Sunday, June 24, 2012

An End to Risk-Free Tax Evasion

Just a quick thought on the Jimmy Carr story - one interesting feature is that the Revenue have decided to claw back tax on his K2 and other similar schemes, in such a way that they may end up paying more than they would have done had the scheme never been hatched.

Of course, this suggests one very useful property of anti-evasion strategy: increase the risks. Up to now, the worst thing that could happen to people caught evading is that they have to pay what they were trying to avoid. If the penalties are made more severe, then it becomes more of a gamble: you may pay nothing, but you may pay so much that you would have been better settling for the tax everyone else has to pay. It would then be very reckless for tax advisors to innovate, saving the authorities a lot of resources.

A question of political will, but the public mood is certainly furious on this one.

Friday, June 15, 2012

So much for dynamic provisioning

Nice piece in Bloomberg by Jonathan Weil (The EU Smiled While Spain’s Banks Cooked the Books), pointing out the perverse effects of the Spanish regulatory practice of demanding that banks adjust their accounts for the potential vagueries of the economic cycle ('dynamic provisioning'), supposedly giving them a buffer against downturns.

Turns out that Spanish banks were able in this way to hide their losses from the popping of the housing bubble until quite recently. Has this helped smooth the financial consequences of the downturn? No need to answer that question.

All this goes to show that tweaking accounting practices is never going to achieve much if the financial system is based on the kind of Ponzi schemes we've been seeing in the past two-three decades. Governments are going to have to start getting on top of what banks do, and providing better regulatory and fiscal incentives to real investment in real productive activities. How do they do this? Don't ask me, I'm not an economist.

Wednesday, June 13, 2012

Sinn should repent

Hans Werner Sinn (Germany Can’t Fix the Euro Crisis - provides us with yet further evidence that important voices in Germany simply don't get it, on multiple levels. First, he doesn't get it on the economic level, by espousing policies that have already failed and basing his reasoning on unbelievably crude notions of how debt works (the 'liability principle'). Second, by committing a political and historical howler that Karl Whelan rightly calls him on.

Let's take the 'liability principle' first. Sinn suggests that bailouts would violate that principle, which reads that

'it is the creditors’ responsibility to choose their debtors. If debtors cannot repay, creditors should bear the losses.'

Fair enough. But I thought Germany was the big creditor here? Never mind. The 'liability principle' needs to be respected because

'If we give up the liability principle, the European market economy will lose its most important allocative virtue: the careful selection of investment opportunities by creditors. We would then waste part of the capital generated by the arduous savings of earlier generations.'

Well, I think it's a bit late for that one, don't you? The capital has already been wasted. Hard-earned German savings were funneled through the Eurozone financial system into unsellable apartment blocks in Spain and unsustainable public employment in Greece. That money has been wasted, so the only reason to refuse bailouts is to make future generations aware they could lose their investment if they are not careful which bank they give their money to. In that case, why not drop deposit insurance too? Then people will finally realize they need to perform due diligence with every pfennig they put in a bank.

All of that is in my view idiotic, but at least bears some relation to a recognizable theory. But the history part is really shocking. Sinn forgets that before the Marshall Plan - for which he at least expresses grudging gratitude - the US spent four years, nearly half its GDP and nearly half a million American lives fighting Nazism in Europe. Instead of punishing Germans for the crimes of their leaders, the country was helped back onto its feet. Has Germany responded to this generosity by doing it all again? No. Moral hazard apparently only works in economics.

The saddest part of all this is that really this should not be about Germany vs Greece, or anyone else. It should be about the people, across Europe, who have been taken for a ride by their political leaders and their financial institutions. Germans who could lose their jobs and savings are in the same boat as Greeks who have lost their jobs and their credit. Nobody should be punished because of a flawed institutional design that required them to exercise impossible prescience and restraint. Instead, people should be helped on their feet and the right institutions created. Germany, of all nations, should remember that.

Tuesday, June 12, 2012

From technocracy to populism

A blog post for the LSE's EUROPP blog:

In upcoming elections across the Eurozone periphery, voters are likely to react to austerity by replacing technocracy with populism | EUROPP

"As Spain lurches into economic and financial collapse only months after electing a new government with a landslide majority, the difficult relationship between crisis management and democratic politics once again comes into view. Spain’s rapid descent into economic meltdown has been greeted by anti-austerity commentators such as Paul Krugman and Martin Wolf as further evidence of the need for fiscal and monetary expansion on a massive scale in the Eurozone. But it also has important implications for the nature of democracy in the European Union...."

Saturday, June 9, 2012

The myth of moral hazard, or why punishing debtors is futile

This crisis, and its Eurozone variant in particular, is teaching us an awful lot about the political economy. Sadly, most of what we are learning is entirely at odds with the conventional wisdom which still informs policy. And a good part of the wrongheadedness that we are subject to revolves around the concept of moral hazard.

The plausible expectation of bailouts creates moral hazard, we are told. Yes, it does. There is plenty of evidence that big financial institutions take risks because they expect governments to pick up the pieces if everything goes pear-shaped. Certainly, if top bankers are anywhere near as smart as their paypackets suggest, they should lever up and max on risk, confident that governments will plug the gap if their bets go bad.

Trouble is, we also know that finance is also prone to bouts of irrational exuberance and panic. Moral hazard may exacerbate the exuberant parts of the cycle, but it also mitigates the panic when things turn bad. Part of (maybe most of) the reason that the Eurozone periphery is in such a self-fulfilling debt trap is that there isn't enough moral hazard around - investors are terrified that if their paper goes bad, they will lose everything. And so the downward spiral accelerates, making bailout infinitely more expensive as panic sets in.

What about governments? Well here the virtuous Northern economies in the Eurozone are afraid that bailouts now will encourage Southern sovereigns to ignore their fiscal problems in the future, leaving Germany and the others on the hook forever. Moral hazard here gives politicians an incentive to run deficits and buy popularity, whilst others pick up the tab.

The trouble with this one is that the politicians that are punished are not usually the ones who exploited moral hazard. Mariano Rajoy took over when Spain's fiscal situation was already out of control, yet he is the politician being exposed to popular anger now. For the anti-bailout policy to work, voters would have to be sophisticated enough to gauge how likely it is that a party's fiscal proposal at time t will result in another party having to impose brutal austerity at time t + 1. Very often, as in Greece, successive alternating governments are responsible for the fiscal mess. How can voters cast a partisan vote that sends the correct signal to politicians, so that the risk of irresponsible policy is averted? Do we really think that if this crisis ever ends Greek voters will become eager observers of fiscal rigour on the part of their politicians, anxious to avoid this all happening again? For this to happen some Greek politicians would have to offer voters fiscal prudence whilst others stuck to deficit-fuelled patronage politics, making elections a clear choice between happiness and hazard. That's rarely the way politics works.

In short, moral hazard is a red herring, and theorizations of its role in the crisis are crude, confused and make no historical sense. In the real world of politics and markets, when you get to the point where bailouts are necessary, it's far too late to worry about moral hazard. This is what we should be worrying about.

Wednesday, June 6, 2012

Angela's dilemmas and the nightmare scenario

The FT has a nice piece today about the loneliness of Angela Merkel, torn between seeing the Eurozone fall apart and taking decisions that would rescue the periphery but provoke a furious backlash at home. It is indeed easy to criticize Merkel for her cagey approach, which given the fear in the markets seems almost designed to make the costs of rescue as high as they could possibly be. I agree completely with these criticisms, but what people like Martin Wolf and Paul Krugman often miss - focused as they are on debating the stupid austerian policies advocated by many economists - is that this is a political process.

Merkel is not doing what is necessary, but the reason may not be just that she doesn't know what she's doing. First, she is a government leader in a consensus-oriented democracy, with coalition government and federal institutions, and like any other party leader she faces the constant threat of dissent from within her own party. Juggling these various threats to her position are probably her main concern, regardless of how much she understands about the nature of the Euro crisis. It could well turn out that a plan for economic recovery, involving massive bailouts, permanent ceding of German fiscal autonomy, and the collapse of the Euro's monetary conservatism, would cost her her job.

Second, even if Merkel understood what Krugman and Wolf eloquently argue day after day, and had the political authority to convince the German political class and electorate of what needed to be done, she would run into another problem - the European-level joint decision trap, Fritz Scharpf's well known conceptualization of the restraints on policymaking in federal states like Germany and intergovernmental organizations like the European Union. What if the European Commission, the ECB and the other Northern Euro member states said no? Merkel would have blown her political clout in Germany for nothing. Getting anything through the European institutions is complicated and time-consuming. Add the permanent subsidizing of the hapless 'Club Med' nations by the virtuous Weberians of Northern Europe, and you get a recipe for the worst kind of Euro-paralysis.

Finally, we get to a further dimension to the politics of crisis that has been widely ignored, even by the smartest commentators - democracy and the people (easy to forget about, I know). Even if all the dilemmas outlined above could be resolved, there is no way a solution to the Euro mess can be sustainable if it doesn't have popular support. So far, this point has been made most obviously in the struggling periphery, where elections have wiped out the governments responsible for crisis and austerity in Ireland, Spain and Greece, whilst Berlusconi has been forced out in Italy. Yet the same problem could easily arise in the North, as Geert Wilders' recent departure from the Dutch governing majority shows. If Merkel signs up for a Eurozone welfare state, there's every chance that an electoral earthquake could shake the German party system just as it already has in Greece.

Which brings me to my nightmare scenario. I still believe that politicians will blink before allowing the Eurozone to implode, wreaking havoc all around. The reason for this is that I think most policymakers are sufficiently aware of what the consequences could be, and are rightly terrified. But democratic elections are a cruder instrument for making decisions. Greek and German voters, exercising the democratic right to express their outrage, could place Europe in an impasse which would lead inevitably to the catastrophe we all fear. Popular pressure for intransigence in the North, to match popular pressure against austerity in the South, could place Europe's leaders in a chicken game that will end badly for everybody.

The only way out is leadership. Come out, explain to people what is going on, and hope for the best. But that has never been the way European integration works.