What really caused the financial crisis

The Global Financial Crisis (GFC) defines how we think about our recent past, our present and our future, yet there is no clear consensus account of why it happened. There have been so many explanations put forward. On the US side these have included the Asian savings glut overwhelming the financial system, a failure of US monetary policy and a US housing bubble (and too much lending to poor people). [1] On the European side the focus has been on excess borrowing by, or excess lending to, the Eurozone periphery, and sometimes on the poor Eurozone architecture. Yet as I have read more and more on this, it seemed to me that we should be focusing on the financial sector in both the US and the Eurozone, and of course the UK. My view has become that the crisis happened because banks in the US and Europe became too highly leveraged, and were therefore a crisis waiting to happen.

It was for this reason that I found Tam Bayoumi’s presentation of his new book so interesting.

He argues that by 2002 almost all the ingredients for the crisis were in place. In Europe we had very large universal banks (combining retail and investment banking) which were far too highly leveraged. In the US retail and investment banking were separate, with tight regulations on retail banks but little regulation on investment banking leading to shadow banking (deposits effectively moved to investment banks, like Lehmans, that again became too highly leveraged). In 2002 these two were separated by geography, but a small regulation change in 2003 allowed linkages between the two to develop, and then it was only a matter of time before we had the GFC, where ‘Global’ here means the US and Europe.

How did these banks become over leveraged? According to Bayoumi in Europe the creation of Universal Banks represented a flawed attempt to create a single European market in banking. There were subsequent failures in regulation that allowed these banks to expand (increase leverage) by manipulating their own risk weighting. This allowed these banks to move into Southern Europe and North America in a big way. In the US investment banks were not regulated because of a firm belief by the Fed that competition provided its own regulation for this type of bank.

Thus the GFC was the story of an over leveraged, interconnected banking system on both sides of the North Atlantic, just waiting for a shock significant enough to bring the whole system to crisis point. The presumption, which history confirms, is that finance is naturally prone to such crises, which is why the sector is regulated, so this story is also one of regulation errors. Bayoumi argues that each one of these errors can be put down to genuine intellectual mistakes, but he did agree with me that it was sometimes difficult to tell to what extent they were also the result of political pressure from powerful financial interests.

Have governments and regulators on either side of the North Atlantic done enough since the GFC to correct the mistakes that were made? The answer is complex, and it is best you read the book to find out Bayoumi's answer. Instead I want to end by making one observation of my own. Whenever a crisis happens, in the immediate aftermath people bring their own biases to understanding why it happened. So those who had been writing about global imbalances re orientated their analysis to explain the GFC. Those who wanted to attack US monetary policy, sometimes as a way of distracting attention from the culpability of the financial sector, did so. Those that had designed the Eurozone in such a way as to avoid profligate periphery governments talked about excess borrowing by those governments.

You can see the same with Brexit and Trump. Although a protest by the ‘left behind’ played some role, the idea that they are the full story suits some narratives but it is simply incorrect, as the new paper by Gurminder K. Bhambra argues. Over time things become clearer. What this analysis by Tam Bayoumi convincingly shows is that finance always has to be carefully regulated, and failures in regulation can have catastrophic consequences.

[1] New evidence suggests that the housing crash may have actually had more to do with lending to property speculators than low income mortgage holders.

The Brexit interest rate increases and misunderstanding inflation

Last week’s rise in UK rates has been extensively analysed (see for example Tony Yates here) so I will be very selective. First, the justification for the title of this post is provided by an extract from the inflation report:

“The overshoot of inflation throughout the forecast predominantly reflects the effects on import prices of the referendum-related fall in sterling. Uncertainties associated with Brexit are weighing on domestic activity, which has slowed even as global growth has risen significantly. And Brexit-related constraints on investment and labour supply appear to be reinforcing the marked slowdown that has been increasingly evident in recent years in the rate at which the economy can grow without generating inflationary pressures.”

The last sentence is particularly important: in plain language it is saying that Brexit is contributing to lower trend productivity growth, which the Bank now put at 1.5% compared to a pre-recession level of 2.25%. The wording is chosen carefully: they are not talking about uncertainty effects, but permanent effects from a likely deal. So last year worries about the demand side effects of Brexit led the Bank to reduce rates, and now concerns about the supply side effects of Brexit are contributing to higher rates.

Whether these modest increases in interest rates continue, as the Bank are signalling, should largely depend on whether the pickup in earnings growth they anticipate actually happens. As Torsten Bell from the Resolution Foundation argues here, the set of information that might justify the Bank’s expectations of an imminent recovery in earnings growth is not empty, but nevertheless many economists regard it as a brave forecast.

However the labour market is not the only reason the Bank is raising rates. Putting labour market issues aside, they think that because firms are operating with little ‘spare capacity’, any large increases in demand will be met by firms raising prices. Ergo the Bank’s job is to use higher interest rates to stop demand rising too fast. I think this is conceptually wrong, because it underestimates the role that demand and expectations about demand play in determining investment decisions.

A firm can meet rising demand in three ways: by investing in more productive processes, by raising prices or by using more of its spare capacity. In a traditional economic upswing firms first use spare capacity, then invest, and when capacity utilisation is at a peak and there are no profitable investments to make it raises prices. At that point it is right for a central bank to step in to moderate demand growth.

This has not been a typical recovery from a recession. Firms have used up spare capacity, but have not invested in more efficient processes. This is what measures of capacity utilisation suggest (taken from an earlier Bank of England Inflation Report).

If you just take these surveys as measuring the state of the cycle (and if we ignore the Bank Agents) since 2013 the economy has been experiencing an economic boom. Yet from 2013 core inflation has been below target and falling. You can resolve this paradox by thinking about firms acting unusually, by failing to invest and meeting additional demand by utilising capacity as if they are in a boom The result of that is stagnant productivity growth.

The conceptual error is to read these capacity utilisation numbers as indicating that there are no profitable investments to make. We know these profitable investments exist, because leading firms are improving their productivity.* What we have is an innovations gap, where lagging firms are not copying leading firms and are instead holding back on investing. We do not know why they are holding back, but one obvious reason is they have expectations of low future growth and/or high uncertainty about this growth. Empirical evidence shows the strongest determinant of investment is output growth, and the obvious rationalisation for that ‘accelerator effect’ is that current growth influences expectations about future growth.

If this is right, increases in demand will be met by firms finally coming off the fence and investing, rather than raising prices. But if the central bank starts raising interest rates to choke off demand, even when it is growing slowly by historical standards, it will validate the pessimism that has been holding back investment and productivity will continue to stagnate. There is a very real danger that the Bank may be playing its part in a self-fulfilling low growth recovery.

*Postscript (8/11/17) Discussion here by Berlingieri et al shows this growing divergence between leading and lagging firms is a global phenomenon.

The journalist as amateur scientist

Paul Romer has talked about two types of discourse, one political and one scientific. He uses that distinction to critique aspects of current practice among economists. I want to do the same for journalism.

Political discourse involves taking sides, and promoting things that your side favours. It is like a school debate: you consider only evidence that favours the point of view you want to promote. Scientific discourse involves considering each piece of evidence on its merits. You do not aim to promote, but assess and come to a conclusion based on the evidence. That does not prevent the scientist arguing a case, but their argument is based on considering all the relevant evidence. There are no sides that are always right or invariably wrong.

Of course, any scientist makes choices about what evidence is relevant, and this will be influenced by existing theories. Ideally the theory you prefer can be changed by new evidence, but scientists being only humans can sometimes be reluctant to accept evidence that contradicts long held theories. But there are always younger scientists looking for new ideas to make their name. The scientific method works in time, which is why we are where we are today.

My argument is that journalists should be like amateur scientists. Amateur because part of their work will involve seeking out expertise rather than starting from scratch, and they do not have the time or resources to investigate each story as a scientist might. A term frequently used is ‘investigative journalist’, but that normally means someone who has weeks to work on one story. Instead I’m talking about journalists who only have a day. The key point is that they should not search for evidence that fits the story they wanted to write before doing any research, but allow the evidence to shape the story.

For example, suppose the story is about EU immigrants and benefits. What a journalist should note is that unemployment among EU immigrants is lower than natives. What a journalist who wants to write a story that makes immigrants look bad might do is say that the number of EU immigrants without a job make up a city the size of Bristol. This combines selection of evidence (where is the equivalent figure for natives is not reported) with simple deception: most people conflate ‘without a job’ with ‘unemployed’, rather than being people happy looking after children, for example.

If this all strikes you as obvious, at least to journalists working in broadsheet newspapers, the example above is taken from the Telegraph, and the post in which I discuss it contains a tweet from a Times economics editor saying that all journalists (and yours truly) take a stance and select facts that supports this stance.

There is actually a third type of journalism, which you could call acrobatic discourse, because it is always looking for balance. It is sometimes called ‘shape of the earth: sides differ’ journalism. Its merit is that it appears not to take sides, but as this extended name is meant to demonstrate, it is certainly not scientific. It is the kind of journalism that says the claim that £350 million a week goes to Brussels and could be spent on the NHS is ‘contested’, rather than simply untrue. In that sense, it can be uninformative and misleading, whereas scientific reporting is informative and is not misleading. Here is a twitter thread from Eric Umansky on a particularly bad example from the New York Times. Of course acrobatic journalism is easier and keeps the journalist out of trouble.

One of the side effects of acrobatic journalism is that it typically defines the two sides it wishes to balance. It therefore tends to be consensus journalism, where the consensus is defined by the politicians on either side. To see why this is problematic you just need to look at how Brexit is discussed and reported by the BBC since the referendum.

I began writing this post during the debate surrounding Nick Robinson’s Steve Hewlett Memorial Lecture. It is certainly strange for that debate to focus on outfits like The Canary, rather than the elephants in the room that produce political journalism to millions every day, who also tend to criticise the BBC whenever they get the opportunity. Yet the copy from these newspapers, and not The Canary, is regularly discussed by the broadcast media. The emergence of left social media journalism is a result of the consensus defining by-product of acrobatic journalism, which for a year or more defined the other side as the PLP rather than the Labour leadership.

I suspect many journalists would say that my idea of them being an amateur scientist is just impractical in this day and age, when they have so little time and resources. But what I have in mind (journalism as amateur scientists) is not very different from what journalists on the Financial Times do day in and day out. Chris Cook is an example of a journalist working in the broadcast media who does the same. But it is wrong to blame individual journalists for being more acrobatic than scientific, because the institutions they work for often demand it.

Nick Robinson’s lecture is much more nuanced and interesting that the subsequent media discussion would suggest. For example he identifies the problem with the way Facebook selects news that is discussed in more detail by Zeynep Tufekci in this TED talk. But there are two elephants in the room that he fails to discuss: the role of the increasingly politicised right wing press I have already mentioned, and the conflict between scientific and acrobatic journalism, both of which he praises without addressing the conflicts between them. [1]

[1] There is a clear example of this in the comments he recalls making on the Brexit debate just before the vote. He proudly says he called the £350 million claim untrue, but he then adds

“I did, incidentally, also say that the Remain claim that every household in Britain would be £4,300 a year better off was misleading and impossible to verify.”

This is acrobatic journalism at its worse. Yes, the BBC did think the £4,300 figure was ‘misleading’, but only because they did not talk to an economist who would have told you it was not. It shows a failure to be a good amateur scientist. But worse that that, this clumsy attempt at balance puts the central claim of the Remain campaign in the same bracket as £350 million a week lie, which it certainly is not.

Links between austerity and immigration, and the power of information

This discussion by Roger Scully about why people in the Welsh Valleys voted Leave is depressing although not surprising. In essence it is immigration, bolstered by local stories of Polish people coming into communities and reducing wages. I doubt if quoting econometric studies about how little immigration influences wages would make much difference to these attitudes (although that is no excuse for people in authority who should know better ignoring these studies). I think it is attitudes like this, in places unused to immigration partly because work is not plentiful, that makes some politicians say that arguing in favour of immigration is ‘politically impossible’.

This is the first link between immigration and austerity I want to draw. The Labour party before 2015 had also decided that attacking austerity was politically impossible: ‘the argument had been lost’. Focus groups told them that people had become convinced that the government should tighten its belt because governments were just like households. The mistake here, as I wrote many times, was to assume attitudes were fixed rather than contextual. I was right: austerity is no longer a vote winner. [1]

Why might attitudes to immigration change? I strongly suspect that anti-immigration attitudes, along with suspicion about benefit claimants, become stronger in bad times. When real wages are rising it is difficult to fire people up with arguments that they would have risen even faster in the absence of immigration. But when real wages are falling, as they have been in the UK in an unprecedented way over the last decade, it is much easier to blame outsiders. Equally when public services deteriorate it is easy to blame newcomers.

It is wrong to think that this only happens among working class, left behind communities. Catalonia is a relatively rich part of Spain, and there has always been resentment about this area ‘subsidising’ the rest of the country. But it is very noticeable how support for pro-independence parties increased sharply as Spain turned to austerity, although that could also be a reaction to corruption scandals.

Here is the second link between immigration attitudes and austerity. Austerity has contributed to the slow growth in real wages and is the main cause of deteriorating public services, but often outsiders are easier to blame.

This is particularly true when it is in the interests of the governing political party and its supporters in the press to deflect criticism of austerity by pretending immigration is the real cause of people's woes. This is the third link between austerity and immigration, and it is one deliberately created and encouraged by right wing political parties. In this way Brexit has its own self-reinforcing dynamic. People vote for it because of immigration, its prospect leads to falling real wages as sterling falls and the economy falters, which adds to bad times and anti-immigrant attitudes.

If all this seems very pessimistic, it shouldn’t be. While the right will almost certainly continue to play the anti-immigration card in the short term, because they have few other cards to play, they can be opposed by a left that makes the case for immigration. As just as views on austerity have clearly changed, so can views on immigration. particularly once hard times come to an end.

However it is a mistake to imagine it is all about economics, or even ‘culture’. One of the unfortunate consequences of the culture vs economics debate over populism is the implication that one way or another views are deterministic, and the only issue is what kind of determinism. The reason I go on about the media so much is that information matters a lot too. Although people may be anti-immigration because they have xenophobic tendencies which are reinforced when times are bad, they can also be anti-immigration because they have poor information, or worse still have been fed deliberately misleading facts.

In my intray of studies to write about for some time has been this paper by Alexis Grigorieff, Christopher Roth and Diego Ubfal. (Sam Bowman reminded me it was there from this piece.) It is well known that people tend to overestimate the number of immigrants in their country. This international experiment showed that when people were given the correct information, a significant number changed their views. What is more, this change of view was permanent rather than temporary. Here is a VoxEU post about an experiment from Japan pointing in the same direction.

As well as emphasising simple information like this, politicians should expose the kind of tricks people promoting tougher controls on immigration play. The public tends to be receptive to the idea that it is beneficial for the economy to have immigrants with important skills, so they switch to calling for controls on low paid, low skilled workers. As Jonathan Portes demonstrates, that in practice can involve plenty of pretty skilled workers. The trick for pro-immigration politicians is to ask which occupations do we want to exclude: nurses, care workers, construction workers, primary school teachers, chefs? With UK unemployment relatively low, there are not many jobs where employers are not complaining of shortages.

Of course most people want to stop immigrants coming here and claiming unemployment benefit. This is why newspapers keep playing the trick of talking about the large number of migrants ‘who are not employed’, conveniently forgetting to mention that this includes people like mothers looking after children. In reality unemployment among EU immigrants is below that among the native population. In addition, we can already deport EU immigrants that remain unemployed under EU law if the government could be bothered to do so.

For politicians who do want to start making the case for immigration, the place I would start is public services. Few economists would dispute that immigrants pay more in tax than they take out in using public services. Yet most of the public believe the opposite. In this post entitled ‘Is Austerity to blame for Brexit’ I show a poll where the biggest reason people give for EU immigration being bad is its impact on the NHS. Getting the true information out there will have a big effect. Just as public attitudes to austerity can change, so can they over immigration, but only if politicians on the left start getting the facts out there.

[1] To be fair, whether I would have been right in 2014/15 if Labour had taken a clear anti-austerity line we do not know.   

A short guide to why we should not raise UK interest rates

Everyone expects the MPC to raise rates on Thursday. This would be a mistake. Discussion about interest rate changes in the press normally involve large amounts of data and charts about the state of the economy. Here I want to do the opposite: to present the minimum you need to know to understand that raising UK rates right now is the wrong thing to do.

Everyone should know that UK inflation is currently around 3% because of the Brexit depreciation. But because the impact of a deprecation on price inflation is temporary if wage inflation remains flat, the Bank said they would ignore this temporary rise. The key is to look at whether average earnings inflation is responding to higher consumer price inflation. The answer is they are not: average earnings growth has been slightly above 2% all this year, which is a little lower than the average for 2016.

But what about unemployment being at a 42 year low? Surely that means earnings growth is just waiting to kick off. The first point is that unemployment is not currently a good measure of labour market slack. A better measure is the Resolution Foundation’s underemployment index, which is still above levels before the global financial crisis. And before you say but that was a boom period, it wasn’t. UK core inflation was below 2% throughout, and earnings growth was consistent with this.

The other thing to say is that it is quite wrong to assume that we know what the level of labour market slack is that would lead to increases in earnings growth (what economists call the NAIRU). The NAIRU moves over time. As just one example of why it might move, a labour force that rents is likely to be more mobile than one that owns a house, and so the trend towards renting should reduce the NAIRU.

So looking at the labour market, there is no sign that we are close to a level where earnings inflation might pick up. And that is pretty well a precondition for inflation to exceed its target of 2% over the medium term. That is all you really need to know. If you want to know why the MPC probably will raise rates, read on.

What I suspect the Bank are worrying about is that Brexit has created what economists call a negative supply shock. In particular, both investment and productivity growth are much lower than the Bank were expecting before Brexit. They will point to various survey measures which show firms do not have any spare capacity. But this reasoning I think indicates a conceptual weakness.

Firms have two responses to lack of capacity: raising prices or investment. By choking off demand and raising rates when firms run out of capacity the Bank will discourage investment, and right now what the economy desperately needs is more investment and the productivity improvements that brings with it. The Bank shouldn’t worry about a bit of inflation that might come with higher investment, because 2% earnings growth is an anchor that will prevent inflation deviating from target for any length of time.

That should be enough, but there are two other reasons why the Bank should not raise rates. First, right now the downside risk on the demand side from Brexit surely exceeds the upside risk. Second, as the OBR chart here shows (look at orange bars), after a pause in 2017 austerity is planned to return in 2018 and 2019. Combining fiscal and monetary tightening in a boom would make sense, but we are currently in an economic downturn, with GDP per head growing this year at a third of its average pace since the recession of 2009. [1]

Finally, it is always important to consider risks. Suppose earnings growth does pick up sharply just after the MPC’s monthly meeting. The Bank always says it wants to be ‘ahead of the curve’, to avoid too rapid an increase in rates. This is the mentality that has led inflation to undershoot in the US and Eurozone since the recession, and if you take out the impact of depreciations by looking at the GDP deflator the same is true for the UK. The problem for the UK economy since the recession has not been too much inflation, but far too little demand.

[1] Specifically, average growth in 2017 is 0.1% per quarter, and averaging quarterly growth rates from 2010 Q1 to 2016 Q4 gives 0.3% per quarter          

Why is the UK making such a mess of A50 negotiations?

The obvious answer to this question is that the negotiator, the UK government, is completely split on what it wants. But that is only part of an explanation for this shambles. In the first year I think actions were dictated by a completely unreal perception about power, and perhaps more recently by a need to avoid a coup by the hardline Brexiteers.

The people who might have thought about the negotiations before the vote itself, the Leave side, didn’t do so partly because they didn’t expect to win. But they also had completely unrealistic expectations of the relative power of each side. This was an advantage during the campaign, because they could say ridiculous things about the economic consequences of Brexit without knowing it was a lie. But once they had won, there were only two ways to go, and either of them led to an early implementation of Article 50.

The first possibility is that after the campaign they continued to believe that German car makers would pressure the German government and the EU to give us what we want, so why not bring that on by triggering A50. The second was that they began to doubt this, but that in turn led to a fear that once the people found out they had been told falsehoods about leaving they would change their minds. That too lead to an urgent need to trigger A50 before this happened.

But Leavers did not have a majority in parliament. Remain MPs must surely have realised that the EU had much more power than the UK (the proportionate cost of no deal is much greater for the UK), and that once A50 was triggered the clock was ticking for the UK, not the EU. David Allen Green has justifiably said I told you so, and I knew when I wrote a post entitled “The Folly of triggering Article 50” in November 2016 that I was just repeating expert opinion, and to be honest common sense. As I said there

“this has absolutely nothing to do with whether you voted to Remain or Leave. Anyone who actually wants a good deal from the EU when we leave should realise that the UK’s negotiating position becomes instantly weaker once Article 50 is triggered.”

The worst explanation for why the majority of MPs ignored this advice was that they didn’t hear it. (We know the Prime Minister did hear that advice from Sir Ivan Rogers.) Almost as bad was that they heard it but thought it was just a desperate ploy by experts to delay leaving. Those who want to say it is all because of mixed motives from the Labour leadership will do so. But I suspect there is a simpler explanation: MPs felt voting to delay was ‘politically impossible’.

Part of the reason it was ‘politically impossible’ is that the standard of reporting and debate among broadcasters on these issues is so poor that the argument that triggering A50 was bad tactics would simply not have got a proper hearing. In addition the tabloids would have screamed “enemies of the people” just as they did when three judges allowed MPs a vote. In this sense our media not only gave us a Leave vote, they forced an early triggering of A50 which was not in the country’s interests.

As I wrote in that earlier post, it “would only be a slight exaggeration to say [triggering A50] allows the EU to dictate terms” which is exactly what they are doing. In these circumstances, the best approach to the negotiations is to treat them as a cooperative exercise rather than a zero sum game. Yet we were led by Theresa May and David Davis, who were instead determined to treat this as a classical zero sum negotiation where, because you had more power, your best hope was to make the other side believe you will walk away. Yet that walking away threat was never credible, partly because of reasons already given, but more importantly because a deal on the EU's terms was better than no deal.

But despite this, in our negotiators minds the delusion that we have power in these negotiations as long as we threaten to walk away seems to persist. The lack of flexibility by the EU can be dismissed as them playing hardball. As firms move abroad because they need to plan and they cannot be certain of any transition arrangements, the cost of delusion will be paid for in lost UK output and lower incomes.

It is just possible that both May and Davis have begun to realise this, but the delusion of power has been replaced by something else, which is the fear of a coup by Brexiteers. The pro-Brexit views of Tory party members makes such a threat credible, but any coup would have to happen well before the negotiations ended. Perhaps the reason May is now being so slow to move is to make the possibility of a coup less likely. But perhaps that involves a level of strategic thinking the Prime Minister is not capable of and Davis has simply given up.

Whatever the motivation, the end result has one certain consequence: the economy is damaged. As one final example, take the length of the transition period. The logical thing to do is to have a transition period until a new trade agreement is agreed. Anything else involves significant economic and administrative costs. But the UK government does not seek this because it pretends a trade agreement can be done quickly, and it pretends this nonsense to avoid a confrontation with the hardliners.

Even if this turns out to be pretend and extend, because the transition period will keep on being rolled forward at the last minute, this arrangement suits the EU and damages the UK. It is good for the EU because their exports to the UK do not suffer. It damages the UK because the uncertainty continues to make moving production to the EU rather than exporting to the EU attractive. Just one more way that the fantasies of Brexit hardliners are costing us all.

A European Monetary Fund

Sapir and Schoenmaker at Bruegel have a discussion of what a European version of the IMF might look like and do. Here are my thoughts on the sovereign debt (not banking) side, which I am sure will be regarded once again as radical and will therefore be ignored.

I think some new Eurozone institution is necessary, but not for the reason that most people might think. The idea that the Eurozone might have a common fund that lends to Eurozone countries in fiscal difficulties with associated conditionality, as the IMF does, is a terrible idea. We know it is a terrible idea because of Greece.

Think of the following scenario. A country getting into difficulties is lent some money by the EMF. That sum increases as existing private investors take fright. For whatever reason the ‘recovery plan’ imposed by the EMF goes wrong, and it becomes clear to all neutral observers that the country needs to default on its debts, including those to the EMF. As the EMF loan is regarded as ‘our money’ by a good part of the EZ electorate, this default is resisted and punitive austerity is imposed on the country so that the EMF can get its money back. This does not happen to the IMF because the electorate in any individual country do not think of their loans as ‘their money’, but it is naive to believe that wouldn’t happen with an EMF. It is exactly what happened in Greece, and it is also why moves to a political union are far too premature..

This raises an obvious question: why have an EMF, when we have an IMF? The wrong way of thinking about that question is that the Eurozone needed to supplement the IMF during the last crisis. The last crisis is not a good example because the ECB did not operate OMT until September 2012. The right way to think about the past is what would have happened if OMT had been operating from the start.

The ECB is (rightly) only prepared to operate OMT for a country that is returning its financing to some sustainable level. For some countries that may not be possible, or desirable, without default. That was the case for Greece. For others that will be possible without default, as Ireland and Portugal have shown. You need somebody, or some institution, to decide which category a country finds itself in. But whether default is needed or not, a recovery plan (austerity) has to be put in place to return the public finances to sustainability and once that plan is in place OMT then operates.

Once that happens, I think any lending should be done by the IMF for the reason I have already given [1]. However it may well be that as long as the austerity is sensibly mild and drawn out [2], private sector lending will resume because of OMT.

I think a new institution to do both the job of initially deciding about default and to create the recovery plan would be a good idea. But both decisions have to be kept as far away from politicians as possible. The reason again comes from history: the loans to the government that may require default are likely to be from banks or institutions in other EZ countries. That creates a serious bias towards ‘lend and pretend’, as we saw with Greece. 

How can you achieve such independence in the EMF? In addition, how do you justify giving an institution staff and resources when it hopefully will be hardly ever needed? One answer could be to use the IMF, although at the moment the IMF is not sufficiently independent of EZ politicians. Another is to utilise the network of independent fiscal institutions or fiscal councils that every EZ country now has. If those institutions live up to their name, they should be independent of politicians. In addition, they have exactly the expertise to decide on any default and to put together a recovery plan.

Now the great thing about this set-up is that it allows fiscal autonomy in countries that have not got into fiscal difficulties. Fiscal discipline through the market is restored, because there is a clear default risk (but not the self-fulfilling default risk that operated before OMT). There would be less of a feeling in countries like Germany that they had to worry about fiscal policy in other EZ countries because they will pick up the tab because there will not be any tab to pick up. In that sense the no bail out rule is restored. 

What would the Brussels machinery that currently monitors each EZ country do? Am I proposing to put some Brussels bureaucrats out of a job? Not necessarily. A potential problem with the system I suggest is that fiscal councils will be captured by their governments. Brussels could ensure that the fiscal councils are independent, which would involve checking their assessments and forecasts (or even supplying them with forecasts).

I can predict with almost certainty that some comments will be that I am taking crucial decisions away from democratically elected politicians and giving them to technocrats. We have enough of that in the Eurozone as it is they will say. There are two simple responses. First, in the absence of the Eurozone, governments that were no longer able to borrow would face the technocrats at the IMF. Second, we have tried the democratic route and it has failed spectacularly for reasons that will not go away in a hurry. 

There you have it. A feasible plan to increase sovereignty in the Eurozone and mitigate another Eurozone crisis and avoid another Greece. Now tell me why we have to move to fiscal and political union.

[1] Obviously in that case the IMF would also have to approve the recovery plan.

[2] A short sharp shock will almost inevitably lead to damaging negative feedback on output, perhaps creating another Greece.