Thursday, August 8, 2013

Political credit cycles (JEP paper by Fernández-Villaverde, Garicano, and Santos)

This just-published JEP paper explains where the troubles of the eurozone periphery come from. Basically, the gist of the paper (as I understand it) is that the single currency imposed monetary constraints (no more devaluations), but relaxed others (capital flows). The constraints that were lifted allowed for abnormally high growth, consumption, and employment, while hiding the pitfalls of the new economic model of growth and removing incentives for structural reform. Economic constraints before and after the euro were radically different, but the result was the same: absence of real reform.

I would say the insights are not new, but they are wonderfully articulated:

The elimination of exchange rate risk, an accommodative monetary policy, and the worldwide ease in financial conditions resulted in a large drop in interest rates and a rush of financing into the peripheral countries, which traditionally deprived of capital. Figure 1 shows the convergence in interest rates,which resulted in much lower interest rates for Ireland, Greece, Spain, and Portugal—indeed, they became able to borrow at German-level interest rates. This paper argues that, as the euro facilitated large flows of capital and a financial bubble in peripheral countries, economic reforms were abandoned, institutions deteriorated, the response to the credit bubble was delayed, and the growth prospects of these countries declined.  

In the next section, we explore the two main channels through which these n the next section, we explore the two main channels through which these large inflows of capital led to the abandonment of economic reforms. First, these capital inflows relaxed the economic constraints under which agents were acting, thus reducing the pressure for reforms. Second, they made it harder for principals to extract signals about who was performing well or poorly. When all banks are delivering great profits, all managers look competent; when all countries are delivering the public goods demanded by voters, all governments look efficient. As a result, bad agents are not fired, incompetent managers keep their jobs, and inefficient governments are reelected.The efforts to reform key institutions that burden long-run growth, such as rigid labor markets, monopolized product markets, failed educational systems, or hugely distortionary tax systems plagued by tax evasion, were abandoned or even reversed. It is often argued that the inflow of capital to the peripheral countries led to a number of difficulties, such as a debt overhang from excessive borrowing. But in our view, the reform reversal and institutional deterioration suffered by these countries are likely to have the largest negative consequences for growth.

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