The Eurozone Crisis: The Much Praised “Convergence” as a Cause

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Eurozone crisis, Eurozone and UK Government borrowing rates, 10 year yields, January 1993 to October 2011

The Eurozone crisis is complicated, and a mess.  Europe as a whole is probably already in an economic recession.  But one of the seeds for this crisis (there are several) can be found in what was seen then as the remarkable, and at the time much praised, “convergence” in government borrowing rates among the Eurozone members from the introduction of the Euro on January 1, 1999 (and Greece from its entry on January 1, 2001), until the Lehman Brothers collapse in September, 2008.

The graph shows how markets drove interest rates on government bonds to equality for Eurozone members, until the Lehman collapse in 2008.  It is really quite remarkable that the markets acted this way.  They treated the Government of Greece as if the probability it would default or otherwise reduce the value of the loans made to it (e.g. by an involuntary restructuring), were the same for it as for Germany (or any other Eurozone member).  Even if the markets thought that Germany would in the end always bail out any member otherwise unable to repay its debt, one would have thought that the markets would have at least viewed this as not 100% certain, and that they would in any case ultimately face some degree of loss even with a German bailout.  That the markets did not act this way shows how unbridled faith in markets acting rationally and fully informed is dogma, and is not supported by history.

The graph also shows the 10 year borrowing rate by the Government of the UK.  The UK has its own currency, and it must have been painful for it to see that the markets treated Eurozone members such as Greece and Ireland as better risks than the UK in the middle of the last decade.  I have included the UK in the above graph in part to show how tightly bound the borrowing rates were for the Eurozone members during this period. And despite a UK fiscal deficit which is now higher than all Eurozone members other than Greece (and in fact close to that of Greece, where the Greek fiscal deficit is projected to be 9.1% of GDP in 2011, vs. 8.8% projected for the UK), and public debt ratios similar to the EU average (and a third higher than that of Spain, for example), the UK 10-year borrowing rate is now almost the same as Germany’s (as of this writing on December 12, the 10 year UK rate was 2.10%, vs. 2.02% for Germany).  An independent currency helps.

The Eurozone crisis has reached the point that it has, threatening a renewed world-wide downturn and a possible break-up of the euro itself, because the traditional tools to manage a crisis are not there, due to the euro and the rules under which it was established.  The European Central Bank says it is not permitted to be a lender of last resort to Euro member governments, thus forgoing an important mechanism normally available to countries with a sovereign currency.  And as a member of the Eurozone, individual countries cannot devalue, where a devaluation could improve competitiveness and spur growth.  Many conservative economists have argued that putting nations is such straightjackets is the way to prosperity.  The Eurozone crisis shows that is simply not correct.

There are no good alternatives in what to do now.  The time for corrective actions should have come much earlier, including from the launch of the euro when the convergence in government borrowing rates was observed, despite the clear differences in capacity to service public debt among the Eurozone members.  But in coming up with a resolution to this crisis, one element will need to be that losses are taken by the lenders who had earlier treated all Eurozone governments as the same.  It was this failure of the market to differentiate across the Eurozone members that supported both profligate governments (such as Greece) and profligate private borrowers (such as banks in Spain and Ireland that  drove real estate bubbles), and more broadly financed at too low a price the trade imbalances that developed among the member countries.

Ensuring the lenders suffer such losses is not only morally justifiable (that is, all the costs should not be imposed Greece, Italy, Spain, and others, even if this would suffice, and it won’t), but also important to ensure another such crisis does not develop again in a few years.  Angela Merkel and Germany are trying instead to impose strict fiscal rules on public sector deficits and the accumulation of public debts, but it is unlikely that such blunt rules will suffice to cover the complexities of any real world situation the countries find themselves in.  Furthermore, such fiscal rules, if seriously applied, will limit the ability of governments to respond as they should to economic downturns, even recognizing that the rules in principle allow for some flexibility in such circumstances.

And by Germany insisting that banks and other lenders not take losses on the loans they made to the riskier countries (other than Greece), where such loans were made at rates that reflected an assumption of no risk, lenders might well feel that in other than extreme cases (like Greece) they will in the future again be bailed out.  While one should hesitate in relying solely on the markets, given their poor track record, the markets would function better if lenders were forced to take losses on their bad lending decisions.  That would then act as a check on excessive government borrowing in circumstances when such borrowing truly was excessive rather than a reasonable response to the real world situation the countries might find themselves in at some point in the future.  And such market discipline would function better than crude, one size fits all, fiscal rules that limit a government’s ability to respond appropriately to downturns.

Why Does the Press Do This? The Washington Post on DC Public Schools

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The lead article in the Metro section of today’s Washington Post is headlined: “DC has widest race gap in tests”.  It reports on two studies released yesterday (math and reading) by the US Department of Education, which provide figures from test results of 4th and 8th grade students in various urban jurisdictions around the country, with these results broken down by race among other categories.   Figures are provided on 19 urban jurisdictions, which vary between large cities such as New York, Chicago, and Los Angeles, and smaller  jurisdictions such as Jefferson County, Kentucky (Louisville) and Fresno, California.

As the headline states, and as the primary point of the article, the gap in test scores between white and black students in DC public schools, is larger in DC than in any of the other jurisdictions.  This is factually correct.  But the Washington Post article never notes that the reason the gap is so wide in DC is in part due to the fact that the test scores for whites in DC public schools are the highest in the nation among the 19 urban jurisdictions reviewed, for both reading and math, and for both the 4th graders and the 8th graders.

Indeed, the test scores for whites in DC public schools are higher in all four categories than the average scores for whites in any of the 50 US states reported in the similar studies issued by the Department of Education on November 1.  And note that these test results are only for students in DC public schools:  students in charter schools and in private schools are not covered.  Note also that the share of white students in DC public schools, while low, was not the lowest in the country:  7 of the 19 jurisdictions had a lower share of whites in their public schools in the 4th grade, and 2 of the 19 jurisdictions had a lower share in the 8th grade.

The gap is wide in DC also because the test scores reported for blacks are low.  For the four scores for 4th grade and 8th grade reading and math, the scores for blacks vary between the second worst and the fourth worst among the 19.  It is important to know this. The results indicate that students can do well in DC public schools (the white students score higher than any of the others in the 19 urban jurisdictions, and higher than whites in any of the 50 states).  But black students are not doing well, and one should focus on trying to understand why.

Finally, the city with the “best” (lowest) racial gap among the 19 was Cleveland for the 4th grade students, in both reading and math.  Cleveland’s gap in the scores was only 22 in reading and 21 in math.  In contrast, the gap for Washington, DC, 4th graders was 64 in reading and 60 in math.  But Cleveland achieves this distinction of being “best” in the nation by the criterion the Post judges as most important, by having the worst scores among the 19 jurisdictions, for both whites and blacks in both reading and math.   This is obviously not something to emulate.

One clearly should want to reduce the racial gaps in such test scores in DC as well as elsewhere.  But the intelligent way to start to do this is to recognize that at least a certain group of students is performing pretty well in DC public schools, with scores that are consistently the highest in the nation in the jurisdictions reviewed.  This is relevant, but never mentioned in the Post article.  It suggests that the curriculum and other practices in DC public schools can produce good results.  But blacks in DC public schools have struggled, and the focus should be on how to raise this.

The Worsening Distribution of Income: The Top 1% vs. the Other 99%

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The Occupy Wall Street and related groups have brought to the fore concerns about the distribution of income in the US.  And there is validity to these concerns, as the distribution of income has deteriorated markedly in recent decades, starting with the Reagan period in the 1980s.  The share of the top 1% has well more than doubled, to a level not seen since the 1920’s just prior to the Great Depression, with this coming out of a declining share of the bottom 90%.

The graph above is taken from material assembled by Professor Emmanuel Saez and his colleagues and co-authors, and is available through his web site (link here). The specific data here is from a July 2010 update of material originally published by Professor Saez with Professor Thomas Piketty in 2003, with data now through 2008.  Professor Saez and colleagues from around the world have assembled an amazing set of data for a large number of countries, using tax return data to produce long time series of family (tax unit) income levels.  Such data can go much farther back in time than available income surveys will allow, to produce historical data otherwise unavailable.  While there are drawbacks (for example, tax units are not always the same as the household units one would prefer), nothing else can span such periods of time.

The US data show that there was a previous boom in the 1920s in the income share of the top 1%, peaking at 23.9% of national income in 1928.  But the share then fell in the Great Depression and during World War II, and with the reforms and structural changes implemented during that period, eventually came to about a 10% share in the 1950s and 1960s, and to about 9% in the 1970s.  But it then started to grow, and reached a 23.5% share in 2007.  It fell back in 2008, with the onset of the financial collapse in the last year of the Bush Administration.  But as noted in this blog posting of November 26 on this site, profits rebounded in 2009 to now, so it is likely the top 1% share has also rebounded.

It is also interesting that this increase in income concentration is essentially only at the very top:  the top 1% is seeing almost all of the increase.  Those in the 90 to 95% percentile, and in the 95 to 99% percentile, have seen some trend rise in their income shares in recent decades, but they have been close to flat.  Rather, the higher share of the top 1% has come out of a falling share of the bottom 90% (the shares of all groups together must sum to 100%).  The share of the bottom 90% has dipped to about 50%, from a level of about 65% (plus of minus a percentage point or two) from 1942 to 1982.  This is a remarkable change after four decades of such stability.

Another interesting calculation, done by Professor Saez, found that 52% of the increase in real national income between 1993 and 2008 accrued to the top 1% of families, even though this top 1% only had a 14% share of national income at the start of this period (and 21% at the end).  That is, more than half of income growth over this 15 year period went to just the top 1% of the population, and where this group accounted for only a 14% share of income at the beginning.  Had the growth been balanced, the top 1% would have obtained 14% of the income growth, not 52% of it.

The data here does not explain why there has been this increasing concentration of income in the US.  One has also seen increasing concentration in other countries around the world in recent decades (the data is available here), which suggests some basic global structural changes are part of the cause.  But the global pattern has not been as extreme as in the US, suggesting that policy changes in the US begun under Reagan and continued since, are also part of the cause.