Monday, June 04, 2012

European banks, balance of payments and thinking out loud about something I don't understand

Paul Krugman knows lots more about this stuff than I do. Which is what most people could say, too. So I pay attention when he says things like "the euro crisis is, at its root, a balance of payments problem." (The Breakeven Point (Wonkish But Terrifying) 06/01/2012)

But I'm not convinced from what he's written why the balance of payments problem should be considered more fundamental than the weakness of the financial system in Europe, mostly due to the under-capitalization and insufficient regulation of the banks. And this formulation seems to suggest that he thinks the banking problem is the basis of the current crisis:

And this in turn means that overall eurozone inflation must be sufficiently high. That’s a necessary but not sufficient condition for salvation; not sufficient because a banking crisis can still blow the thing apart, but necessary because you can't resolve the banking crisis unless there's some plausible path back to sustainable economies.
Maybe it's a matter of perspective. He's looking at the way the euro has created a trap in dealing with the current situation, so maybe what he's trying to say is that is that until the EU leaders start handling this thing in full recognition that Germany has to inflate its economy in order to provide counter-cyclical relief to the eurozone countries like Greece and Spain hardest hit by the depression, they can't solve the crisis.

He discussed the balance of payments point in a post earlier this year, European Crisis Realities 02/25/2012. There, he puts it like this:

What we're basically looking at, then, is a balance of payments problem, in which capital flooded south after the creation of the euro, leading to overvaluation in southern Europe. It's not a perfect fit — Italy managed to have relatively high inflation without large trade deficits. But it’s the main way you should think about where we are.
Maybe it's partly a difference of perspective from my own background in banking. But as I understand it, I would call this a banking problem generating a balance of payments problems which compounds the difficulty of dealing with the banking problem and the depression due to the weaknesses in the structure of the euro.

I'm not sure it makes any difference on Krugman's point in the 06/01/2012 post, which is that the eurozone needs higher inflation in Germany and the measures of inflation expectations provided by the German bond market don't point to that happening in anything like the time frame in which it's needed. Krugman's conclusion: "This chart shows a euro on the verge of imploding. If the ECB can't change this perception very, very soon — and I think it really is up to them — this goose is cooked."

And I'm pretty sure he means the euro as a whole, not just a "Grexit" (Greek exit from the euro).

I should say that part of my reservation about Krugman's position on the currency question is connected with what I suspect is too much faith on his part in the effectiveness of monetary policy. Yes, I know he's been saying for years that in depression conditions with interest rates hitting up against the zero lower bound that monetary policy has very limited effectiveness. Here I'm still a hardcore follower of the Galbraiths John Kenneth and Jamie, who don't encourage much faith in monetary policy even in normal times.

I'm not going to resolve that here!

But Krugman's post, Catastrophic Credibility 06/02/2012, is one that I tend to think overvalues the "credibility" of central bankers. He coined the term "confidence fairy" to debunk the con-man arguments about how the One Percent always need lower and lower taxes and more and more deferential treatment to bolster their confidence and make them invest. I suspect there could be a "credibility fairy" flitting around out there, too, when it comes to estimations of the mystical powers of central banks over money.

Here again, his basic point is right. To the extent that the Federal Reserve and European central banks can do anything to boost economic growth in the current situation, like raising their inflation targets, they should be doing it now.

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