[The] dismal science’s [forecasting] record suggests is that there is something profoundly wrong with the mainstream economics profession’s understanding of how modern economies work. The models on which its forecasts are built are clearly badly flawed.

It is true that forecasting performance is poor, but that is largely because forecasting is very, very difficult. The DSGE models Nixon refers to are important in modern macroeconomics but they were originally designed to estimate the impact of monetary policy, not to forecast the future. In fact, until very recently, most forecasting was not done with structural DSGE models but with statistical models that take their structure from the data. They provided better forecast performance and so were preferred by professional forecasters. These days, the best forecasts tend to be made by estimated DSGE models that outperform the best statistical models because they incorporate some of our understanding about how the economy works. No doubt they will be improved over time but it is incorrect to suggest that forecasters are too constrained by theory to forecast accurately. In fact, economists’ understanding of the economy helps them to provide better predictions about the future than simply using statistical relationships.

Nixon then discusses a paper by Claudio Borio at the BIS, which suggests building models that describe not only business cycles but also ‘financial cycles’. Borio’s paper highlights the monetary nature of the current recession and recommends that the next generation of macro models give serious consideration to the slow buildup of disequilibrium forces in financial booms, which then trigger deep recessions. Whether or not you agree with that diagnosis, the question he tackles is crucial: how do crises endogenously develop? Part of the reason forecasting is so difficult is that turning points are hard to pick because we don’t really understand all of the mechanisms that lead to recessions. Nixon uses that paper to claim that…

…[for] investors, the sensible response is surely to disregard all short-term forecasts based on out-dated models. They should focus instead on identifying those economies most likely to deliver a medium-term recovery by aggressively addressing their stock of debt. In the European context, it is the euro zone where the process of debt reduction and restructuring seems likely to proceed most rapidly, not least because the greater independence of the European Central Bank means there is less prospect of loose monetary policy being used to defer tough decisions.

I don’t think that is what Borio’s paper claims. Can Nixon really be advising you to ignore expert forecasters and instead put your money into EU countries, many of whom are currently facing the possibility of further recession in 2013? He has good company in suggesting that current economic models have problems and could be improved; however, the chances that they can be improved upon by following a simple heuristic like ‘less debt equals more growth’ are exceedingly slim. Indeed, there is considerable public debate among economists over the impact of debt on growth. Reinhart and Rogoff’s work has generated a lot of discussion, and there is a paper entitled ‘Macroeconomic Risk and Debt Overhang’ being presented at the ASSA conference. It’s hardly a matter that has been neglected by the profession!

Of course, it’s very difficult to diagnose and fix a problem with a single newspaper article: witness Paul Krugman’s repeated attacks on the current state of macroeconomics and the heated responses that they’ve generated, for instance. When even Nobel prize-winners can’t agree on whether there is a problem it is a sign that we don’t really understand what needs to be done. It’s great that Nixon is bringing interesting papers like Borio’s to public attention and airing the debate that’s going on in the profession. Unfortunately, in this case I don’t think his diagnosis or proposed solution are quite right.

However, we are currently in the middle of a fascinating example of political economy – something I am poorly versed in, and so will instead just link to.

The Eurozone needs a lender of last restort, a credible lender of last resort.  The weird actions going on in Europe are indicative of some institutions recognising this, while other groups who have to take on any perceived risk (eg Germany) are less than willing to do so.

Of course, the belief that the Eurozone needs a lender of last resort depends on the “multiple equilibrium” view of credit markets in Europe – are these banks truly insolvent, or do they just look insolvent because of liquidity/expectations.  If you are in the first camp there is a burden that must be shared in some way, if you are in the second camp there is much less of a real burden – and a strong requirement of a lender of last resort.  The different things being said by different people inside and outside of Europe are not just a result of a normative belief in what is a “fair distribution of the burden”, but also a different implicit model which implies different costs and benefits from different policy actions.

No wonder agreement has been so difficult.

Eric and my work colleague here both hit option 52, while I hit option 54.  To see what 54 is I’ll repeat it below:

Maynard is staring at his legal pad. “This looks like a mess to me. Greece has defaulted, left the euro, and had a tax commissioner appointed – how many more humiliations can you heap on them? Economically it has a certain internal logic but politically it is all over the place and I think that kills the chance of the transfer payments which you need if you’re going to achieve primary balance after the default without massively contractionary domestic fiscal policy. We can type it up and submit it, but I think it’s only going to be looked at as an example of the kind of idea that an economist might come up with”.

The kind of an idea an economist might come up with – I’m taking that as a compliment even though I suspect it isn’t meant to be …

This in no way means that the fundamental issues in Europe are over – in fact, it makes focus on the structural problems in Europe an essential part of what people should now be doing.

However, if the bank run really is over, and credit markets really are unfreezing (something we will know in the next couple of days), it is a positive for the short-term for a little country like NZ.  But lets not forget a few things:

1. Japan, and now Europe, have shown us the vulnerability of public and private finances to changes in demographic structure – we ignore these issues at our peril, and with plenty of warning.
2. Europe still has massive structural issues.  These still need to be solved, or we will merely have another crisis down the line.
3. If Europe isn’t going to sort itself out, hopefully the rest of the world will see the risk and reduce their implied exposure to Europe.

Hopefully they go down this track.

These alleged technocrats have in fact systematically ignored both textbook macroeconomics and the lessons of history in favor of fantasies. The European Central Bank has placed its faith in the confidence fairy, while imagining that it can run policy in a way that has never worked in several centuries of central bank experience. Meanwhile, the European policy elite has simply wished away the clear evidence that the euro zone needs to make an adjustment that is virtually impossible unless inflation targets are raised.

Not only are we seeing why the Euro was a silly idea in technical terms – we are seeing how endemic policy failure can be in places like Europe.

Seriously, the vast majority of economists knew that we just needed the ECB to act as a lender of last resort, and for the default in Greece (and policy changes in the rest of the PIIGS) to be determined in a reasonable amount of time – instead we’ve seen failure from both monetary and fiscal authorities around the region.  Embarrassing failure.

The current crisis has very much been one of people wondering “who the hell will bear the burden of default”.  The closer we get to solving that question, the closer we get to putting this junk behind us.

I don’t like how people are calling these things “buying time” – in reality there just needs to be a clear set of policies set down, and a clear lender of last resort for the regions banking sector.  Get those things in place and the crisis will get the hell out.

There has been progress this month, but the international situation is still pretty weak.

The issues in Europe remain the most concerning thing for me at the moment – the US has a large drought and a weak patch, but at least we don’t have to ask if their central bank has the ability to always act as a lender of last resort.

The fact that there is no central fiscal authority in Europe, and the fact that people are unsure whether they can trust the ECB in a worst case scenario, makes matters difficult over there.

My concern for NZ comes from the same place they always do during these financial crises: will it lift the cost of funding (which is happening in part – albeit at a time when additional credit remains cheap) and lower export commodity prices (which hasn’t happened).  With a stagnant Europe NZ can do fine, but if they lose the plot we will not be left unharmed.

Update:  For future reference (as I often use these types of posts when I’m going back to look at history – it is amazing how useful blogging has been in this context), growing issues regarding German’s willingness to bail out the region (following election defeats for the incumbent) are a major driver of increasing uncertainty at this point in time.  Also note that the decision to start suing US banks now, in the middle of a crisis, isn’t particularly helpful.

On the surface there appears to be a lot in common with the Irish, Greek, and NZ economies.  All three have high net foreign liability positions, liabilities are highly concentrated through banks who are borrowing overseas, all three have experienced some form of housing boom and lift in consumption, and finally all three appeared to have a relatively strong fiscal position before the GFC before moving into fiscal deficits after the shock.  And yet (so far) while the Irish and Greek economies and banking systems have collapsed, New Zealand’s has been fine.

There are two major differences that have helped reduce the implied risk on our debt, making New Zealand much less likely to experience a bank run:

1. Our banking system is primarily foreign owned (Eric Crampton expands on why this is a good thing),
2. We have a freely floating exchange rate – combined with having much of our debt denominated in NZ$ this is useful.

These are important points to recognise.  While many commentators are saying we should “peg” our dollar and set up more domestic ownership of banks GIVEN the risks associated with the GFC, I tend to reach the opposite conclusion – namely, the reason why we haven’t suffered as much as these countries has been largely the result of our free floating exchange rate and the fact that a larger economy has a large stake in our banking system.

The terms of trade boost and our proximity and exposure to Asia has also helped, but I would say that the Greek and Irish crises give us a reason to hold onto the status quo – not to chuck it out!

“They are not cranking up the printing presses,” said James Nixon, co-chief European economist at Societe Generale SA in London. “This is a much more targeted, surgical approach. They buy the duff stuff that no one in the market will touch.”

The point is to buy stuff that would otherwise be good, but is only struggling because of the crisis – not to actually buy duff stuff.  The intervention is supposed to prevent a run on good assets – not to keep bad assets in business.  Of course, in practicality they will have to buy some duff stuff, but saying that this is the goal is an exaggeration.

Still, this isn’t my main point.  My main point is that sovereign debt is a different beast to private debt.  If the ECB starts buying up government bonds, and there is no plan to get government budgets under control in the medium term, then the result is high levels of inflation – and probably the collapse of the Euro Zone.  The second point doesn’t concern me – the first point does.

With private debt we had a response when effective interest rates exploded upwards.  Will we get the same response from domestic governments in Europe?  I don’t know.