: the interwar crisis of agrarian Europe”

While I do not agree with all of Tooze’s thinking continue to think that he is one of the most inspiring historians in the world to listen to – particularly for economists. Enjoy the lectures!

PS I equally recommend Tooze’s two latest books Wages of Destruction and The Deluge. Both books give great insight not only into history, but also teaches us great lessons for today’s world.

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Update: For some reason I had missed David Frum’s excellent review of Wages of Destruction and The Deluge – and Brad DeLong’s “thoughts on David From’s review”.

Gary Becker has died. Long live economic imperialism!

As geopolitical tensions in Ukraine have been rising I have found myself thinking about the impact of such events on markets and economies. One thing is to understand what is actually going on and another thing is to understand the economics of such events. How are geopolitical tension or terror impacting investment and consumption decision?

Most people would tend to give ad hoc explanations for the economic and financial impact of such events. However, that would not be the way I would look at it. I would always start out by trying to understand such events and the impact of such events from a rational choice perspective. The tools economists use to understand the pricing of beer or the demand for football tickets can also – and should – be used to understand for example suicide bombings or how markets react to geopolitical tensions.

This was the key message from Nobel laureate Gary Becker who passed away on Sunday at an age of 83.

Becker was awarded the Nobel Prize in economics in 1992 “for having extended the domain of microeconomic analysis to a wide range of human behaviour and interaction, including nonmarket behaviour”.

Airport security and the Economics of discrimination

Gary Becker is one of the economists who has had the biggest influence on my thinking about the world in general – also the “nonmarket world” – so his ideas often come up when I encounter different decision making problems.

Recently I was going through security control in Copenhagen airport. In Copenhagen airport there is a special security control called something like the “Express” track. It is basically a quasi-fast track. I fundamentally think it is used to get people who are late for the their flight fast through security and for example for people in wheelchair. However, I have noticed that I often will be called over to this Express track. Last time that happened a couple of weeks ago I came to think about the concept of “statistical discrimination”.

The idea with statistical discrimination is that it can be rational for example for employers to discriminate against certain ethic groups if there is a cost of gathering information of about individuals’ skills. While Gary Becker did not come up with the theory of statistical discrimination he nonetheless was the economist to pioneer the economics of discrimination. His work on discrimination was published in his great book The Economics of Discrimination from 1971.

Becker books

So why am I so often called to the “Express” security control in Copenhagen airport? The answer is statistical discrimination. When I travel I am mostly wearing a suit and look like a seasoned business traveler. The security staff will based on my looks fast conclude that I am a seasoned traveler and know the security routine well and I therefore would not slowdown the process if they got me through there. This obviously was completely rational because I am in fact well accustomed with the security process.

As I was going through the express security control I was thinking about Gary Becker and what he taught us about using standard economic thinking (rational choice theory) to understand non-market phenomena.

Fear and the Response to Terrorism   

I consume a fair amount of working papers every month. As it happens the last working paper I read (or actually re-read) was a paper by Gary Becker (and Yona Rubinstein). The paper – “Fear and the Response to Terrorism: An Economic Analysis” (2011) – “offers a rational approach to the economics and psychology of fear”.

The reason I re-read the paper was that wanted to better understand how the increased geopolitical tensions in Ukraine might impact particularly the Central and Eastern European markets and economies.

Try to think about the geopolitical tensions while reading this part from the abstract from the paper:

“We explicitly consider both the impact of danger on emotions and the distortive effect of fear on subjective beliefs and individual choices. Yet, we also acknowledge individuals’ capacity to manage their emotions. Though costly, people can learn to control their fear and economic incentives affect the degree to which they do so. Since it does not pay back the same returns to everyone, people will differ in their reaction to impending danger … Education and the exposure to media coverage also matters. We find a large impact of suicide attacks during regular media coverage days, and almost no impact of suicide attacks when they are followed by either a holiday or a weekend, especially among the less educated families and among occasional users.”

This might help us understand why the increase in geopolitical tensions in Ukraine and Russia has had so relatively limited impact on global financial markets. Obviously there has been a marked impact on the Russian and Ukrainian markets, but while we initially saw a “fear factor” in the global stock markets this “shock” fast ebbed.

In reality there is a similarly to Becker’s original theory of discrimination, where economic agents could have a “taste” for discrimination. Hence, an employer might have a dislike for jews or blacks, but this “fear” is not for free. If the employer refuses to hire a certain individual because of his or her race or religion despite that individual is as productive as a more open-minded competitor might hire other candidates for the job then that individual. Therefore racist employers will have to pay for their racism by having to accept a lower profit.

Similar it is costly to maintain an irrational fear of geopolitical risks. This I think is pretty important in terms of understanding the impact of the Ukrainian crisis on the global markets.

Long live economic imperialism!

This is just a few examples of how Beckerian thinking is influencing my own thinking at the moment. Gary Becker made a huge impact of me when I really got into studying his research in the second half of the 1990s when I was doing research on the economics of immigration at the Danish Ministry of Economic Affairs and at the same time was teaching a course in the Economics of Immigration at the University of Copenhagen.

I will gladly admit that I am a strong proponent of economic imperialism. I strongly believe – and learned that from studying Gary Becker – that economic method (rational choice theory) can be used to understand most societal issues whether it is stock market pricing, suicide bombings, why politicians are asshats or sports. In fact the latest book to arrive in my mail from Amazon I got to today is a book – “The Numbers Game” – on how to apply economic methods to understanding football (for my American readers – that is what we call soccer in Europe).

I am sure Gary Becker would have agreed that if you want to understand for example the impact on team success by firing a coach you need to apply rational choice theory. It is not about “psychology” – it is all about rational choices.

Thank you Gary Becker for making me understand this.

Numbers game

Update – See also these links on Gary Becker:

Greg Mankiw: Very Sad News

Peter Lewin: Gary Becker: A Personal Appreciation

David Henderson: Gary Becker, RIP

Bloomberg: Gary Becker, Who Applied Economics to Social Study, Dies at 83

Reuters: Nobel-Winning Economist Gary Becker Dies at 83

Chicago Tribune: Nobel-prize winning economist Gary Becker dead at 83

Fox News: Gary Becker, University of Chicago Economics Nobel Laurete, Dies at Age 83

Peter Boettke: Gary Becker (1930-2014) — An Economist for the Ages

Mario Rizzo: Gary Becker (1930 – 2014): Through My Austrian Window

Russ Robert/Café Hayek: Gary Becker, RIP

 

 

 

Echoes from the past – how Molotov declared war on Poland in 1939

I got this from Erwan Mahé‘s excellent newsletter Thaler’s Corner:

NOTE OF THE GOVERNMENT OF THE U.S.S.R.
DELIVERED TO THE POLISH AMBASSADOR IN MOSCOW
IN THE MORNING OF SEPTEMBER 17, 1939
September 17, 1939

Mr. Ambassador!

The Polish-German War has revealed the internal bankruptcy of the Polish State. During the course of ten days’ hostilities Poland has lost all her industrial areas and cultural centres. Warsaw, as the capital of Poland, no longer exists. The Polish Government has disintegrated, and no longer shows any sign of life. This means that the Polish State and its Government have, in point of fact, ceased to exist. In the same way, the Agreements concluded between the U.S.S.R. and Poland have ceased to operate. Left to her own devices and bereft of leadership, Poland has become a suitable field for all manner of hazards and surprises, which may constitute a threat to the U.S.S.R. For these reasons the Soviet Government, who have hitherto been neutral, cannot any longer preserve a neutral attitude towards these facts.

The Soviet Government also cannot view with indifference the fact that the kindred Ukrainian and White Russian people, who live on Polish territory and who are at the mercy of fate, should be left defenceless.

In these circumstances, the Soviet Government have directed the High Command of the Red Army to order the troops to cross the frontier and to take under their protection the life and property of the population of Western Ukraine and Western White Russia.

At the same time the Soviet Government propose to take all measures to extricate the Polish people from the unfortunate war into which they were dragged by their unwise leaders, and enable them to live a peaceful life.

Accept, Mister Ambassador, the assurance of my high consideration.
People’s Commissar for Foreign Affairs of the U.S.S.R.
V. MOLOTOV

To
The Extraordinary and Plenipotentiary Ambassador of Poland, Mr. Grzybowski
Polish Embassy
Moscow

A Crimean style aggregate supply shock

It has been a busy couple of weeks for me. It is events in particularly Ukraine, Turkey and partly Venezuela that have kept me very busy so there has not been much time or energy for blogging.

My blog is mostly about monetary issues, but the most important thing going on in the global economy and markets right now in my view is not monetary affairs, but rather the escalation of geo-political risks or what Robert Higgs in the most general sense have called “regime uncertainty”.

So let me quote myself. This is from EMEA Weekly – a Weekly produced by my hard working colleagues in Danske Bank’s research department and myself. This is on the recent developments in Ukraine:

Centre of attention moves to Crimea

This week there has been a sharp increase in geopolitical tension on the back of the violent in recent weeks and particularly since the Ukrainian parliament voted to oust President Viktor Yanukovych at the weekend and appointed a new caretaker president and a new government ahead of presidential elections, which are now scheduled to be held in May.

As we pointed out in Flash Comment Ukraine – geopolitical risks increase, the events over the weekend sharply increased geopolitical risk and we expected the focus of the markets to turn to eastern Ukraine and the peninsula of Crimea. The events this week have confirmed this.

We also note that most of the population in Crimea is ethnic Russian and many hold a Russian passport. During the Russian-Georgian conflict in 2008, fears about increased separatist sentiment in Crimea increased tensions between the then Ukrainian government and Russia. These concerns have now returned. This morning a group of apparently pro- Russian armed men seized Crimea’s regional parliament and the government headquarters of the Russian-majority region.

Yesterday, Russian President Vladimir Putin ordered tests of the combat readiness of Russian armed forces in western and central Russia and today the Russian Ministry of Defence said it had put its fighter jets on ‘combat alert’ on its western border.

The new Ukrainian government has reacted angrily to recent geopolitical events. Hence, Ukraine’s interim President Olexander Turchynov has warned Russia against any ‘military aggression’ in Crimea.

The clear escalation of the geopolitical situation is now having a very clear impact on not only the Russian and Ukrainian markets. Hence, over the past couple of weeks there has been some contagion – so far fairly moderate – to other central and eastern European markets but, as of today, it seems that we are seeing an even broader spillover as fears of an armed conflict have increased.

The Ukrainian hryvnia has fallen sharply this week and today alone it is down around 10% against the US dollar. The Ukrainian central bank has effectively stopped defending the hryvnia as it has more or less run out of foreign currency reserves. Furthermore, it is very clear to us that the banking sector has effectively stopped working in Ukraine and the country is close to default. Indeed, we think it is impossible to avoid a sovereign default unless the Ukrainian government receives foreign financial assistance. This is also reflected in the pricing of Ukraine’s credit default swap.

The Russian rouble has also come under additional pressure. The rouble, which has been under pressure for some time and has lost some 20% in value over the past year. yesterday hit the weak end of the official fluctuation band against the basket of the euro and the US dollar.

This morning USD/RUB reached 36.11 – a five-year high. The dual currency basket hit a record high of 42.11. The Russian central bank Bank Rossii has refrained from significant support of the rouble, intervening by around USD300m per day and shifting repeatedly up the rouble’s trading band. We do not expect any significant turnaround in the rouble’s rate this year or any significant support from Bank Rossii as the authorities believe the rouble’s weakness helps the domestic economy.

As a direct consequence of recent events, we have changed our already very bearish forecast on the Ukrainian hryvnia to 15 against the dollar. This implies an almost 70% devaluation of the hryvnia compared with pre-crisis levels. We are also considering whether to revise our rouble forecast and it is obvious to us that there is considerable downside risk for the rouble if the geopolitical situation worsens further.

It is also obvious to us that these events have significant negative ramifications for both the Russian and Ukrainian economies.

I normally like to tell my stories within a simple AS/AD framework. If you want to understand the economics of what is going on right now in both Russia and Ukraine think of recent events as a negative aggregate supply shock to both economies. So we will have lower growth and higher inflation – as well as weaker currencies in both Ukraine and Russia as a result of these events.

This is how it looks – the geo-political shocks pushes the short-run aggregate supply curve (SRAS) to the left – from SRAS to SRAS’. This causes inflation to increase from p to p’ and real GDP growth drops to y’ from y.

AS AD SRAS shock

From a monetary policy perspective the worst thing to do would of course be to tighten monetary policy in response to such a shock. Interestingly enough it seems like both countries despite initially tighthening monetary conditions to “defend” their currencies now have accepted that this is a foolish policy and both countries’ central banks are now moving in the direction of freely floating exchange rates. So at least here there is some common ground.

Lets hope and pray that peace prevalence.

I Am An Ukrainian

My readers have to excuse me, but these days I can’t think about monetary policy. What is on my mind is the terrible events in Ukraine. I have for the past 15 years spend a lot of time in Central and Eastern Europe. I have seen the miracle of a country like Poland. But I have also seen how the people of Ukraine have been cheated by their corrupted and criminal politicians from seeing the same kind of progress as their neighbours in Poland.

I could write a lot about how I feel about this, but you have to excuse me because today I am not able to express my sadness about the terrible events in Kiev. I fear things will get even worse in the coming days. I pray it won’t.

Today I am an Ukrainian. Please watch this.

Ukraine should adopt an ‘Export Price Norm’

It has not be a great year for Emerging Markets and the next Emerging Markets country to worry about could very well be Ukraine.

This is what my Danske Bank colleague Sanna Kurronen has to say about Ukraine:

We have been expecting a soft devaluation of the Ukrainian hryvnia for some time, as the artificially strong exchange rate is creating severe imbalances in the economy. Currently, we see it as a likely scenario that Ukraine will allow soft devaluation in accordance with the IMF, which would lead to a 10% devaluation of the currency and then move to a managed float regime following the Russian example. However, as the necessary devaluation has been continuously postponed, it is beginning to seem more likely that the devaluation will be more dramatic.

GDP has been contracting for a year now in Ukraine as domestic production has been declining significantly. Yet, retail sales growth was still 6.7% year-on-year in August, supported by low inflation and rapid wage growth. A large current account deficit has been putting a pressure on the hryvnia, which has led to a rapid deterioration in Ukrainian foreign exchange reserves. The reserves are already at a critical level, below three months’ worth of imports. As market sentiment remains vulnerable for emerging markets, we believe external debt issuance is now very difficult for Ukraine and that significant debt redemptions are ahead.

A little more than a third of outstanding loans to both households and firms in Ukraine are still foreign-currency denominated. This makes devaluation politically very difficult. Nevertheless, we believe it is a good time for Ukraine to close a deal with the IMF, hike domestic gas tariffs and allow devaluation of the currency. Co-operation with the IMF would of course reduce the country’s independence, but only temporarily. The other alternative would be closer co-operation with Russia, which might have less predictable consequences. A hike in gas tariffs would speed up inflation, but the CPI is now around 0%, so there is room for tariff increases. The presidential election is still some time away (in March 2015), which allows the economy to grow while the election draws nearer. By postponing a necessary devaluation of the currency, Ukraine risks a severe collapse in its currency, whereas the IMF could provide the tools for a more restrained devaluation.

This is very much a story of fear-of-floating (due to significant foreign currency lending) and regime uncertainty (the political situation is nearly by definition always extremely uncertain).

Ukraine’s fundamental problem is an extremely dysfunctional political system and all other problems seems to smaller or large extent to be a function of the fundamental “regime uncertainty” in the country. However, purely looking at the monetary side of things it is clear that Ukraine should move towards a much more “floating” exchange rate or alternatively introduce a variation of what I have termed an Export-Price-Norm (EPN).

Ukraine could introduce an Export Price Norm by pegging the hryvnia to a basket of US dollars and the price of the country’s main export products – steel and agricultural products. That I believe would do a great deal to stabilize aggregate demand growth in the Ukrainian economy and at the same time introduce a lot more rule-based monetary policy in Ukraine. Something badly needed in a country known for extremely low levels of transparency in economic policy making.

If the hryvina was pegged to a basket of the dollar and the price of the main export goods then the hryvina would automatically weaken if the price of for example steel or agricultural products drop. That would lead to an significant stabilization of export prices (measured in hryvina), which on its own would do a great deal to stabilize overall aggregate demand in the economy. It would not be perfect, but it certainly be much better than the present quasi-pegged exchange rate regime and would likely also work better than a freely floating currency.

If you want to read more on why I think an Export Price Norm would work well for Emerging Markets commodity exporters see more here in the case of Angola, Russia, VenezuelaMalaysia and South Sudan.

Ukraine NGDP steel

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