Weimar Europe?

Harold James


BERLIN – Germany’s position in Europe looks increasingly peculiar and vulnerable. In the chaos of German unification in 1990, when Germany’s neighbors were terrified of the new giant, then-Chancellor Helmut Kohl promised a European Germany, not a German Europe.
Today, however, the terms of any European rescue effort are obviously set by Germany.

There is widespread recognition that Europe needs substantial economic growth if it is to emerge from its debt woes. But German concerns about stabilityfounded on its catastrophic interwar experiencepush in the opposite direction. As a consequence, Germany-bashing is now in fashion.

Germany’s critics make two points: the real European problem is the German current-account surplus, and Germans are perversely obsessed with their past.

The German current-account position is in fact a long-standing issue that predates the monetary union. By the 1960’s, Germany had emerged as the strongest and most dynamic European economy, owing to robust export performance. German current-account surpluses, driven primarily by positive trade balances, appeared briefly in the 1950’s, were corrected after a currency revaluation in 1961, and then re-emerged in surges in the late 1960’s, the late 1970’s, the late 1980’s, and again in the 2000’s.

If the resulting imbalances could not be financed and sustained, there was a need for adjustment. At regular intervals since the 1960’s, Germany’s European partners, notably France, faced the prospect of austerity and deflation in order to correct deficits. This alternative was unattractive to the French political elite, because it constrained growth and guaranteed electoral unpopularity.

The French (and the other Mediterranean countries) preferred German monetary and fiscal expansion, which would attenuate Germany’s strong export orientation. But this course was always unpopular with Germans, who, given the interwar legacy, worried about inflation and its implications.

German policymakers thought that the issue would disappear with the monetary union’s launch, on the grounds that no one in the United States worries about a Californian boom that produces the equivalent of current-account surpluses (if anyone bothered to measure them). Nobody tells Californians to relax and go to the beach when times are good.

The second criticism, repeatedly voiced by the Nobel laureate economist Paul Krugman, is that the supposed German history lesson is chronologically false. It was not the famous hyperinflation of the early 1920’s that destroyed Germany’s fragile Weimar Republic and gave rise to the Nazi dictatorship. Rather, democracy was killed a decade later by depression and deflation.

This contemporary criticism misses an important element of the German policy predicament of the early 1930’s. By the Great Depression, Germany was already trapped, owing to previous bad choices. It is precisely that lesson which is deeply engrained in German political consciousness.

Germans are right to notice the parallels between conditions in Europe today and those in the interwar period. The similarities consist in the implications of the choice of currency regime for political behavior and democratic legitimacy.

At the end of its hyperinflation, Germany locked itself into a currency regime, the international gold standard, which was deliberately designed to be so limiting that exit was impossible. The anticipated consequence was that the country would appear credible and become attractive to foreign capital.

As the strategy worked, capital inflows sparked both public-sector and private-sector booms. Governments at all levels funded politically attractive but expensive infrastructure projects.

But there was a downside. The boom’s vigor, coupled with prior experience of inflation, led to wage increases that were not matched by productivity gains. As a result, Weimar Germany lost competitiveness in the late 1920’s, in the same way that Southern Europe did in the 2000’s. In both cases, it was clear that the capital inflows could not continue forever, and weakening competiveness meant brought the end forward.

When the reversal came, Germany was trapped. As foreigners and Germans alike withdrew deposits, banks were driven into insolvency and forced to liquidate their assets at very fire-sale prices. The government had to prop up failed banks; but it could fund deficits only by borrowing from the banks. Given its commitment to the fixed exchange rate of the gold standard, that meant that it had to impose ever more unpopular austerity measures.

Given all of these constraints, there was no easy way out. The path immediately adopted in the wake of the 1931 banking crisis was to impose capital controls.

The crisis was a defeat for democracy. The democratic parties’ obvious response was to flee from political responsibility during the period of the greatest economic hardship. The Weimar Republic’s last fully parliamentary government had already collapsed in March 1930 under the political weight of an impossible fiscal dilemma. Spending cuts alienated the left; tax increases angered the right.

Democratic parties acquiesced in the use of the constitution’s emergency provisions to bypass parliament and enact legislation in the form of decrees. In this way, democracy was already substantially eroded before the appointment of Adolf Hitler as Chancellor in January 1933.

Banking and budget problems, fiscal constraints, and the emergence of “non-politicaltechnocratic governments: all are horribly familiar to Germans with a sense of the past. The negative lesson of the interwar experience – that piling up more fiscal liabilities does not solve the problem – is already apparent in today’s Europe. But there is a positive lesson to be drawn as well: the possibility of an international order that supports rather than undermines democratic regimes at the moment when they take unpopular measures.

That was the lesson drawn from Weimar by Konrad Adenauer, Germany’s first post-war Chancellor, and a man who – as mayor of one of Germany’s high-spending cities in the 1920’s – had seen the German catastrophe up close. Now, as then, Europe – a community of shared values – is needed to maintain democracy in nation-states threatened by economic breakdown.

February 25, 2012

Moral Hazard: A Tempest-Tossed Idea


THE reports outraged America: In the wake of Hurricane Katrina, people who fled the ravaged Gulf Coast were spending disaster relief, paid for by taxpayers, on tattoos, $800 handbags and trips to topless bars.

It turned out that few, if any, Katrina evacuees actually did any such thing. A vast majority used debit cards issued by FEMA to buy necessities like food and clothing. But the damage was done: FEMA swore that it would never hand out money like that again.

Behind this brouhaha was an idea that Americans seem particularly preoccupied with. It is calledmoral hazard” — an obscure insurance term that has taken on new currency in our troubled economy. We’ve heard a lot about moral hazard lately, first in connection with the bailouts for big banks, and now with efforts to help homeowners who got in over their heads.

Moral hazard sounds like the name of a video game set in a bordello, but in economic terms it refers to the undue risks that people are apt to take if they don’t have to bear the consequences. In other words, if the money is free, why not spend it on a designer purse? If you know that you’ll be bailed out, why not roll the dice on some tricky mortgage investments — or splurge on a home that you can’t really afford?

Moral hazard became part of the national conversation in the financial crisis of 2008, when ordinary Americans wondered why they should rescue banks that helped drive the economy off a cliff. Now those same banks point to moral hazard to explain why they can’t do more to help people with mortgages. And it’s not just banks — the Tea Party movement was inspired by outrage over a government plan to, as Rick Santelli put it in a famous rant on CNBC, “subsidize the losers’ mortgages.”

The cherished American ideal of self-reliance has a flip side: discomfort with the idea of bailouts and safety nets. The notion that even a small portion of such aid might find its way to the undeserving can be enough to scuttle support, or restrict help so drastically that few can use it. The specter of moral hazard haunts a basic tension in American life: to what extent are people responsible for their own problems? The more trouble you’re in, moral hazard suggests, the less we should help.

Bankers say that generously easing loan terms or reducing mortgages outright would only encourage homeowners who can pay to pretend they can’t. It would also, the bankers say, send a dangerous message: a financial commitment isn’t really a commitment.

Economists and policy makers say the bankers are right — but only to a point. Shaun Donovan, the secretary of the Department of Housing and Urban Development, said that there was a “nugget of truth” to the moral hazard argument. But he also said that only about 10 or 15 percent of Americans who can still pay their mortgages try to walk away from their debt. Most troubled homeowners, like the Katrina victims, are genuinely hard up.

Kamala D. Harris, the attorney general of California, is adamant that homeowners are not looking to abuse the system. “I have met with these families,” she said, “and every single one of them wants to pay to stay in their homes.”

Still, the $26 billion deal that authorities struck with banks this month over foreclosure abuses — a main element of which will require the banks to reduce homeowner debtangers some.

Homeowners who keep paying their mortgages, even if their homes have lost value, reasonably wonder why neighbors who weren’t as responsible are getting help.

On the other hand, the problems in the housing market are a problem for all of us. Many economists and housing experts agree that the debt that now looms over homeowners is holding back a broad recovery.

Since the settlement was announced, pressure has mounted for Fannie Mae and Freddie Mac, the mortgage giants whose loans are not eligible for the deal, to allow debt relief for their borrowers as well. But concerns over moral hazard, among other things, have held them back.

MORAL hazard has long been used to explain why social safety nets like welfare, unemployment insurance and workers’ compensation should be less generous. It is almost always applied to the recipients, rather than the providers, of such benefits. A lot of energy has gone into arguing that higher workers’ comp payments, for example, make workers careless. Far less is said about how lower workers’ comp invites moral hazard for employers by, say, making them less attentive to workplace safety.

Economists have long complained that moral hazard could easily be described in more neutral language, like “misaligned incentives.” But the term, with its implied judgment, has stuck.

It seems to have originated in the 19th-century insurance industry. (Hazard was a popular game of dice.) Insurers drew a bright line between natural hazards, like storms, and moral hazards, like playing with matches, that stemmed from what the 1867 edition of the Aetna Guide to Fire Insurance called “carelessness and roguery.”

Today, insurers battle moral hazard with co-pays and deductibles. If you have health insurance, you are, based on the theory of moral hazard, less likely to avoid smoking, and more likely to go to the doctor for a common cold. But in a 2005 article in The New Yorker, titled The Moral Hazard Myth,” Malcolm Gladwell noted that people with insurance do not check into hospitals for their enjoyment, and that people without insurance forgo preventive care that could save thousands of dollars. Moral hazard also overlooks the noneconomic costs of risky actions like smokingcosts like ruined lungs, suffering and death.

“The economics of moral hazard work to convince us that, however well intentioned, social responsibility is a bad thing,” Tom Baker, a law professor at the University of Pennsylvania, wrote in “On the Genealogy of Moral Hazard,” a historical account published in 1996. Moral hazard signifies the perverse consequences of well-intentioned efforts to share the burdens of life, and it also helps deny that refusing to share those burdens is mean-spirited or self-interested.”

That is not to say that there is no such thing as moral hazard. Economists point to a 2008 settlement in which Countrywide Financial announced that it would modify subprime loans for people who were delinquent. Suddenly, many of Countrywide’s subprime customers stopped paying.

But remedies can be designed to reduce moral hazard, said Adam J. Levitin, a Georgetown University law professor and mortgage expert. He points out that Countrywide, now owned by Bank of America, offered help only to those in default, instead of to all those who were given suspect loans. In the case of the debit cards, an investigation found that FEMA neither checked the identity of recipients nor told them how the money could be spent.

Under the new foreclosure settlement, only homeowners who were already delinquent will be eligible for principal reduction.

Plenty of other factors keep homeowners from trying to shirk commitments, said Elyse D. Cherry, C.E.O. of a community development group, Boston Community Capital. Ruined credit makes it harder to borrow money, get an apartment and, with employers increasingly doing credit checks, find a job. Moving is hard on families. And then there are the larger social costs: pockmarked neighborhoods and declining property values.

Moral hazard, Ms. Cherry said, “is hogwash.” That is an interesting view coming from a woman who runs what might be considered a petri dish for moral hazard. Boston Community Capital buys homes that have gone into foreclosure, then sells them back to the original owner at a price they can afford. If homeowners later sell at a profit, they must split the proceeds with Boston Community Capital.

Presumably anyone who heard about the program, which is small, would be tempted to default. Banks are so sensitive to this possibility that many forbid the resale of a foreclosed home to its original owner, even though it would make no difference to the banks’ bottom line.

But usually, the clients have defaulted long before hearing about the program. Some, in fact, are packed and waiting for eviction.

Consider the case of one Boston Community client. In one view, she might seem like a classic case of moral hazard — the kind of person many Americans are loath to help. When the banks offered to lend her money against the rising value of her home, she happily accepted. Now she owes $400,000 on a house worth closer to $100,000. Aiding her now might only encourage that type of behavior.

Another view is that she is a working person striving for the American Dream. She had every reason to believe that her bankers knew more about finance than she did. She paid a contractor for renovations; he absconded. When the recession hit, her work dried up and her home’s value dropped. Now, she’d love to buy back the home for its current market price.
WHICH view is correct?

Ms. Cherry answers that question with a question: Does it matter? Moral hazard, she said, has been used to fend off solutions long enough.

“Let’s assume that the guy who says, ‘I paid my mortgage; why shouldn’t she pay hers?’ wins, right?” Ms. Cherry said.Now what do we do? How is that a strategy for getting out of the problem that we’re in?”

G20 must protect the IMF from Europe

Mohamed El-Erian

February 24, 2012

At this weekend’s G20 meeting, European countries are likely to press for an increase in the International Monetary Fund’s resources as a means to bolster the firewalls against the eurozone debt crisis. The other G20 members must resist such pressure until Europe starts showing more signs that it’s getting its act together.

The balance sheet of the IMF – an organisation with 187 member countries – is already heavily exposed to the eurozone crisis. Greece, Ireland and Portugal combined account for almost 60 per cent of outstanding loans. And this is before the fund participates in the new bail-out for Greece that was announced earlier this week.

Europe is attracted to IMF financing for four reasons. It is a very cheap source of funding, especially for countries that are essentially shut out of private markets. It can act as a catalyst to unlocking other public and private financing. It is accompanied by a set of policy conditions, including both quantitative and qualitative performance targets. And it can come with technical assistance to strengthen the borrowing country’s administrative capabilities.

It should come as no surprise that over the last couple of years Europe has pressed the IMF very hard to make exception after exception - and it has succeeded. This has resulted in a number of firsts by an organisation that prided itself on the “uniformity of treatment” for member countries.

This went well beyond an easing in the maximum limits on loan amounts. More worrisome, it also involved supporting programmes that were inadequately designed when it comes to three core IMF criteria: they had little chance of restoring medium-term debt viability, they were not fully financed, and they risked the ‘preferred creditor status of the institution.

All this has understandably raised concerns among the other members, most acutely in Asia and Latin America where people still have vivid memories of what they were made to go through before receiving what now seem like relatively small loans compared to Europe. It has also damaged the standing of the IMF in the private sector.

There is some evidence to suggest that, in recent months, the IMF seems more willing to stand up to pressure from Europe. This is certainly commendable. Yet, as widely acknowledged, Europe is still significantly over-represented on the institution’s executive board and, therefore, retains a considerable influence.

The continued pressure on the IMF is also unfortunate given that Europe does not lack financial resources. The eurozone as a whole is a net creditor, with a tiny current account deficit. Its core countries, such as Germany, and regional institutions, such as the European Investment Bank, can borrow at very low interest rates.

Europe’s problem is not a lack of financing, but deep divisions about how the eurozone should operate in the presence of very different initial economic, financial and socio-political conditions among its member countries.

This is an internal issue that the IMF cannot, and should not be expected to, solve. It is up to the eurozone to decide whether to go forward in its current configuration towards a fiscal union or whether to first slim down to a more coherent and stable configuration. This would provide a better basis for a larger European-financed firewall.

As tempting as it is, Europe should not seek to obfuscate this critical decision by using IMF financing to give the appearance of sustaining the unsustainable. It must start making the necessary, albeit very difficult, decisions. Until this happens, the G20 has a global responsibility to protect the IMF from further damage to its credibility and legitimacy.

The writer is the chief executive and co-chief investment officer of Pimco