Beware of journalists bearing history lessons

Today’s Irish Times contains this gem from Stephen Collins:

Another issue that did not get serious traction in the talks was the simplistic call to “burn the bondholders” for which German chancellor Angela Merkel has to take a lot of responsibility.

The European Central Bank was adamantly opposed to the notion as any such move would threaten the financial stability of Europe. It is ironic that the zealots of the US Tea Party movement and many of those on the left in Ireland share a common belief in “burning bondholders” and damn the consequences.

The lesson of the Great Depression of the 1930s was that taking that kind of approach leads to widespread bank failures and national economic collapse which, in turn, threatens the democratic foundations on which our society is built.

Give me a break.

The bank failures of the 1930s were due to bank runs caused by excessively conservative monetary policies, and in particular by the determination of elites to stick with the gold standard well past its sell-by date. Burning bondholders had nothing to do with it.

Insofar as the 1930s involved debt restructuring (in Latin America, for example), this was part of the solution, not part of the problem — cf. the work by Eichengreen and Portes.

The lesson of the 1930s is that slavish adherence to economic orthodoxy can lead to disaster, and that sometimes you need a radical break with past policy mistakes in order to turn around expectations and prepare the way for recovery. FDR’s abandoning the gold standard was one such radical break; there were other radical breaks with the past that were much less benign, and that were directly caused by previous hyper-orthodoxy.

Finally abandoning the socialization of private losses would not just have made the Irish state more solvent, but would have clearly signalled a new beginning in Irish political and economic life. As things stand, it is hard to disagree with Mohamed El-Erian that the present deal is not the game-changer that Ireland needs.

Forfas: Review of Labour Cost Competitiveness

This report is available here.


This report examines the scale of the competitiveness challenge facing Irish firms and considers the reasons and implications for the deterioration in Ireland’s cost base over recent years. It looks at recent labour market developments in terms of employment and earnings trends including setting earnings trends against the international context and wage movements in key competitor locations. The report also provides an overview of the key drivers of labour costs and the impact of a range of factors on Irish wage levels is assessed. Drawing all of this analysis together, the report identifies a set of actions designed to improve the efficiency of the labour market, facilitating employment creation and protecting real incomes.

Migration, the limits of internal devaluation, and the bailout

It is time to dust off old ways of thinking about the Irish economy that were useful in the past.

In the long run, migration sets a floor to Irish wages. It has been thus ever since the Famine of the 1840s, and I don’t believe that the Irish have become less mobile in the last 20 years. Now, a lot of Irish wages are still high by international standards, but eventually as ‘internal devaluation’ proceeds, and as peoples’ living standards are lowered as a result of tax hikes and cuts to public services, it seems inevitable that the ‘migration constraint’ will start to bind again.

Once this happens, then very roughly speaking the size of the Irish economy will be largely governed by relationships of the following sort:

w(1-t) + b + P = E

where w is the wage (which determines employment and output, for given levels of the capital stock and technology); t is the tax rate; b is the value to workers of the public services they receive; P is the premium we enjoy as a result of living in Ireland; and E is the living standard which we can enjoy overseas. If the left hand side of this equation falls too far below the right hand side, people will leave until equilibrium is re-established.

Once we hit this constraint, either because w falls, or t increases and b declines, adjustment in the economy will be more quantity-based and less price-based than it has been to date.

And it gets worse, since t and b depend inter alia on the levels of output and employment. There are fixed costs to running a state, and the debts we are now being saddled with are not population-dependent. You don’t have to be Paul Krugman to see the potential for some pretty nasty feedback loops here.

What can politicians do? The most obvious thing to do is to minimize the debt overhang facing this State, so that t is not higher, and b is not lower, than they otherwise would have to be. Less obviously, if politicians — not the existing ones, obviously, but an entirely new political class — can increase P, by providing people with a political project for national renewal that they can buy into, this might also help convince some people at the margin to stay at home. This is not just essential for our democracy, but for the economy as well.

Banking Crisis, Bondholders and the Single Currency Project

When a country finds itself overburdened with debt, the solution – if the debts are denominated in its own currency – is to inflate its way out of the problem. Debt is denominated in nominal terms so inflation reduces the real debt burden. Ireland cannot do this, but the ECB can. It would not do it for Ireland or Greece or Portugal alone but if Spain comes under attack, given its size relative to the European Financial Stability Facility, this option will be forced up the agenda.

What would inflating our way out of the debt entail? It can be seen as a type of orderly default. Assume for the sake of argument that the ECB is the owner of all Irish bank bonds; the Irish taxpayer currently owes these funds to the ECB. The ECB could accept a debt for equity swap, which would mean a substantial haircut, so that it – rather than the Irish taxpayer – now owns the banks. It recapitalises them by printing money and then sells them on. The downside is higher European inflation (it will have to take similar steps all across Europe because many banking debts are in fact to other banks, meaning that many will require recapitalisation) and a higher risk premium on all European debt. The risk premium could be moderated though by a pan-European regulatory system which would tackle one of the design flaws in the entire single-currency project.

The major design flaw was that there was no mechanism to tackle asymmetric (i.e. region-specific) shocks. The US has a huge federal budget which absorbs a major share of such shocks; e.g. if California goes into recession, it pays 25 cents less in federal taxes for each dollar its income drops, and it receives 10 cents more in federal funding. There is no such “fiscal federalism” in Europe (the nearest to it, the Structural Funds programmes, transfer about one cent for every dollar gap in income). Asymmetries prevail however, as is evident in that the business cycle in peripheral countries such as Ireland is out of sync with Germany and the core eurozone countries. This design flaw featured strongly in contributions made by Kevin O’Rourke, myself and others (all of us at the UCD School of Economics at the time) during the Irish national debate on whether to join the single currency. So Spain and Ireland got very much lower interest rates than were appropriate over their respective booms, which fuelled their property bubbles. The problem could have been reduced, though not eliminated, by tight pan-European regulation of the financial system.

These design flaws must be tackled in one way or another if the eurozone is not to stumble from crisis to crisis, though it is doubtful that there is the political will for substantial fiscal federalism. There is no painless way out of the current crisis, but inflating our way out of the debt and coming to grips with the design flaws look to me to be the least painful option.

I try to make these points in a politics programme recorded several days ago and due to be shown on RTE when the EU/IMF announcement is made. They’ll only use snippets so I’ve tried to join up the dots here.