Monday 25 July 2011

The Road to European Unification: There and Back Again?

Crisis? What Crisis?

The unthinkable suddenly appears possible: the politicians, popular media and the European public alike are openly discussing the possibility of some countries defaulting on their public debt or leaving the Eurozone or even committing both of these ‘sins’. How has it come to this and where does it lead?

Sovereign defaults and Eurozone exits have been proposed as possible solutions to the on-going debt crises in the peripheral member countries: Greece, Ireland, Portugal and Spain. The immediate causes of these countries’ troubles are similar: they found themselves with excessive stocks of public debt at a time of a major global recession. Their paths to their shared destination, however, differed.

In Greece, the root of the problem was reckless spending by the government to finance generous provision of public goods, create public-sector jobs, offer attractive pension terms and the like. Excessive fiscal spending was made easier by convergence of interest rates in the Eurozone countries following the the advent of the euro. As a result, the interest rate fell in the peripheral countries and borrowing became cheap. In Ireland, the government policies remained comparably sound but the general public and the banking sector alike got overexcited by the sky-rocketing house prices. The housing market boom, in turn, was fuelled, you guessed it, by the low interest rates that were brought about after adopting the euro. Once the housing market collapsed, this left the Irish banking sector on the brink of bankruptcy. The Irish government sought to avert this by guaranteeing and eventually taking over the banks’ bad loans. Portugal and Spain, finally, lie in between Greece and Ireland: Portugal shares some similarities with Greece while Spain’s troubles are not too dissimilar from Ireland’s predicament.

Debt crises have important elements of self-fulfilling prophecies. Once investors cease to believe in the ability of a given country to repay its debt, they will charge ever increasing interest rates to extend new loans – if they offer it any loans at all. Unable to refinance their debts and being hit by prohibitively high interest charges, default becomes ever more likely, which makes investors even less willing to lend to them and so on. As the situation continues to worsen, eventually a default becomes the less painful option. This was, for instance, how Argentina concluded its foreign-exchange and debt crisis of 1999-02.

The Eurozone’s response, so far, has been to deny that there is a major crisis and instead to prop up the flailing countries with vast amounts of cash. They are not doing this only out of solidarity and altruism: allowing a sovereign default of one country would produce contagion effects: if one is allowed to go bust, the market would expect the remaining countries to meet a similar fate. Furthermore, the crises need not stay limited to the aforementioned four peripheral countries. Italy and Belgium could well be next: both have debt to GDP ratios that are only exceeded by Greece within the EU.

So far so good: the bailouts of Greece and Ireland, while politically controversial, were agreed upon by the Eurozone members (with the notable exception of Slovakia, the most recent and the poorest euro member, which refused to pay for Greece’s past mistakes). It is, however, widely assumed that Spain will be too big to save. In that case, the earlier bailouts may only serve to postpone the euro’s downfall, without preventing it.

Looking for the Exits

If the Eurozone breaks up, would the euro disappear altogether or would only certain countries leave the common currency (or be expelled)? As many have pointed out, a complete break up would be very costly, destabilizing as well as practically very complicated: replacing all currency in circulation in 16 countries is no trivial matter and certainly it could not be pulled off at a short notice.

A more likely scenario would see Greece, and possibly a few other crisis-stricken countries, leave in order to reintroduce their own national currencies. The euro would remain live and kicking in the remainder of the Eurozone. Less realistically, Germany, perhaps with a few likeminded countries (such as Austria, Netherlands and maybe one or two others) could leave, setting up a new and improved currency union for themselves and leaving the euro to the rest. In either case, the key to the successful execution of the exit strategy is to carry it out before the collapse of the euro becomes widely expected. If, for example, Greece were expected to abandon the euro, both international investors and Greeks themselves would have a strong incentive to move their funds out of Greek banks and into a safe haven such as Germany (or hide it under their mattresses). In fact, they would probably want to take out a large loan and stash that money safely away too, in order to make a handy profit after their country dumps the euro and the new currency depreciates. This would lead to a modified Gresham’s Law: one would want to hold assets in strong Eurozone countries and liabilities in the weak ones.

The advantages of the crisis-stricken countries leaving the Eurozone would be substantial. The leavers would be able to devalue their new currencies and thus to improve their competitiveness and revitalize their economies (if they stay in the Eurozone, they can only achieve a similar effect by real depreciation driven by falling prices and wages). The resulting growth acceleration would allow them to lower the deficit without as drastic tax rises and spending cuts as would be required otherwise. Their debt, as long as it is subject to their national law, would be redenominated in the new currency. Once the currency depreciates, the euro value of debt would thus fall. The domestic lenders would not be hurt by this but the foreign ones would effectively receive a ‘haircut’ equivalent to the size of the subsequent depreciation, without the country formally defaulting on its debt.

The stayers, in turn, would benefit too: they would avoid the fiscal cost of propping up the flailing countries and would be left with a currency union that is smaller in size but is more robust and less crisis-prone.

United We Stand, Divided We Fall

The background of the current troubles of the Eurozone can be understood quite well in the light of Robert Mundell’s Theory of Optimum Currency Areas (American Economic Review, 1961). Mundell argued that common currency is optimal for regions or countries that either encounter symmetric shocks or that possess effective mechanisms for absorbing the adverse effects of asymmetric shocks. The core Eurozone economies are closely integrated and therefore broadly meet this definition: the shocks that affect them tend to be similar and/or spillover easily through flows of trade, capital and, to a lesser extent, migration. The same cannot be said about the peripheral countries.

What about the adjustment mechanisms that are the second part of the optimum currency area definition? Mundell’s article emphasized labor mobility which is known to be low in Europe, especially across national borders. Another solution is fiscal transfers. The EU thus may need to turn into a transfer union, a term which has been giving the Germans sleepless nights lately. The contrast between the EU and the US is striking: not only are Americans much more mobile than Europeans, the US Federal government wields fiscal tools that allow it to intervene fiscally in any State. Even more importantly, no one questions the preparedness of the Federal government to do so in times of crisis. In Europe, in contrast, the willingness of the Eurozone nations to continue helping their troubled counterparts is widely doubted.

Besides international comparisons, helpful lessons as well can be also found in Europe’s not so distant history. The EMU is not the first attempt at monetary integration in Europe: its predecessors include the Latin Monetary Union (formed by Belgium, France, Italy and Switzerland in 1865) and the Scandinavian Monetary Union (Sweden, Denmark and Norway, from 1873 onwards). Both of these ultimately failed in the late 1920s or early 1930s. Benjamin Cohen (“Beyond EMU: Problem of Sustainability,” Economics and Politics, 1993), analyzed these cases. He concludes that economics matters when determining the stability of monetary unions but international politics matters even more: the two previous attempts at monetary unification failed because the participating countries did not to share a feeling of common destiny. This lesson could not be more pertinent now: as long as some countries in the Eurozone are willing even to contemplate throwing in the towel on other countries, no matter how deserved it would be to do so, the Eurozone in its present form is doomed.

Don’t Panic!

Besides the lack of political commitment, there is another reason why allowing the crisis to run its course may be a good thing. Crises, whether of the fiscal or foreign-exchange kind, are caused by unsustainable policies. Often, the fact that the policies are unsustainable is widely understood, yet it is still difficult to abandon them. We may all agree that the budget deficit is excessive, but how do we cut it? Should we cut spending on national defence, health care, welfare benefits, civil-servant salaries, or pensions? Should we raise the income tax across the board or only for the highest or the lowest tax bracket? Or raise the VAT instead? Greece is a case in point. The country has been teetering on the brink of default and bankruptcy for over a year now. Yet every couple of weeks, it is paralyzed by a massive strike by those who stand to lose out as a result of the proposed austerity measures. Civil servants don’t want to accept lower salaries. Truck drivers are angry that the excise tax on fuels has gone up and changes in regulation make it easier for new firms to enter the market and drive down freight rates. Pensioners and students alike are furious that the government is going to be less generous to them. And virtually everyone is seething because a German newspaper had the audacity to suggest that Greeks should sell some of their islands or, god forbid, the Acropolis.

A full-blown crisis tends to put a stop to bickering about who should pay for the required reform. This argument has been made convincingly by Alberto Alesina and Allan Drazen at the beginning of the 1990s (“Why are stabilizations delayed?” American Economic Review 81 (5), 1170-1188, 1991). Their arguments was motivated primarily by the experience of Latin American countries, several of which experienced episodes of fiscal recklessness and/or run-away inflation in the preceding years. Alesina and Drazen argue that stabilizations are delayed because of disagreement over who should bear the cost of the required adjustment. In such cases, a war of attrition ensues. The crisis then continues unabated until one of the groups affected by the stabilization throws in the towel and agrees to bear a disproportionate share of the cost. This happens when that group is better off accepting the adjustment rather than allowing the crisis to continue. For instance, the civil servants may decide that it is better for them if they receive a 20% salary cut rather than risk that the government goes bankrupt and is unable to pay their salaries at all. Or employers may agree to pay higher taxes rather than face the uncertainty associated with run-away inflation.

Crisis, in other words, begets reform, and things therefore may have to get really bad before they can start getting better. Or, put differently, unless things get really bad, people won’t be prepared to accept short-term costs in return for the promise of a long-term improvement in the future.

So far so good, but does Alesina and Drazen’s argument hold in real life? Their article is theoretical and therefore we need to turn to empirical analysis to test its predictions. Allan Drazen and William Easterly found some supporting evidence (“Do crisis induce reform? Simple empirical test of conventional wisdom,” Economics and Politics 13, 129-157, 2001). Specifically, they found that countries with extremely high inflation tend to report lower subsequent inflation rate compared to countries that experienced moderate inflation. Similarly, countries with very high black-market premiums manage to stabilize their currency markets more effectively than countries with moderate premiums. In another paper, Hans Pitlik and Steffen Wirth (“Do crises promote the extent of economic liberalization? An empirical test,” European Journal of Political Economy, 565-581, 2003) conclude that deep crises foster market-oriented reforms. Hence, both theory and empirical evidence suggest that crises indeed do beget reforms.

This is all very good but how about the impact of crises on economic growth? Crises are accompanied with sharp economic downturns. Hence, even if the crisis leads to reform, the country in question may end up poorer in the long term because of the economic contraction caused by the crisis. In a joint paper with Ariane Tichit of University of Auvergne (entitled “How I Learned to Stop Worrying and Love the Crisis”), we there pursue the effect of crises further. Since crises and reforms are relatively rare occurrences, we focus on a sample that experienced both in sufficient measure – the post-communist countries in Eastern Europe. During the 1990s, these countries underwent crises of varying severity and, roughly at the same time, attempted economic reforms with varying success. Our measure of the crisis severity is thus the depth of the economic contraction between 1989 and the trough of the output trajectory. We find, reassuringly, that the depth of the output fall translates not only into more rigorous subsequent reform but also into faster economic growth. Hence, crises beget reform and growth alike.

For the time being, Greece, Ireland and Portugal are off the hook, thanks to the solidarity and generosity of Eurozone countries. This may have stopped the crisis from spreading, at least for the time being. This short-term gain, however, may come at the cost of allowing these countries to avoid undertaking a fundamental reform of their economic policies and especially public finances.

Wednesday 6 July 2011

Is the Queen Good Value for Money?

It has been reported recently that the cost of the Royal Family to the UK taxpayers was £32.1 million during the last fiscal year. Is this a lot? Are we getting good value for money?

Having a royal family used to be a very foreign concept to me. I gradually developed a liking for it, however. Many other countries have a president who does little beyond holding a largely ceremonial office: Germany is a good example. Such presidents are not much more useful than monarchs. Royal families, however, have an important sideline in providing entertainment to their loyal subjects. The recent royal weddings – here in the UK or in Monaco – are evidence of that. I wouldn’t be surprised if someone found evidence that events such as royal weddings or births of royal babies are good for the economy. At 52p per person per year, which is what the £32.1 million amount to, I think we are getting a good deal.

Until recently, my favourite example of inefficiently expensive public goods was multilingualism in the EU. This costs way more than the UK Royal Family: the cost of maintaining 23 official languages is estimated as over €1 billion per year. Per person, this amounts to approximately €2.30 – 4 times as much as the Queen and her extended family. Plus the entertainment value of official EU business is usually close to zero.

The €2.30 figure, however, is misleading. Nearly two Europeans out of five speak English well (either as native speakers or because they have learned it). Therefore, the remaining 22 official languages cater to less than two thirds of Europeans. Moreover, if the six largest languages – English, German, French, Italian, Spanish and Polish – were the only official languages of the EU, only 16% of the EU population would not be able to speak any of them. The bulk of official languages, 17 of them, are thus needed only for one sixth of the people. Moreover, even the remaining 17 languages are not all equal: the cost per person per year ranges from around €7 for Hungarian to a whopping €831 for Maltese (assuming translation and interpretation services are only required for those who do not speak English, German or French; these figures are based on my article with Victor Ginsburgh published in the European Economic Review in 2007).

But even these figures pale with the costs of the on-going Greek bailout. The one-off cost of that exercise has been estimated currently as in excess of €500 euros per household. Moreover, over the next three years, this figure is expected to increase to €1,450 per household (these estimates are due to Open Europe, a think tank). Assuming the average household has 2.5 members, this comes up to £524 or the cost of the UK Queen and the whole Royal Family over the course of a millennium! Some of it can be recovered subsequently but few believe that €1 in Greek government bonds is worth anywhere close to that value. Of course, the bailout will bring certain benefits: Greece need not go into a sovereign default (which would in turn be costly for many European banks), it forestalls contagion to other vulnerable countries and prevents the embarrassment of Greece being potentially forced to leave the Euro area. Whether all this is worth the costs, I have my doubts.

The cost of the Greek bailout is to be borne by Eurozone taxpayers so that the UK is off the hook. We can consider ourselves lucky that we only have to put up with supporting the Queen.

Jan Fidrmuc

Tuesday 5 July 2011

Why We Should Tax the Tall and the Fat

Taxes play a number of roles. First, they are a way to raise revenue to finance public goods. Maintaining law and order or invading another country is not cheap and it is easier to finance such projects by compulsory levies than by voluntary contributions. Second, taxes can be used discourage undesirable behavior. Many countries, for example, levy ‘sin’ taxes on alcohol and tobacco to discourage their consumption and thus to reduce their harmful effects. Finally, taxes redistribute income from those who are (relatively) rich to those less fortunate. The taxes that we all pay reflect these various objectives: virtually all of us pay taxes but those of us who are relatively well-off and those who engage in ‘sinful’ activities such smoking, drinking or driving a car tend to pay more, sometimes a lot more, than others.

The current tax system, however, is far from perfect. Consider redistribution. Surely, it is only fair to tax the rich and subsidize the poor. Life is a lottery in many respects. If we care about equality, we should therefore redistribute so that those who happen to have drawn the short straw are compensated for their bad luck. This argument, however, only holds if distribution of earnings is sufficiently random. Earnings are not random, however: they reflect one’s wage (which may be, to some extent, determined by luck) as well as effort (broadly defined to include both the amount of hours that one works as well as their investment into education and other human capital). If we tax effort, we will discourage people from working and acquiring human capital. Therefore, a far and egalitarian tax system should tax the income-earning ability but not effort.

The problem is that it is not always easy to tell what part of one’s income is due to luck or effort. We do know, however, that some people tend to earn more than others. It is well know that men tend to earn more than women and whites tend to paid better (and find jobs more easily) than members of ethnic minorities. There is more: a well-known paper by Daniel Hammermesh and Jeff Biddle (American Economic Review, 1994) found that attractive people get higher wages. Another study, by David Jonhston (Economics Letters, 2010) concludes that women with blond hair get paid more than women with hair of other colors. And, finally, tall men and women also earn more; this is in addition to enjoying other benefits such as having higher education and being on average more confident, happier and less likely to suffer various psychological problems (see the discussion in my own paper with Michèle Belot in Economics and Human Biology, 2010).

Therefore, a fair and egalitarian tax system should take into account characteristics that are related to tax-payers’ ability to earn high wages. Beauty is highly subjective and hair can be dyed. Height, in contrast, does not change during a person’s adult life and can be measured easily. It would make, therefore, an ideal criterion for setting tax rates. This insight is not mine: a similar idea was originally formulated by George Akerlof (American Economic Review, 1978) and a recent article by Gregory Mankiw and Matthew Weinzierl (American Economic Journal: Economic Policy, 2010) fleshes this proposal out.

Not surprisingly, this idea is controversial: one person that I tried to convince about its merits even likened it with the Nazi predisposition to decide one’s fate based on their physical characteristics. Yet the labor market puts a premium on certain physical characteristics, even on those which (unlike education or hair color) workers can do little about. Taxing according to height would only correct for this inherent unfairness of earnings distribution. Under the present system, two persons with the same income usually pay the same tax. Under height-dependent tax, the taller one would be taxed more. This is fair because, holding everything else constant, the taller person has an easier time to earn a given level of income while the shorter person has to work harder for it.

Now how about the role taxes play with respect to discouraging undesirable behavior? One particularly pressing issue these days is the increasing prevalence of obesity. This has grave consequences: obese people are significantly more likely to suffer from heart disease and diabetes. This, in turn, is costly for the public purse (plus it lowers the wellbeing of obese people and their families). The increase in obesity rates reflects unhealthy life style choices: mainly caloric intake that is too high and too little exercise. We already have so-called sin taxes on alcohol and tobacco that seek to remedy this. In the UK, the VAT rate is higher (20%) for sugary drinks and salty and fatty snacks than for other food (0%). A recent Finnish paper (“Health and distributional effects of differentiated food taxation,” by Kaisa Kotakorpi, Jukka Pirttilä, Tommi Härkänen, Pirjo Pietinen, Heli Reinivuo and Ilpo Suoniemi) argues that taxing sugar at a relatively modest rate of 1€ per kilogram would result in a 6% reduction in the prevalence of type-2 diabetes as well as lower incidence of heart disease in Finland. They also argue that these higher sin taxes should be complemented by lower taxes on healthy food such as fruit, veg and fish (which is already the case in the UK).

Sin taxes, however, are a blunt instrument. Taxing sugar would also affect the prices of other foodstuffs (bread, for example). More importantly, this change would hit equally those who are obese and those who are not: two persons can have very similar sugar intakes and yet have very different BMIs (body mass index, a common measure of obesity, computed by dividing one’s weight in kilograms by the square of their height in meters), depending, for example, on how much exercise they do. Taxing them based on their BMI, therefore, should be preferable to taxing sugar, fat and/or alcohol content of foodstuffs and beverages.

Income tax should therefore depend on how far one is from the median height (1.75m for men and 1.62m for women in the UK) and also on how far their BMI is from the ideal range of 20-25. One problem, however, is that a person’s current BMI reflects their life-long choices. Therefore, linking income tax with the level of BMI would unfairly penalize them for their actions before this reform. To avoid this, the tax could be levied according to one’s height and the annual change of BMI. Variations in one’s BMI within the 20-25 range should be ignored, while those with BMI above 25 should be taxed more if their BMI increases. This obesity penalty should be further increased for those with BMI over 30 (the threshold between being overweight and obese).

If this idea catches on, being audited by the tax authorities may soon mean that you would need to strip down to your underwear to have your height and weight checked.

Jan Fidrmuc (height 1.83m, BMI 29.6)