What Have We Learned From The Crisis So Far?

Just like Paul Romer once said "a crisis is a terrible thing to waste". A crisis is good for several reasons: first of all it makes you understand what you have been doing wrong and allows you to fix it; whether you are willing to accept change is nonetheless something completely different. Second, it makes you get rid of your prejudices and third it makes all those theories which we have been bombarded over the years and had no connection to reality fail spectacularly. Just everything in life, we can learn a lot more from a difficult situation than from an easy one. What follows is an extract from what I believe were the most important revelations of the crisis:

1. Prices are sticky

If we exclude a small interval in 2009 in Portugal, Spain and Ireland, inflation has not been low in the countries where most of the attention has been over the past 2-3 years. The 2009 incidents can be attributed to the sub-prime lending crisis and not the European one; when the government spending cuts, reductions in wages and salaries and increases in taxation occurred, the inflation rate did not fall as spectacularly as many had expected. In fact, in cases like Greece, deflation (which should be the natural outcome of decreased money supply in the economy) did not occur until more than 2.5 years later. The trend one might argue, has been negative in Greece. True, but this does not mean anything: if austerity was to work as it was meant to be, what we needed was deflation not disinflation.

2. Wages are Sticky - Unemployment is not

Source: A Cross of Euros

The graph above hardly needs any commenting. Employment has been steadily falling in all 4 countries while wages have been falling just in Greece and increasing in all others. Even the decrease in Greece is not as large as the decrease in employment which fell by 20% whereas wages by a mere 7%.

3. Lower GDP means higher debt ratios

I cannot even remember how many times I have said this over my blogging life (but here's an example). There is nothing more mathematically obvious than this and yet it has been largely ignored by most. If a country's debt is 100 and it's GDP is 80 the the ratio is 125%. If GDP falls to 70 then the ratio goes to 143%. How more obvious can it get? That is the reason why Greek debt has been on the increase despite the 70% PSI (which forced Cyprus to bankruptcy) and various other attempts to decrease it.

4. Even if we get deflation, it increases the real value of debt

The point of austerity was supposedly to decrease spending and simultaneously decrease prices and costs. As we have seen in points one and two, this does not really happen. Yet, what we also forget is that deflation is bad for banks as well. Let's say I borrow 100 from my bank at a time when my salary is 10 per month. Because of the austerity measures and the decrease in wages and prices I now earn 8 per month. No big deal one might comment since all goods prices have decreased; all but the loan installment though. If I had been spending 5 and paying the other 5 to the bank, with a 20% decrease in wages, I will now be spending 4 and paying once more 5 to the bank, for a total of 9, 1 unit of currency more than my salary! This is nothing new really. Irving Fisher knew this in 1933 and many others, such as Mervin King the former governor of the Bank of England, made even more research on the subject. What got economists confused was that deflation is good in a simple recession but not at all good when we have a banking crisis in addition to a recession. When a recession occurs, deflation is a natural outcome which helps the economy recover; when we have a banking crisis, the already deteriorating balance sheets are better off without the added pressure of deflation forcing more lenders to default on their loans.

5. Fiscal Multipliers are greater than one in recessions

Don't take my word for it; just look what other researchers have done. Data from the 1930's are consistent with "(..)the idea that the impact of fiscal stimulus will be greater when banking system are dysfunctional and monetary policy is constrained by the zero bound." In essence, financial crises cause spending multipliers to increase by much more than their original values (multipliers in the sample varied from 0.4 to 1.9) with this making their effect much higher on the real economy.

6. People and consequences are all in the short run

How would you feel if you had no money today and someone tried to console you by saying that you will have some money 3 years from now? Not too much of a consolation I am sure. People do not live waiting for the long-run to materialize. Despite economic modelling, they cannot postpone all of their consumption for the future even if they want to; they will simply die trying. Similarly, looking at the long-term does not assist a country which has a 28% unemployment rate and whose people are fed up with policies. The time-frame in which politics occurs in the short run, whether we like it or not and this is what we have to deal with. 

Would the European South be better off had there not been for such policies? Most likely yes. But we should not forget the benefits of the euro in such circumstances. The only reason southern countries did not face a "textbook" triple crisis (banking crisis, sovereign crisis and currency crash) is that they did not have their own sovereign currency. In this case, having strong countries in addition to weaker ones helped in stabilizing the currency and not let it take a free fall (even though it had been depreciating over time).

Did these countries deserve to find themselves in such situations? Most likely yes, yet, in most of the times the punishment was much worse and much more prolonged than the sins committed. Knowing the above would have made it easier on the citizens of each country. Summing up, we have had the opportunity to learn from this crisis. Yet, as already said, whether we are willing to do so and whether we will not repeat such mistakes when we may be forced to face similar trouble is something that is completely up to us.

The Banking System Made Simple

One of the most popular discussions on the web is banking. Numerous commentators have been commenting on how banks work or how we perceive that they work. These views are occasionally correct while they are also occasionally wrong. In addition, a relative confusion on how bank loans are created or why deposits are needed by the banks appears to exist. What follows are three simple examples intending to indicate how banking really works, how deposits and loans are created and how the Central Bank functions in a financial system.

In all examples, we assume (for simplicity) a closed economy where banks face a mandatory reserve requirement of 10% and a Tier 1 ratio which cannot fall under 10%. It is also assumed that the money needed in the economy for transactions is on average a fixed amount M (already existing in the economy) and all loans have a fixed risk weight of 40%. 

Note: all of the above assumptions can be altered with no change to the conclusions reached.

Example 1:One-Bank Economy

In this economy we have a bank which has in its balance sheet deposits of 100 units of currency with its equity being 10. In period 1 it decides, according to the regulations imposed above, to lend out 90 units. These units, we have just one bank in the economy will be deposited in the banks' accounts. A simple balance sheet would indicate the following:

Then, the bank would continue to operate under the same way until it reached the limit of 10%. This limit is nevertheless not the one imposed by the reserve requirements but by the Tier 1 needs. The reserve requirements would, under these assumptions, allow the amount of loans available in the economy to reach 1000 units had there not been for the Tier 1 ratio which essentially forces the bank to stop at 250 (for more details about the money multiplier see this). The "final" balance sheet would look like this:

Example 2: Two-Bank Economy

Now let's suppose that 2 banks exist in the economy, both having a 50% share of the market. Their equity values would be 5 each and their starting deposits would be 50.

In the first period of time, each bank will lend 45 units to the public. Each bank knows that it controls only 50% of the market thus it makes sense to expect 22.5 of those units to be deposited in its rival. Yet, the total amount of loans in the economy has not been altered even though the banks are now more and lending less individually. Total loans will still be 90 and they will be divided equally between each bank. Thus, each bank now knows that if the other bank lends as much as it will they will both get back in the form of deposits as much currency as they have provided as loans. In addition, the number of banks is irrelevant to the conclusion, as is their market share. If we had 10 or 200 banks in the economy total loans would still be 90 and the market share would have been the same after the lending as it was before. More still, the situation would not have been altered even if market shares were unequal. 

With some frictions, this is what most commonly occurs in real life: as banks do not have the same amount of loan applications or do not grant the same amount of loans in each period of time, market shares are continuously changing. Thus, although banks (usually) want to lend until their Tier 1 limit is reached, they cannot do this as easily (either because of lower demand or because applications do not match the perceived risk-reward profile needed) thus making market shares and loans growing at different paces in every bank. In addition, reputation makes a great difference; banks who were leading the market once are now mere followers as clients view others as better alternatives.

Example 3: Two-Bank Economy with a Central Bank Providing Liquidity

Assuming that the previous initial conditions hold, the situation should theoretically be the same. Yet, reality is different. Since the Central Bank can provide liquidity (what is called ELA in the Eurozone) for banking needs then it means that the banks can allocate their loans based on demand and not based on their liquidity constraints; what the Central Bank essentially does is eliminate the liquidity constraints in the short-run by lending banks. 

The situation would unfold as following: In period 1, banks face increased demand and decide that they should lend 60 units each instead of the 45 they are allowed by their liquidity constraints. This means that the Central Bank has agreed to lend an additional 21 units of currency (additional 10 to cover for the difference from 50 to 60 and another 11 so that they can have their regulatory minimum and not fact trouble in their day-to-day operations) to each bank with the banks promising to return it at a later date. The banks' balance sheets would now look like:

Notice that the Tier 1 ratio was 28% in Example 1's first period while it is 21% now. The reason is simple: more loans can be generated in less time using the Central Banks' available liquidity. 

A question is how the Central Bank will get its money back; after all this funding is nothing but a loan to the bank. Notice now that the bank who received the funding still has received 60 units of capital as deposits back. Now, according to the rules, the bank only has to maintain 11 units (10% of total deposits, i.e. 110) for liquidity. This means that it can afford to give the liquidity back to the Central Bank, hold the regulatory minimum for liquidity and still have 28 units (60-21-11) at hand which it will be able to lend in the next period.  That is if the bank does not get any more funding from the Central Bank to boost its loans.

As with example 2, in reality things are a little different. Banks not only borrow from the Central Bank but from each other as well, since their liquidity is changed every day (as stated before loan grants and demand is unequal between banks) and they may find themselves in need of some extra cash or have some extra liquidity which they prefer to lend out in order to get some interest instead of having it idle.

From the above examples we can derive the following conclusions:

• Deposits matter with regards to liquidity. Yet, they do not matter to the amount of loans to be given. As the balance sheets have indicated loans cancel out since their creation is a simultaneous creation of an asset and a liability. Thus, the bank has no limitation to the amount of loans it can create other than the regulatory capital requirements (e.g. Tier 1)
• The amount of money given by the Central Bank will be returned to it, yet its effect will be permanent. If the Central Bank agrees to give X units of currency to the banks then the money supply will be increased by more than X permanently even if banks return it to the Central Bank. This happens because that money is created by the banks and even if the extra liquidity is returned the amount of loans in the economy would have still been increased.
• The starting value of deposits is irrelevant. It does not matter whether initial deposits were 10 units of 10 million units. The amount of loans to be granted will be exactly equal to the amount allowed by the regulatory requirements and not by the initial state of deposits (obviously, deposits have to be greater than 0 for this to work since the bank cannot print money).
• The more cash at hand and the more government bonds banks purchase the more money supply they can create since both instruments are of zero risk weight and are thus excluded from the calculation.
• Increased regulatory requirements at a given amount of equity, means that less loans can be created, thus making money supply will in general be less; an increase in the regulatory requirement (e.g. from 10% to 11%) means that ceteris paribus less new loans will be created in the future. This situation is evident in the EU at the moment.
• The only way for money supply to be increased is for banks to raise more equity. If it is raised then more money can be created in the economy.

As the reader has seen through this analysis, the way banking works is not as complicated as we usually think it is. Nevertheless, understanding how the banking system works is paramount to the economy and has been an issue which had received much less attention than it should have. As stated above, the examples can be very easily extended to include more complexity; yet understanding the larger image can most of the times provide us with more knowledge than by narrowing our focus to the specifics of banking.

Why Austerity Doesn't Work as Expected

Proponents of austerity appear to have the impression that the whole supply and demand issue (as discussed here) holds and prices adjust automatically to any fall in demand. Truth is, this does not appear to be the norm in real life. Inflation data from Greece indicate the following:

The three vertical lines indicate the three austerity packages passed by the country's parliament. The most shocking observation is that prices did not fall not even after the third austerity package. Data show that the first reduction in prices occurred in January 2013, i.e. 2 years and 8 months after the first austerity package (in May 2010). In comparison, data from the other countries which have been struggling with austerity show similar patterns:

(Vertical lines again indicate austerity packages. Gaps indicate lack in data.)

As the graphs show, Ireland has been luckier than Portugal in the sense that prices were falling before the austerity package came along. However, we cannot infer that the austerity package has indeed caused the reduction in the inflation rate. It is more likely that the reduction had been caused by something completely different and the packages may have helped to prolong this phenomenon. As the above graphs indicate, all sample countries had an inflation reduction in 2008, which is probably the outcome of the sub-prime crisis in the US.

Increased inflation indicates that people can afford less with a given amount of money. Then, as unemployment increases, the amount of money circulating in the economy is reduced. Thus, reduced money in addition to increased prices means that consumption is much less than expected. Then, as consumption falls, GDP falls and the vicious cycle continues. This self-perpetuation of contraction is a notion very similar to the Debt-Deflation Theory of Irving Fisher, which appeared in 1933(!) in the aftermath of the Great Depression; it is more recently presented the other way around (i.e. borrowing and boosting growth can result in less debt) by DeLong and Summers about a year ago. According to Edward Hugh a version of this has appeared in Spain and we can almost be sure that this has happened (or will happen) in probably every other Southern country.

The big question here would be why are not prices lowered as soon as producers witness a drop in consumption? Well, the world does not really work that fast. First of all, a producer cannot fully distinguish a permanent drop in sales from a non-permanent one unless some time passes. The reason for that is that sales fluctuate significantly over time (e.g. seasonally or over business cycles). Then, even though sales drop, the cost of producing (i.e. raw materials, etc) does not; the producer's supplier is further back the chain and will need an even larger amount of time to realize a drop in consumer demand. Only when the producer reduced order sizes over a long period does the supplier note the change. In addition, a drop in producer prices (as can be seen below) does not necessarily mean that consumer prices will also be reduced since the transfer mechanism takes a significant amount of time to understand that this reflects a permanent reduction. As it appeared, oil prices started an upwards trend in early 2009 so the producers were right in not reducing their prices significantly (the reduction can be largely attributed to an oil price reduction of more than 50% in the fourth quarter of 2008).

The above arguments have been one of the reasons that Moody's (and every other ratings agency for that matter) has been unwilling to increase the ratings of any country in which harsh austerity measures have been implemented. It appears that the agencies have a clearer view on the subject than politicians and policymakers. Lately, it has been suggested that the UK downgrade by Moody's is more of an opportunity than a calamity. The rationale behind this suggestion is that it provides policymakers the incentive to realize that austerity measures are not helpful to the economy. In Moody's words the UK's "most significant policy challenge is balancing the need for fiscal consolidation against the need for economic stimulus". The same would hold for the rest of Europe as well.


Although the debate on Fiscal Multipliers has been raging over the past months Simon Wren-Lewis is correct to note that their sign (i.e. that it's positive) has never been argued. Yet, for some politicians (like David Cameron who still believes that "(...) we are making the right choices. If there was another way I would take it. But there is no alternative." ) nothing of the above holds as it is too "complicated" to see that austerity measures bring more trouble to the economy than increased public debt.

If each nation has the politicians it deserves then people surely deserve the outcome of their (irrational) decisions...

Fiscal Multipliers Explained (and Proved)

The Panic of 1837, blaming the Treasury Policies of Andrew Jackson

The IMF spokesperson, Mr Jeffrey Rice, said the following in a Press Briefing in Washington about 10 days ago:

(...) there's been a lot of discussion of this fiscal multiplier, which is probably something very few people had heard of until some months ago.(...)

I have shown the inaccuracy of Mr Rice's statements in a previous post and have no intention of doing the same again. It appears that the publication of Oliver Blanchard and Daniel Leigh's IMF paper about the problems of forecasting multipliers has caused more stir than it should, because it essentially does not say much. Quoting from their conclusions (page 19): "Our results suggest that actual fiscal multipliers have been larger than forecasters assumed. But what did forecasters assume? Answering this question is not easy, since forecasters use models in which fiscal multipliers are implicit and depend on the composition of the fiscal adjustment and other economic conditions."

What has not been noted in the existing literature of comments about the paper is that it does not really estimate multipliers or anything similar. It just points that the estimations concerning these multipliers, when the IMF staff were making them in 2008, can be proven wrong, ex post. (For those interested the IMF staff assumed a multiplier value of merely 0.5. We will see later why this does not appear to be very valid)

Thus, what we may infer from their comments is that the previous models of estimating multipliers had been wrong, yet they are not proposing how these errata can be fixed. In fact, they are not actually even saying how a multiplier actually works or how it affects the economy. Since many economists and politicians do not appear to understand the rationale of fiscal multipliers, I have decided to play the game on their own terms.

Let us consider the following model:

In each country the yearly output is measured by GDP=G+C+I+NX where G stands for government spending, C for Private Consumption, I for Private Investment and NX for Net Exports (Exports - Imports). We assume then that G is increased by €X billion. The amount of G here is unimportant to the result we are about to reach.

First of all, we have to understand where the €X billion chunk of Government Spending goes to. Wikipedia states that Government spending is the sum of government expenditures on final goods and services. It includes salaries of public servants, purchase of weapons for the military, and any investment expenditure by a government. Thus, we may safely conclude that this amount goes right into the consumers' pockets in forms of salaries, or other payments towards companies or individuals. 

Then, what do these consumers do with that €X billion "given" to them by their government? As usual, they have two options: either spend it or save it. There is also the option of repaying their loans but this falls in "saving" part for reasons which are not the purpose of this article. We may assume that this €X billion amount is saved or consumed in any fraction we can think of. Here we will note it as s*€X billion where is s signifies the amount saved in banks or other institutions (hiding under the mattress is not an option here!) and (1-s)*€X billion the amount consumed.

As it may have become visible through this analysis, Private Consumption will be increased by (1-s)*$€ billion. Then, if we believe neoclassical economics, i.e. David Ricardo or Alfred Marshall, all savings are used in the form of loans to entrepreneurs by banks and thus Investment is increased by s*€X.

What can be seen here is that through the standard measures of GDP, Government Spending is calculated twice. Once as spending by the government in the G part of the equation and then partly as an increase in Private Consumption (in C) and an increase in Private Investment (I). The total increase of C and I equals €X.

Now imagine if Government Spending was to be decreased by €X. The total contraction of GDP would equal €2X in the above example. (In the real world this amount might be slightly exaggerated or underrated, since other issues may also arise. For example the economy's rate of growth would cause the effect to be less but a further decrease in consumption as a result of people's fear about the future would contract GDP even more.)

For the skeptics, let us assume that neoclassical economists are all wrong and that the fraction of G which ends up in banks does not find its way to the entrepreneurs. Then the an €X increase in G would mean a (1-s)*€X+€X increase in GDP, which is still greater than €X. The decrease would go the other way around.

Are we forgetting something here though? If the reader was careful during the above analysis the fact that in the definition of government spending transfer payments, such as social security or unemployment benefits are not included should have rang a bell. Now, think about it again: transfer payments are being employed the same way as government spending, i.e. given to people for them to consume or save. Now, have a look at the following data compiled in an older post:

Now I will not even suggest that all of this money goes unnoticed in measuring Government Spending for GDP (although probably most of it does). Yet, even if 40% of the above amounts goes unnoticed and as already mentioned, people consume or save that amount, then an €X cut in the benefits would mean a 0.4*X*(1-s) reduction in consumption and a 0.4*X*s reduction in investment. In total, even though these amounts are not measured in GDP their effect appears to be of great importance.

The above are in accordance to empirical findings by the IMF (have a look at this article, pages 41-43) which now estimate that fiscal multipliers are in the range of 0.9 to 1.7. (This admittance that the multipliers were actually higher than they had expected, did not actually gain much publicity, only in the form of articles like Is the IMF short for I Must Fail?) Although the 0.9 number does appear to be rather too little based on the previous analysis, it may occur if the change in spending is little and the country experiences strong growth (although it would be tremendously difficult to achieve such low values for rapid changes in the level of spending) the 1.7 one appears to be more in the line of the above simple model.

Conclusion: Government spending is affecting GDP more than we believe. This means that we either have to alter our understanding about it or change the way we measure GDP. The former is much easier. I think...

Note: The above calculations would only be important if the amount slashed off the budget is significant. A country's GDP will surely reflect a 1-2% reduction in spending, yet nobody is going to notice a 0.0001% reduction in G when the natural growth rate of an economy is about 1%. On aggregate that is...