Economics & Finance – Page 22

Taming the banks: two views from the FT

Oh the shame of the FT’s paywall! Yesterday the paper presented a wonderful view of the debate on the UK banking reforms proposed by the Vickers Commission with two opinion pieces under the title Taming the banks, long overdue or utter folly? For the reforms was regular columnist John Kay. Mr Kay (though I’m sure he’s not really a mere Mr) is one of my favourite FT columnists. His articles do come out on his website in due course, but not this one yet, I’m afraid. It is a very lucid article, pointing out the massive size of UK banks balance sheets: at £6 trillion, four times the size of the country’s income. Of these but a tiny fraction is lending to industry, and a rather larger fraction is domestic lending such as mortgages. The bulk of it is to the finance industry pumping up the great game of leverage. The idea of ringfencing, the critical part of the proposed reforms, is to stop the small fraction of balance sheets that matters to individuals and “real” businesses from being poisoned by financial engineering gone wrong; or to put it another way, to stop the British state from having to underwrite the latter to protect the former. Mr Kay’s only criticism is that the reforms are being implemented too slowly.

The opposing article is from Sir Martin Jacomb. Sir Martin is no more a banker than Mr Kay, that is to say he’s done non-executive directorships but not much more; he’s a lawyer and chiefly famous for saying that universities should be independent of government, and that Oxford University should cut its ties with the state. The bankers are in fact rather quiet on the reforms, after some rather clumsy lobbying to get the implementation delayed, which appears to have been quite successful. The weakness of their case seems reinforced by Sir Martin’s article, which nearly nonsense. Is this really the best the FT could find?

Sir Martin reiterates a familiar litany:

The reforms advocate breaking up “universal banks”, but this model “can be perfectly safe”.
It will hurt the City’s international position. “There must be universal bankers in Frankfurt rubbing their hands.”
It will cause the loss of jobs and taxes.
the new banks will not able to offer helpful products to industry.
It does not address the immediate problems besetting European banking, “which result not from mistakes by bankers so much as blunders by European Union governments in the management of the euro.”

This lot is readily disposed of:

Universal banks did not come out the recent crisis well. It is true that some of the better managed ones did not need direct government rescue (Barclays and HSBC in the UK, BNP Paribas, JP Morgan), though still benefited from implicit and explicit guarantees. But far too many did, especially in America (notably Citigroup and Bank of America), here (Natwest and HBOS) and Switzerland (both UBS and SBC).
This is yet another cry of “Wolf!” from the City. I remember how us not joining the Euro was supposed to kill the City in favour of Frankfurt. The City’s standing is based on network effects of people, skills and time zones. Most of its activity is from foreign owned institutions already. If the UK owned activity shrinks, it is because the public liabilities that go with it are too large. It best that we adapt.
This sort of answers the jobs and taxes bit. As Mr Kay points out, lending to job-creating non-financial businesses should not be affected, and might even benefit if they do not have to compete for attention with gearing up of financial products. It is much healthier if our economy is less dependent on highly paid bankers’ jobs.
Sir Martin uses the example of a currency hedging, which might be useful for an exporter with a long term contract. But surely his ordinary banker can introduce him to an investment banker at little extra cost?
This is true; it’s a separate issue. But is quite astonishing for him to suggest that the Euro area problems are the fault of politicians rather than bankers. It was the bankers that bankrolled the Italian, Portuguese and Greek governments at absurdly cheap prices. It was its banking industry that laid the Irish government low. It was bankers from across the zone that pumped up the Spanish property bubble. This kind of “it wasn’t us” defence from bankers simply shows how little they have learned from the disaster.

Apart this whingeing, Sir Martin makes a more subtle point. We should be promoting more competent management amongst banks, and excessive regulation does the opposite. Well, we must ask what caused the rampant incompetence in the most of the world’s banks before the crisis. Surely it was the thought that if things went bad governments would come to the rescue, and it would all then be somebody else’s problem? This is exactly what the reform seeks to address. By separating the investment banking side out, it means that failure from that side will be easier to tolerate, and should not require the UK tax payer to stump up. The retail side would be bailed out in the event of a failure, true, but it will be more difficult for these banks to pump themselves up to create a massive hole.

There is an irony behind all this. The point about banking reform is to make banking more, not less risky, for bankers anyway. We need to see more bank failures, not less. The by-line to Sir Martin’s article is perhaps its most cogent bit: “Beware the paradox that a system to limit risk invariably increases it”. But risk to whom?

Time for Plan B?

Predictably, the heat is mounting on the British government to soften its fiscal policy in light of weak economic growth. Today the new IMF chief Christine Lagarde seems to be adding to the pressure, even if she wasn’t explicit. The code for changing this policy is referred to by political types as “Plan B”. I am now convinced that some sort of Plan B may now be a good idea – but it would not take the form that a lot of Plan B advocates, especially the Labour opposition propose.

First, why? I have been progressively convinced by the FT’s economics editor Martin Wolf. I have found him to be easily the most cogent commentator on the current economic situation, better than any number of economics Nobel Laureates or former members of the Bank of England monetary policy committee, who seem to think that their past glories can compensate for the shallowness of their analysis. Paul Krugman, Ken Rogoff, Joseph Stiglitz, to name a few, have disappointed somebody that has respected their weightier works; David Blanchflower has turned downright silly in order to widen his audience. Mr Wolf has been consistent, logical, and has gone further than most to try and understand all facets of the arguments.

The problem in the UK economy is not lack of consumer demand, since consumers are right to pay down debt as a priority right now. The problem is lack of business investment, and a weak world economy, and hence potential export markets. And excessively tight fiscal policy may send investment into a doom-loop, since so much depends on confidence. Add to that the fact that current levels of public expenditure are unsustainable, and the massive size of the public deficit, and you will understand that most versions of Plan B are unconvincing. Reducing the cuts simply creates problems for later, and builds up a false confidence in what this nation can afford. Cutting VAT temporarily, as advocated by Labour, addresses the wrong problem.

The answer must be to promote investment. As Mr Wolf points out (here but behind the FT paywall), there is a golden opportunity for the government to do so because its borrowing costs are so low. The trick is finding projects that deliver a convincing financial return; borrowing against such projects does not undermine the country’s finances. Unfortunately this is easier said than done. A lot of public projects make extravagant claims about their worth, but are in reality wasteful prestige initiatives – think of the Building Schools for the Future programme. Or else they turn out to be so badly managed that promised returns are never delivered – think of NHS IT, or Edinburgh trams, or anything undertaken by the Ministry of Defence.

There is no doubt some scope for increasing funding to standard public projects. But actually what needs to be done is to provide more support for medium sized and small businesses, especially growing ones. The banks are not stepping up to the plate, demanding ludicrous returns for their efforts. Surely there is scope for the government to beef up regional development funds and increase funding for institutions such as the Green Investment Bank. This will not open the floodgates to usher in an era of rapid growth. But surely it would help.

The Euro: Thatcherism by other means

It’s a grim time for supporters of the Euro project like me. Hardly a day goes by without hearing some highly patronizing person going on about how a country fixing its exchange rate is a terrible idea because it can’t then devalue when it hits trouble, and how the austerity policies in the Euro zone are doomed to fail. One irony is that many of these people are from the the political right; the sort of people who think that the Thatcher revolution of the 1980s was not just a good thing, but a turning point for the British economy. In fact the Euro advocates are proposing very similar medicine for southern Europe.

The UK economy inherited by Mrs Thatcher in 1979 was a mess. Both unemployment and inflation were persistent, and the country was referred to to as “the sick man of Europe”. Mrs Thatcher’s solution was to focus on the long or medium term drivers of success, with utter contempt for short-term palliatives. She progressively liberalised the economy, and in particular the labour market, then dominated by trade union power, and taxation, which had reached punitive levels on the rich (and not so rich, come to that). In macroeconomic policy she believed in squeezing down inflation through tough monetary and fiscal policies. Interest rates soared. Amongst other things, the pound rapidly appreciated. This was all part of the medicine.

The results were indeed dramatic. Unemployment got much worse, with devastation sweeping through great swathes of industry – all of which makes our current troubles look like small beer, even though, according to GDP statistics, we are supposed to be in a worse mess now. But in due course the economy prospered and reached undreamed of heights – though some parts of the country never recovered.

Back to the Euro zone. The underlying problem with all of the currently struggling economies, except Ireland maybe, is not entirely dissimilar to that faced by Britain in 1979. A host of product market, labour market and tax inefficiencies have conspired to make their economies relatively uncompetitive. The political will to tackle these problems has been lacking. Before the Euro they could simply let their currencies slide to offset this lack of competitiveness. But all this did was to ensure that the living standards of citizens stayed below their potential. And it was unsustainable in the long term; eventually you get to stagflation and even hyperinflation – a fate which Portugal in particular was reaching before the Euro project offered rescue. Once in the Euro devaluation is not an option, and so politicians have to focus on medium and long term reforms. This is what they are now doing, some with more enthusiasm (say Portugal) than others (say Italy).

Mrs Thatcher, of course, would never approve of a country joining the Euro – she treasured national sovereignty too much – but she would have approved of many of its consequences. Mrs Thatcher did not believe in devaluation.

But this is hardly an advertisement for the Euro for many. A lot of people still think that the Thatcher years were a period of gratuitous violence with adverse consequences that we are still suffering. It was she that was responsible for the trashing of so much British manufacturing, with the appreciating pound very much part of this. And the work she started was capably continued by Messrs Brown and Blair, since a high pound, together with aggressive exporting practices from China and India, had a similar effect in the 2000s – albeit compensated by unsustainable jobs in finance and building.

And there is no avoiding that the southern European economies need to go through a process of harsh economic reform, or else suffer a slow slide into poverty. Euro advocates had always foreseen this; what they had not foreseen was that reduced government borrowing costs once in the Euro would allow these countries to put off the evil day, only to make it infinitely worse when it arrived.

British banks shoot themselves in the foot.

Oh dear! The Vickers review on banking reform hasn’t been published yet, and the news is full of people taking positions and what it might or might not recommend. I have a lot of sympathy with our Prime Minister, who wants the blessed thing to be published before we have a row about it. What to make of it?

The reporting is a bit confusing. The Independent has hyped the thing up to be a war between the Vince Cable and George Osborne, not so much about the proposed reforms, but how quickly they will be implemented. Meanwhile somebody has briefed the FT that Cable has pretty much given way on timing so there is no real row at all.

The proximate cause of this flurry is a lobbying campaign by the banks. This campaign will do nothing to redress their general aura of incompetence. They are basically saying the reforms should be kicked into the long grass because they will interfere with their lending to British businesses, which is critical if business investment is going pull us out of the economic doldrums, as most people hope. There is some merit in this, because some of the reforms (on capital requirements and liquidity) could have just that effect. But the ineptitude of their stance is staggering.

Politics is built on simple messages, and the banks are offering the Liberal Democrats a very tempting proposition. This is a wonderful opportunity for them to show what they are doing in government by showing that they are resisting pressure from the banks. As the banks themselves continue to insist on paying large bonuses for reckless trading activities, this is a popular stand. Ed Miliband and Labour have not been slow to take up the anti-banker sentiment. The Tories, meanwhile, don’t seem to know what’s hit them, and none of their side are sticking their necks out on the banks’ behalf. Meanwhile John Cridland, the CBI director general, has weighed in on the banks’ behalf calling a rapid implementation of the reforms “barking mad”. It is difficult to understand what he thought he was doing; the CBI’s credibility has been badly damaged as a result.

There may not even have been much of a row in the coalition in the first place. There is consensus on the general thrust of the reforms; no doubt Vince Cable was quite flexible on the timings of some aspects, provided others proceed fairly quickly. Now it is important to him and the Lib Dem part of the coalition that they are seen to get results. A public row makes things worse for the banks. If ever there was a time for quiet lobbying based on dry details, this was it. Using the megaphone is totally counterproductive.

Not that I have much sympathy with the banks. They are making too much money, and any sensible reform would reduce their profits, both by taking away the implicit government subsidy and by increasing competition. It’s bound to hurt. If the banks want to take some of their activities, and even their HQs, elsewhere, then so be it. I’m not actually sure where they would go though. Switzerland has dramatically increased its capital requirements for banks, and the stratospheric Swiss franc doesn’t make operating there cheap. If they don’t have the implicit backing of a big government then their business model breaks down anyway – ruling out places like Ireland and Bermuda. Going into the Eurozone when its own banking system is under incredible stress hardly looks a good idea either. In America they have a habit of sending bankers to prison.

The central reform is to separate banks’ trading activities from their “ordinary” ones of taking deposits and lending to the public and non-financial businesses. This was quite contentious in the commentariat when it was first mooted a year or so ago. But there seems to be a much greater consensus behind it now. Who would have guessed it? A lot of people assumed the bankers would get away with it while politicians tried to make up their minds, and the disaster of 2007/08 faded into the memory. Not so. The banks’ inept PR machinery can take some of the credit.

When confidence is lost

A scary day. Here in London people are appalled by the looting and burning, and angry and panicked. Something analogous is going on in the world’s financial markets. At times like this we realise how much of a modern society is built on trust and confidence in strangers.

On the streets we hope that our well-ordered and safe lives are built on more solid foundations: law and the agencies that enforce it. But in fact it depends on almost everybody imposing voluntary boundaries on their behaviour. Even a tiny minority can create havoc. If it truly is a tiny minority then we can contain it, but at the cost of deadening society around us and reducing the level that different communities mix. It’s impossible to know where we will end up, but our town centres may never recover and the divisions in our society may simply grow.

The financial markets are likewise built on trust. We also like to think that it has more solid foundations, on decisions taken based on solid information, with effective regulation and security. Alas no. Decisions are taken in an instant, and often by computer algorithms with a limited digital input. A lot has to be taken for granted, so when confidence diminishes panic is likely to follow. One of the more irritating aspects of these markets is the way people jump to quick explanations as to why a market has moved in a particular direction. This week there was a lot of talk about the downgrading of US debt. But the causes are unknowable, the sum of many decisions based on partial information and individual circumstances.

The downgrading of US debt simply cannot be a rational explanation. It was based on no new knowledge; it directly affects investors only at the margins. US debt actually rose in price, while share markets tumbled. Share prices had in fact mostly lost touch with reality anyway, so a sharp fall in value should hardly have been a surprise. The ability of professional investors to accept clear nonsense as a basis for valuing shares is one of the remarkable features of modern finance.

The panic will subside. Life must go on. But the difficult times will continue, both in the economy and civic cohesion.

A brief guide to Keynesianism and the economic crisis

Hardly a day goes by without the dead British economist John Maynard Keynes being invoked, such as this article from this morning’s Independent. Generally it is the critics of austerity that use his name, although this article is more nuanced, blaming George Bush and Gordon Brown for getting us into this mess by ignoring Keynes’s prescriptions. And many more economists, including big names like Paul Krugman, use ideas that most people understand as “Keynesianism” even if they do not evoke the great man directly, rightly thinking it is better to appeal to logic and evidence rather than dead men, however great. Inevitably a lot get taken for granted in these arguments. For the benefit of amateur economists like me, in this long posting I want to explain and re-examine Keynesianism, in order to assess its relevance to the current crisis, especially here in the UK.

What do we mean by “Keynesianism”? It is the idea that government fiscal policy, public expenditure and taxes, should be used to counteract a deficiency in demand in the total economy. It originated with the insights of the great economist, and his reflections on the Great Depression of the 1930s. Its starting point is that a whole economy does not work like a household budget. It may be very sensible for a household to choose to spend less than it earns, but a whole economy cannot do this. Supply must equal demand; you cannot store more than a trivial amount of production from one period to the next. If across a whole economy more people want to spend less than they earn, in other words to save, then there isn’t enough demand to meet supply and the economy must shrink; people are put out of jobs and so on.

Not so fast. Things balance out of the net saving can be channelled into investment. Investment, in economics, refers to production for future benefit. This usually refers to business investment (machines to make future production more efficient) but can also refer things like building houses which are “consumed” over a long time period . But if savings are not matched by investment there is trouble.

The possibility of trading with another economy complicates the picture, of course. Net saving can be balanced out by net exports. But net exports across the world economy are zero, so this option isn’t available to everybody.

In classical economics there is no lasting mismatch between savings and investment, because markets balance the two out. If there is too much saving, then this stimulates the supply of investment opportunities, for example by reducing the rate of interest. Keynes’s great insight was to see that often this market mechanism doesn’t function properly, leading to prolonged unemployment. And unemployment is a waste; production lost forever. Much better to use this surplus labour inefficiently than not at all.

Extra spice is added to this logic by the idea of the multiplier effect. If, for example, you stimulated the economy by paying extra benefits, then the recipients of the benefit would go out and spend them, and the people receiving this spending will spend more in turn, creating further demand and so creating more work. The same logic applies in reverse; austerity tends to multiply itself too. This effect is probably what students remember best about Keynesianism. It gives the idea of Keynesian stimulus gravity defying properties – so that government spending on stimulus can pay for itself in extra taxes generated by multiplied demand (and the reverse, of course, with cuts being self-defeating).

Keynesians point to the Great Depression as an example of how things can go wrong, where excessive austerity turned a setback into a disaster, only rescued by the War (and what could be more wasteful than fighting a war?). Critics of this view, incidentally, point out that the primitive state of the world’s banking systems had a lot to with this disaster, and so you can’t really compare it to now.

After the war, demand management by governments using fiscal policy became pretty much the orthodoxy. But this went wrong in the 1970s, when a Keynesian response to the oil crisis simply led to rampant inflation, rather than reduced unemployment. What are the problems?

First of all, Keynesian stimulus can’t push an economy beyond the limits of its economic infrastructure. To do so simply creates inflation. After the oil crisis disaster, economists modified their ideas to take account of this, bringing in such ideas a as a “natural” level of unemployment, and giving a major role to monetary policy alongside fiscal policy. This set of ideas became “neo-Keynesianism” and the orthodoxy of the 2000s. It was what I was taught in my macro-economics course in 2005-08 at UCL.

A more subtle criticism is that fiscal stimulus is undermined by human behaviour. If people respond to extra money in their pockets by saving more, the stimulus effect evaporates. An idea of “Ricardian equivalence” has been developed to postulate that extra government spending would always be offset by extra saving, because people know it would lead to more tax, for which they must save. Responding to this, proponents tend to suggest stimulus to areas where this is less of a risk. For example, benefits to the hard up, rather than tax-breaks for the rich.

Another idea, in floating exchange rate economies like Britain’s, is known as the Mundell-Fleming effect, which predicts that fiscal stimulus simply causes the exchange rate to appreciate and crowds out exports (or is lost in imports). This idea is quite difficult to get a grip on, and anything to do with predicting exchange rates turns out to be impossible to prove. But it does offer an explanation of why the pound appreciated after British government’s stimulus programme following 2001. And the basic idea that fixed exchange rates undermine monetary policy while floating ones undermine fiscal policy has the undoubted merit of symmetry. So British austerity should be offset by a lower pound which stimulates exports. The first part of this prediction seems to be working, but the second is slow to come about, not least because so many of our usual trading partners are in crisis too.

But the strongest objections to Keynesians come from the so-called “Austrian” school, because its more famous advocates (Schumpeter and Hayek in particular) were born in Austria. This sees unemployment as a essential to a process of creative destruction, as inefficient and unwanted businesses go to the wall, to be replaced by better ones. Keynesian stimulus interferes with this process, in particular by leading to wasteful investment; any temporary relief is offset by longer term problems.

From within the neo-Keynesian camp there are also those who advocate the use of monetary policy to manage the business cycle, as being much more efficient and effective that fiscal policy. These seem to include the British Chancellor of the Exchequer, George Osborne.

So how to apply to the current economic crisis, and in particular to Britain? The first point is that the pre-crisis economy was built on false premises, with unsustainable borrowing and a property boom. It cannot be recreated by applying stimulus. Not everybody accepts this, but almost everybody without a political axe to grind does. The serious Keynesian argument is not about stimulus, but about the effects of austerity. Austerity policies are reducing demand, setting up a multiplier effect and causing pointless unemployment before the replacement jobs can be created.

It helps the Keynesians that there does not seem to be a big risk of inflation – or not wage inflation, anyway, which is the critical issue. This seems to be held in check by strong market forces, in the developed world at least. High price inflation in Britain is not matched by pay inflation, and it is much more about forcing Britons to accept a lower standard of living as a result of a lower pound and shortages of key raw materials.

Advocates of monetary policy are also in a weak position. It simply does not seem to be all that effective. Interest rates are rock bottom, and all quantitative easing seems to do is to keep asset prices at unrealistic levels.

Would extra saving undermine a looser fiscal policy? Britons are heavily indebted, after the borrowing binge. That might encourage them to save any stimulus money – but it also suggests that they can’t respond to lower income by borrowing more. Since we are talking about simply slowing a downward trajectory, the latter is the more relevant argument.

For me the most persuasive case for some kind of Keynesian influence on policy is made by the Financial Times’s Martin Wolf (behind the FT paywall). This goes back to first principles. Consumers are over indebted and need to spend more than they consume. Business confidence is low, which means that it is difficult to persuade businesses to invest. The potential for more exports (or less imports) is certainly there, but is limited because to many other economies are trying to play the same game. So we are exactly in danger of the doom loop of excess saving that Keynes worried about. The government’s massive deficit offsets these problems to a great extent, but reducing it too fast could well lead to excess unemployment.

But we don’t know. Austerity policies are stronger in rhetoric than practice. We can’t avoid major cuts to government services, so there is something to be said for getting them over with as quickly as practical. But there is also something to be said for having a “plan B” should unemployment start to escalate. But if the government had one, they wouldn’t tell us.

Cutting VAT is one idea, advocated by Labour Shadow Chancellor Ed Balls, since it is quite likely that it will stimulate some extra expenditure – though it is very unclear by how much. That is probably too much of a humiliating U-turn for the government. But it is a better idea than cutting the top rate of tax, advocated by some Conservatives, since that is unlikely to have much immediate effect on demand, even if it does have longer term benefits. Another idea is to ramp up investment projects – but it is very difficult to do this efficiently in the sort of quantities that would have a major impact on the overall economy. Personally I would favour a go-slow on benefit reform, which is where a lot of the cuts are focused, since mostly benefits get spent. Given how tricky this programme is already, it might happen anyway.

It would not be surprising if the government missed its deficit reduction target over the five year term. What will not be clear is whether this happens because Keynesian policies were applied (i.e. by slowing the pace of austerity) or because they weren’t (i.e. austerity strangling the economy at large). That won’t stop people being firmly on one side of the argument or the other.

Economic growth and the media circus

Today the ONS released their first estimates for economic growth for the second quarter. These quarterly figures have become the centre of a media frenzy; the papers and the BBC have been speculating about them and their implications for days. Some commentators have worked themselves up into a real state, saying these numbers will be critical to the government’s future (see this comment on one which gives quite a good idea of the general coverage before the figures have even been released). This is getting very silly.

The first problem is that these numbers aren’t very accurate; the second is that they don’t mean very much to ordinary people anyway. GDP, and the growth figures based on them, have become very interesting to economists, especially in making comparisons between countries, and looking at trends over a period of time, and compiling all manner of ratios. But they are obscure aggregates that mean very little to us day to day. The economic statistics that matter are those on unemployment, pay rates and consumer prices. Taken together these figures give you a much better idea of what life is like for real people. Further light is thrown by various other measures, like trade figures, retail sales and so on, though these are bit too volatile for single month’s figures to mean very much.

These statistics are painting a clear enough picture of the British economy. Unemployment is high, especially amongst the young, though not as bad as in previous downturns. It remains steady, with employment overall growing. Inflation remains persistently high, largely thanks to higher import costs and taxes. Remarkably, average pay is not keeping up with inflation, so we know that people are being squeezed. The fact that so much of the squeeze is being spread across the working population, rather than concentrated in rising unemployment, is the truly remarkable thing about the economy right now. This is surely a better way for the country to adjust to the new reality. But it does mean that gloom is spread far and wide.

The government should really start to worry if one of two things start to happen. First that unemployment starts increasing again. Second if pay inflation creeps up beyond about 3% (it is now about 2%), since this means that an inflationary spiral might be on hand, so interest rates have to go up. Likewise they should start to feel relief if and when unemployment gets significantly lower, and when inflation falls below 2%. The betting is that the economy will keep bumping on somewhere in between the good and the bad news for some time to come.

Meanwhile there is a very unedifyng argument about the economy going on, with people talking at each other without any serious attempt at improving their understanding. Consider this little discussion on Lib Dem Voice to which I made a couple of contributions. I think the founders of economics as a social science hoped that it would improve people’s understanding of the world around them, but so often economic arguments are just used as ammunition to support prejudices. And you can use them to argue just about anything.

All the more reason to ignore the media coverage of the quarterly growth figures.

Europe’s financial crisis gets dangerous

While the British news media and politicos alike obsess with the unfolding of the News of the World hacking scandal, Europe’s financial crisis enters a dangerous stage. In fact this crisis seems to unfolding just as quickly, and with much more important potential consequences. Was I being too sanguine last Friday, when I blogged that it was a learning curve rather than a fundamental problem? Well, probably.

I had hardly posted it than a flood of dire articles about the crisis came out. One of the best is by eminent US economist Larry Summers in this morning’s FT(£); alongside it an equally gloomy article from FT regular Wolfgang Munchau (£). Mr Summers points to the critical issue of confidence that could be destroyed in a default, drawing a parallel with Lehman in 2008. He then offers quite a plausible way out. But the problem, as Mr Munchau points out, is:

I often hear that Ms Merkel in particular has moved a long way from her original position 18 months ago, when she ruled out any money for Greece. This is true. But the crisis now moves at a rate that exceeds her political speed limit.

There’s clearly a problem. One issue is the expectation that European leaders will muddle through, as they always have. This, unfortunately, is a self-destroying prophesy. Because Europe’s leaders expect everything to come right in the end, they don’t have the incentive to make it actually happen. Actually Europe’s greatest achievements have required some strong leadership, with Helmut Kohl, Germany’s Chancellor in the 1990s standing out. Mr Kohl achieved German unification on his own terms, pushed through monetary union and the massive eastward expansion of NATO and the EU right into the former Soviet Empire. Mrs Merkel does not fill his shoes.

Still, there are plenty of bright ideas for ways out, without the Eurozone collapsing, Mr Summers’s among them. They will all require Mrs Merkel to shift her current stance. Things could get worse before they get better. At any rate it looks more soluble than the US budgetary stand-off.

The Euro crisis: structural failure or learning curve?

Coverage of the crisis in the Eurozone is astonishingly poor. Commentators scarcely try to analyse the situation properly; instead they revert to one of two unsatisfactory critiques. First, the Eurosceptic one, is that the Eurozone was always an unworkable idea and the best thing to do is abandon the whole thing. The alternative, the Europhile critique, is that a currency union without political integration was a major mistake, and the best thing to do is move further towards the political integration of the union.

These positions are both unhelpful. The Eurosceptics fail to see the benefits of the currency union, the awful logistics involved in unpicking it, or the unsatisfactory nature of floating currencies for most countries. The Europhiles want to drag European peoples down a road they do not want to go. There is a third way: that Eurozone governments change their countries’ economic arrangements so that they can live within the currency zone, more or less as it is currently configured. This crisis is a learning experience.

The more far-sighted of the Eurozone’s designers did not want full political integration. It was never to be a currency zone like the USA, with a federal government able to make massive fiscal transfers across the union to help balance out asymmetric crises. Instead the single currency, alongside the single market, was meant to act as a discipline on national governments. This would address the widespread failure of floating currencies, which allowed governments to buy time through currency depreciation rather than addressing economic inefficiency. This was a process leading inexorably to hyperinflation and economic collapse – which was very clearly beckoning for Portugal in particular before the Euro project was taken on board.

Discipline was required in two particular areas: government finances and labour markets. In the former case discipline is to be provided by the threat of default; in the zone it was impossible to evade default by debauching the currency. The consquences of a sovereign default are very severe, and European leaders sought to prevent it through the muddled Growth & Stability Pact, which sought to restrict deficits and levels of government debt. For labour markets the discipline was that without flexible labour markets, economies would become uncompetitive, creating unemployment.

But things went badly wrong almost immediately. Bond markets did not seem to believe the default story, as spreads between the more creditworthy governments (like Germany) and the less so (Italy and Greece) were impossibly narrow. Governments in the shakier countries (especially Italy, Portugal and Greece) found it much too easy to borrow cheaply and used this as an excuse for not proceeding with reform.

Labour markets were largely untouched by reform, as were other economic inflexibilities. This caused major problems in Spain, Portugal, Italy and Greece whose economies became increasingly uncompetitive. Only one country (apart from Ireland perhaps) really grasped the implications of living inside the Euro, and that was Germany. After unification the German economy lost competitiveness and unemployment became a real problem. But through its system of corporate deal-making between employers and unions, pay was restrained and other reforms instituted. Competitiveness was duly restored, as was employment. Unfortunately that made things worse for the laggards.

While the Eurozone had proved a failure in these two areas it proved a bit too successful in another: capital flows. There was a lot of reckless lending, with quasi-public banks in Germany in prominence. Capital flowed freely to countries, like Spain and Ireland, that didn’t really deserve it, allowing problems to be hidden in a property bubble. And then Pop! The Eurozone has lurched from one crisis to the next.

But the basic idea remains intact. Markets now fully appreciate the risks of default and are pricing debt accordingly. This is applying pressure on governments like Italy’s that the Growth & Stability Pact simply could not. And the pressure to make market reforms is likewise proving unbearable. It’s been a horrible experience for many, but this is not a structural failure: it’s a learning curve.

So what next? The Greek government must default, and default properly (i.e. the principal must be cut rather than repayment simply deferred). Maybe it will be forced out of the Euro. If so, it will be a terrible example. Some eurosceptics make it all sound rather easy (“decouple, default, devalue”), but it involves the utter collapse of the Greek economy with private savings being wiped out. The hope would be that it would be easier to rebuild from the ashes than interminable limping along inside the zone. Portugal and Ireland (whose crime was not to manage its banking system properly) may also go through some form of de-facto default. But they will stay in the zone. Portugal must go through a painful period of reforms, but at least for them this path is clearly better than being outside the Euro.

Meanwhile the Euro governments need to keep “kicking the can down the road”. This is not as short-sighted as it sounds, since with each kick the various parties invovled understand the situation better and what needs to be done. The default word is now openly talked of. German bluster over not bailing out the profligate is gradually having to come to terms with the role German banks played in the disaster. There is learning for the Germans too. Bold decisive action can be disastrous – it didn’t help the Irish. This way things are properly thought through.

Reforms? Fiscal reforms are unnecessary. But the banking system does need serious attention. The regulatory system is badly coordinated. There are too many cosy quasi-public banks who have been allowed to make silly investments. Banks remain largely national affairs, with only a limited number of transnationals. There is strong case for a centralised banking regulator. And cross-border banking mergers need to be encouraged.

But the Eurozone is not dead; and neither are we on the verge of a more centralised European government.

Is Britain about to go bust?

The debate about Britain’s economic policy rumbles on, with a speech by the Shadow Chancellor Ed Balls last week. In previous posts I have dismissed the claim made by some that the government’s cuts are unnecessary, and most commentators, including Mr Balls, seem to accept this, even if they don’t say so explicitly. But there is a furious debate about how quickly the cuts should be implemented: 5 years as the government plans, or 8 years as Labour suggests, apparently including Mr Balls, though in the past he has been suggested longer. An impressive array of economists seem to support the Labour argument.

The basis of the critics’ argument rests on conventional macroeconomics, and runs that cutting too fast creates needless unemployment and risks a spiral of lower demand which will make things worse. This argument is open to challenge on its own terms (see The Economist’s Buttonwood column here, or Bagehot here), but the government’s defenders don’t generally try; instead they trump it with an argument about unsustainable levels of government debt. I want to look at the macroeconomic argument in a future post. Today I will consider whether unsustainable debt really is such a risk.

If government debt gets too high, it can derail the whole economy. A default, when governments renege on the terms of their debt, can be absolutely catastrophic. The problem is that if governments can’t raise the money then all the functions of government are threatened. For countries like Greece who are part of the Euro, this means that they literally can’t pay the bills – salary payments are stopped and so on. This is such a frightening prospect that there are strong incentives for other members of the zone to organise a rescue. Countries like the UK do have another option: they can debauch their currency by paying bills with newly created money. That’s how hyperinflation starts; the most recent example is Zimbabwe, and its implications are hardly less disastrous than default.

So what are the risks for Britain? The good news is that before the crisis struck overall debt was modest by international standards at a shade over 50% of GDP. Even better, the maturity profile of this debt, i.e. how soon it has to be rolled over, was long term – longer than any other major economy. The bad news is the massive size of the current deficit – 11% in 2009, and the fact that 8% is “structural” or won’t bounce back with the economic cycle. That means that total debt is increasing rapidly; by the end of 2010 it was already 75% of GDP. This gives two main problems.

The first problem is that debt risks spiralling out of control. Few think that the current economy is capable of more than modest growth, austerity or not, which means that extra wealth is not being generated fast enough to get us out of trouble. And debt comes with an interest bill. There are some classic economic models of this, and on these the warning lights are flashing red furiously. At some point lenders (characterised as the “bond markets”, but potentially including you and me) refuse to lend, or at least start to put the rate of interest up, making things worse.

The second problem is more subtle. If total national debt levels off at a high level, this will drag down the whole economy for a long while to come, as we spend too much resource servicing the debt. One study suggested that serious problems start to happen when debt reaches 90% of GDP – less than two years away at the current trajectory. Taking longer to eliminate the deficit means that overall debt will level off at a higher amount, unless the aggressive option really does lead to meltdown.

There are three further overlapping problems for the UK. Debt markets are very open; there is a degree of dependence on overseas support; and the pound is a floating currency. Government debt problems are much easier to handle if there is ready access to lenders who are effectively forced to lend to you; this has helped such high debt countries as Japan and Italy. Superficially the UK seems to look this way: pension funds are massive, and traditionally hold lots of government debt (gilts) for actuarial reasons. But such funds are aggressively and independently managed, helping to make our financial services industry internationally competitive. That means they switch away from buying gilts as soon as they think it is not such a good deal. Dependence on overseas investors appears to be relatively modest, as buyers of gilts are overwhelmingly domestic (or so I believe). But the country still runs a significant current account deficit (unlike Japan, and even Italy), meaning that the economy as a whole does need foreign lenders. The floating pound is often presented as a get out of jail free card – but the benefits of being able to devalue are two edged. Foreign investors will be wary of sterling if they think it will devalue; domestic investors will likewise increase their overseas exposures in the same event, reducing their ability to buy gilts (unless these are issued in foreign currency, but let’s not go there).

But, the government’s critics maintain, there’s no sign of trouble, and never has been. The government has had no trouble selling gilts, at very low interest rates. The trouble with this argument is that markets can turn in an instant, and you won’t know until too late. An investment decision depends on a judgement looking far into the future, and this can move very quickly. Government ministers seem to have got a genuine fright in May 2010 with the Greek crisis. By and large the closer a commentator actually is to the debt markets, the less sanguine they are about the whole thing. There are just too many risk factors.

So what to think? The Labour plan is probably viable, if backed by a real determination to follow it through (and Alistair Darling, the outgoing Labour chancellor would have been an excellent figurehead, unlike Mr Balls). But it undoubtedly takes more risks with catastrophe. Whether it is worth doing so does come back to your view on the macroeconomic risks. If you think that the austerity programme really will lead to meltdown, then this has real power. But neither is the government argument implausible. It’s about the risks you are prepared to run.