Tom Holden is a lecturer in Economics at the University of Surrey. Prior to this appointment, he was studying for his doctorate at the University of Oxford. His research is focussed on building macroeconomic models of the impact of short-run fluctuations on longer-run productivity growth. He has also worked on the macroeconomic consequences of agents’ learning about monetary policy, and issues around the zero lower bound on nominal interest rates.
Do you think the euro is a viable project? Will it stay together?
The basic problem with the Eurozone is that is still 17 countries, rather than one. The ultimate success of the currency union is going to depend on whether tighter fiscal integration may be sold to European voters. For the Euro to be a success, West German voters (for example) will have to be brought to a point where they consider transfers to Greece in an identical light to transfers to East Germany. This will not be easy given the differences in culture, history and language across Europe. However, it does seem that the crisis has brought about a resurgence in European federalism, so perhaps this idealistic vision may yet be brought about (albeit very, very, slowly).
As of today (26/05/2012), the survival of the Eurozone in its current form certainly looks precarious, to say the least. But it is wrong to assume that even if Greece defaults it will necessarily stop using the Euro. The most likely outcome is “Euroization”. The ECB will cut-off Greek banks direct access to their lending facilities, but the Euro will continue to be the medium of exchange in Greece, much as the dollar was in Argentina in the early 90s. It would be virtually impossible to persuade people to use a hypothetical “new Drachma” due to the looming spectre of an immediate period of hyperinflation.
What do you think of the current strategy of austerity?
The size of government spending in many Southern European countries is large relative to any reasonable norm. So in the long-run some degree of austerity is necessary. Additionally, countries like Greece needed to make dramatic gestures in order to reassure markets and bring down the astronomical risk-premiums they were paying. The speed and severity of many of the austerity packages enacted across Europe were well beyond what was sensible though. The package enacted in Greece was so severe as to lead to political instability, reducing the chance the IMF will ever get its money back, and the package enacted here in the UK is almost certainly a contributing factor to the current “double-dip” recession. There are sizeable costs to adjusting spending, and a recession is not the time to bear them, even if the cuts in government spending might be expansionary in the long run. The austerity in the UK was particularly pointless, as the fact we (unlike Greece) have our own central bank means that we are not in any imminent danger of default, something markets understand well.
This does not mean that we should necessarily be undertaking large fiscal expansions instead. The econometric evidence for fiscal stimulus is incredibly weak, though there is some evidence that it may be particularly effective when interest rates are stuck at zero. If stimulus is to be undertaken, macroeconomic theory suggests that it should be targeted at individuals without access to credit, and that it should be restricted to changes that may be implemented quickly. In light of this, raising unemployment benefits would be an obvious choice.
Should the ECB only care about inflation?
In normal times, I broadly agree with the sentiment that central banks should be focused on fixing problems caused by nominal rigidities. In particular, I favour central banks adopting nominal wage (level) targeting. So, for example, the central bank might commit to have nominal wages increase according to some smooth exponential path. With an inflation rate target (be it price or wage inflation), when wages/prices are knocked off their path the central bank has no reason to return to the old path (i.e. prices are non-stationary). A level target mandates that we always eventually return to the original path. This has two main benefits. Firstly, expectations of a return to path mean that deviations are partially self-correcting, something that is particularly helpful when nominal interest rates are stuck at their zero lower bound. Secondly, it greatly facilitates the private sector in writing contracts that take inflation into account, reducing the distortive effects of inflation. The focus on wage rather than price inflation is justified by recent evidence suggesting that it is nominal rigidity in wages rather than prices that is the key nominal friction in developed economies.
Your question asked explicitly about the ECB, which is currently facing a highly abnormal set of problems. The costs of Greece defaulting and/or leaving the Eurozone would be immense, both for Greece and the rest of the Euro area, and the ECB does have some power to reduce the risk of this happening. (It is currently providing funds to Greek banks for example.) Just as the Fed was right to undertake QE1 to restore normality in markets following the Lehman crash, the ECB might be well advised to put inflation concerns to one side in order to purchase sovereign debt at times like the present. Indeed, the ECB has effectively been doing this, via its lending to Greek banks, which use the lent funds to purchase Greek government debt. The ECB’s concern with moral hazard issues has meant this has never attained the required scale however.
How can we prevent the economy of having a bubble behavior where so many resources are allocated to one sector until it bursts (thinking of construction sector in Ireland and Spain)?
The term “bubble” is highly loaded, and many economists are uncomfortable with it, given its popular connotations of some kind of non-rationality. Even if we restrict ourselves to rational bubbles, precisely what is meant by a “bubble” remains ambiguous. Strictly, it is a period in which prices become detached from present discounted income streams, but in popular use it is applied to any period like those you described in which prices increase, and then fall rapidly. Even ex post it is incredibly hard to evaluate what the rational expectation of present discounted income streams ought to have been.
For example, Ireland was increasing exceptionally high levels of inward migration from Eastern Europe in the run-up to the crisis, creating a lot of additional housing demand. Even now, estimates of the number of immigrants vary widely, with some as high as one million, a truly massive amount for a country the size of Ireland. As soon as the crisis hit, most of these immigrants returned home, but we cannot really blame Irish construction companies (or policy makers) for failing to predict the crisis and its effects. Indeed, even if Irish construction companies had predicted the crisis and its effects, the house-building programme might still have been rational. If they expected Eastern European labourers to return home, increasing their costs in future, then bringing forward future building to the present would have been a sensible act of intertemporal arbitrage. It’s also worth noting that the peak in Irish housing prices (in 2006) was after the start of the slowdown in the US housing market (in 2005). This is consistent with the Irish slowdown actually being caused by expectations of problems in the US economy spreading internationally. Of course, one may reasonably question the plausibility of these precise stories, but the key point is that the effects at work are complicated, with causality generally going in both directions. Blanket pronouncements about the existence or otherwise of a bubble should be viewed with scepticism.
That said, the theoretical literature on rational bubbles does agree that low interest rates increase the chance of bubbles forming. Interest rates in the US had been held very low for a prolonged period following the 2001 “Dot-Com” recession, and those in Ireland fell after it entered the Eurozone. There seems to be broad agreement that the low US interest rates in the run up to the crisis were a contributing policy mistake. Equally, the sharp rises in US interest rates from mid-2004 were a contributing factor to the crash happening when it did.
With respect to housing in particular, one long-standing policy mistake in many countries is the favourable taxation regime of housing. This is highly distortive, and is ultimately counter-productive. Policies marketed to the public as cutting the cost of home ownership end up just pushing house prices up until after-tax returns from housing investment agree with after-tax returns from any other type of investment. One of the many reasons Germany was less hard hit than other countries by the crisis is their culture of house rental, which removes some of the political pressure to give housing these tax breaks.
Do you think DSGE modelling will continue to play a fundamental role in central banking?
Absolutely. DSGE is such a broad church as to be almost a meaningless category. New monetarists, new classicals, and new Keynesians are all producing DSGE models. Although there is still disagreement amongst macroeconomists about what ought to be in our models, there is virtually no disagreement about methodology. People have a misconception that DSGE models are fundamentally tied to rationality, to full information, to market clearing, to complete markets, to the existence of a representative agent, etc etc. In fact, all of these assumptions are widely challenged within the mainstream DSGE literature. The only thing “DSGE” rules out is ad hoc behavioural rules, but we are right to be suspicious of these when conducting policy analysis, as there is no reason to believe such an ad hoc rule would not change were policy to change.
What do you think of forex investments? Where would you invest? Do you favor any instruments or countries in particular?
I am afraid the dusty towers of academia do not pay me enough to be making forex investments! Like many in my profession, I also believe in the weak form of the efficient markets hypothesis, i.e. that given publically available information, and standard levels of transaction costs (both in terms of time and money), you cannot do better than the market through active investment. This is not to say that many people do not make money through active investment, just that once transaction costs are considered, at least on average they would have made the same amount via investing in a broad, low-fee tracker fund, while also significantly reducing their risk exposure. (There is someone on both sides of every trade!) The institutions that make money are those that are able to leverage their size to take advantage of arbitrages that would be dominated by transaction fees for most investors, or those that are able to react incredibly quickly, due to having their servers located metres from the exchange. Since I’m in neither category I’ve no intention of beginning active investment any time soon. However, I can imagine that at some point in the future I may start undertaking a little forex forward trading in order to reduce exposure to exchange rate risk from investing in foreign stock market tracker funds.