Trouble in Paradise

I received a question from someone about whether my 5% NGDP rule would be a good policy for a country like Estonia or Latvia.  Before answering that question, I’d like to talk a bit about why these small countries matter.  I will focus on Estonia, the most interesting case.  Why is a tiny Eastern European country with 1.4 million people important?  Because it might be the only country in the world with the three characteristics that I have argued favor economic success:

1.  Free markets

2.  Low tax rates

3.  Liberal culture

I should say right up front that I know relatively little about Estonia, so please take the following with a grain of salt.  The Heritage Index of Economic Freedom lists Estonia as the 13th freest economy, which is pretty good, especially when you consider that it is the only former communist country to even break the top 25.  Estonia has a flat tax rate of 21% on corporate and personal income—scheduled to gradually decline to 18% by 2012.  And if I am not mistaken, it has a Nordic culture (similar to Finland.)

Here is where I am going a bit beyond my knowledge.  My previous research convinced me that the Nordic countries had the most liberal cultures in the world.  However, Estonia’s population is only 69% ethnic Estonian.  Most of the rest are Russians, which is not a particularly liberal culture.  So I don’t know how all that plays out in terms of their actual culture.  But the high Heritage ranking has me intrigued.

In my post on Denmark I discussed empirical research that showed liberal cultures led to market-oriented economic policies.  For instance, although Denmark has a high level of government taxes and spending, in the other 8 Heritage categories it is actually the freest economy in the world.  Now Estonia comes along and seems to be moving in Denmark’s direction, but with tax rates closer to Singapore and Hong Kong.  But Estonia’s culture suggests that in the long run it should have superior governance to those Asian city-states.  And not just better political governance, but also superior corporate governance.  For a right wing liberal like me, there isn’t much not to like about Estonia.

Yesterday I checked in on the latest real GDP figures from Estonia—down 15.6%, year over year.  (Latvia was down 18%.)  Ouch!  Is it back to the drawing boards for optimal socioeconomic models?  I think it is much too soon to say.  Countries like Chile (1982) and Korea (1998) went through severe downturns, but then recovered and are still considered among the more successful developing countries.  Despite the current depression, I expect Estonia to be a highly successful economy in future decades.

George Selgin talks a lot about “good deflation,” that is, deflation produced by technological progress.  Estonia has had what might be termed “good inflation,” which is inflation produced by a combination of rapid economic growth and a fixed exchange rate (to the euro.)  Balassa and Samuelson showed that when a country grows rapidly, the progress is usually most rapid in tradable goods.  This decreases the relative price of tradable goods and pushes up the country’s real exchange rate.  If the nominal rate is fixed, then they will have lots of inflation.  The easiest way to visualize this is the price of haircuts.  In a poor country wages are low by American standards, and this makes haircuts cheap.  As they develop real wages go up; even for professions like barbers where productivity growth is slow.  When they become rich, the price of haircuts can rise to American levels in one of two ways, nominal currency appreciation, or inflation.  In 2005-07 China chose nominal currency appreciation, while Estonia chose inflation (as they kept their currency pegged to the euro, with the hope of eventually joining the euro.)

With all that as background, should Estonia have a 5% NGDP target?  In the typically annoying way economists answer questions, I will say “no, or maybe.”

No: If Estonia is serious about joining the euro, then I think they need to keep the exchange rate fixed to the euro.  Should Estonia join the euro?  It seems to me that they meet the Mundellian “optimal currency zone” criteria.  They are small, geographically close to other eurozone members, in the EU labor market, etc.  So my specific recommendation for Estonia is to keep the currency peg, which does not allow them to target NGDP.  I don’t know enough about the politics of the eurozone to know whether a one-time 10% devaluation would be feasible or desirable.  Because the Baltic states have a great deal of euro debt, currency devaluation might do more harm than good.

Maybe: I’d also like to answer this question from another perspective, what if we simply considered Estonia to be a small open economy, but not a likely candidate for joining the euro, perhaps a country like New Zealand.  Then what should they do with monetary policy if they are in a severe recession where output is falling at a 15% rate?  Would 5% NGDP targeting lead to 20% inflation?  And if so, would that be a bad thing?  It turns out that both questions are surprisingly difficult to answer.

I strongly believe that if the U.S., European, or Japanese RGDP was falling at a 15% rate, then a more expansionary monetary policy would be desirable.  Except in obvious cases like losing a war, it is almost unimaginable for a big industrial economy to see a decline that sharp without domestic demand playing some role.  And I believe monetary policy can and should prevent demand shocks from reducing output.  But small countries may be different.  Because they are strongly impacted by shifts in world AD, and sectoral shocks, it may not be possible for them to prevent RGDP from falling rapidly if the international environment turns against them.

I am guessing that Estonia is suffering for some of the same reasons as other formerly high flying European economies (Spain, Ireland, Iceland, Latvia, etc.) problems in the real estate and banking areas.  Estonia had been growing very fast, so some of the slowdown presumably reflects less construction, etc.  One question that I would focus on is how the drop in NGDP was distributed.  Estonia now has low inflation, so both nominal and real GDP are falling fast.  Is there high unemployment?  Were there a lot of foreign construction workers who lost jobs?  Did workers take nominal pay cuts?

The best argument for NGDP targeting in a depression is that is leads to the most efficient allocation of resources.  To see why, consider Earl Thompson’s closely related nominal wage rule.  Suppose you have an international shock which requires a 15% reduction in everyone’s real income.  But also suppose workers have been getting 5% pay increases, and wages are sticky.  If nominal wages are rising 5%, then you need 20% inflation to get the optimal fall in real wage rates.  And that is exactly what you get with 5% NGDP targeting and negative 15% RGDP growth.  (And if it works, the RGDP decline may be smaller than 15%.)

Won’t this just lead to a wage price spiral?  It shouldn’t if people are rational.  If you assume sticky wages are the only problem in the labor market, then keeping nominal wage growth steady actually keeps the real wage rate close to where it would be with no wage stickiness.  And remember that you still have a severe recession (-15% RGDP growth.)  So even with wages where they should be, unemployment will rise sharply for the usual Austrian “misallocation of resources” reasons.  This unemployment should keep wages from accelerating, despite the high inflation.

Isn’t this unfair to savers who bought government bonds?  I don’t see why.  They lose 15% (the other 5% of inflation was built into interest rates, ex ante, due to the Fisher effect.)  In other words, they share equally with workers in Estonia’s economic misfortune.

Again, I’m not saying this is necessarily the way a small country should react.  If they are committed to a currency board (Hong Kong), or to eventually joining the euro (Estonia, Latvia), it is not the way to go.  If like New Zealand and Chile they seem committed to a freely floating currency combined with nominal targeting, then I think it is worth considering.  I believe both of those countries now target inflation.  But I don’t see any obvious reasons why NGDP targeting would be worse.  Of course you’d hope that 15% declines in RGDP are rare, but if they did occur once in a while would this adjustment mechanism really be so bad?  There is a tendency to extrapolate into thinking that NGDP targeting would lead to higher long run inflation than inflation targeting.  But that is an illusion created by the fact that we are only considering recession periods in this thought experiment.  Any extra inflation during these periods would be offset by lower inflation (or deflation) during boom periods.

So why did I say “no or maybe,” why not “no or yes” depending on the exchange rate regime?  Because a lot of odd things can happen in a small country that are much less important in a large economy.  Relative price shifts and sectoral changes loom much larger.  For the U.S., I support NGDP targeting partly because it tends to closely replicate the more theoretically desirable nominal wage rule.  But in an unstable small economy those two rules may diverge sharply.  In that case some other rule might be better.  Perhaps Selgin’s productivity norm, or Thompson’s nominal wage rule.  Maybe even a discretionary policy aimed at replicating those norms, until the crisis is over.  I’m not generally in favor of discretionary regimes, but as Rumsfeld might say “you fight against an economic crisis with the policy regime you have, not the one you wish you had.”

Let’s return to the question of why Estonia is important.  Its success would show that the enviable social achievements of the Nordic countries could be achieved with a regime combining low taxes and free markets.  Can it be done?  I think Singapore is showing the answer is yes.  But Singapore is easy for Western intellectuals to write off.  It’s an authoritarian quasi-democracy.  And although it has more people than Estonia, it doesn’t seem like a real country, with cities, towns and rural areas.

The Nordic countries are an interesting laboratory for the world economy.  For instance Holland and Sweden have had success with comprehensive school voucher programs.  Now Estonia is trying another experiment—flat taxes.  It is a country to watch.



32 Responses to “Trouble in Paradise”

  1. Gravatar of Bill Woolsey Bill Woolsey
    16. May 2009 at 10:38

    I think nominal income targeting is the way to go.

    If the rest of the world is dropping aggregate demand, the drop in the value of the currency just helpfully drops export prices to better maintain demand.

    Yes, import prices rise, but that is the best way to adapt to a loss in the terms of trade anyway.

    The foreigners crazy policies means we can’t afford their stuff. To the degree we can, we subsitute domestic production, but we just take a loss in our standard of living.

    Suppose the people of Charleston, SC were presuaded by me that they should all have perfectly flexible prices (and wages.) And so the drop in U.S. aggregate demand resulted in us cutting our prices and wages enough to maintain full employment.

    That is what Estonia would be doing.

    IT is true, of course, that our dollar debts (here in Charleston) would be more difficult to pay. And as it is, people like me (who remains employed) isn’t having a problem. Only the unemployed people and those whose incomes are falling because of less real sales are having difficulty.

    Simiarly, in Estonia, those with Euro debts would be hurt by depreciation of their currency, but no more than they would by flexible prices. With firxed exchage rates and sticky incomes, if some take the loss in output and employment, then they can’t pay their debts.

    Foreign creditors who have lent Euros? Well, they are on the other side of the coin of the debtors.

    What about foreign direct investment? Yes, if they repatriate profits during the “depression” they take a loss from the currency change (if they are selling to Estonians, anyway,) but without the depreciation they can’t sell much anyway. They wouldn’t be making money off the Estonias in their great depression.

    Jane Jacobs argued that each city should have its own currency.

    The fixed exchange rate approach requires drops in nominal incomes. Foreign denominated debts are still hard to pay.

    Now, if nominal incomes don’t fall to clear markets, and some people lose their jobs (and not others,) then those who are unemployed can’t pay their debts. Those who remain employed can. It is good for them.

  2. Gravatar of Giedrius Giedrius
    16. May 2009 at 11:50

    I am from Lithuania, and our situation is similar, so it is very useful to hear an opinion of macroeconomist who knows what he is talking about and is much more intellectually honest than some others 🙂 A couple of remarks:

    – I think you forgot payroll tax and VAT, so the total tax rate in Estonia might be closer to Denmark rather than Hong Kong.
    – You also seem to be looking at the problem from “bureaucrat god” perspective and ignoring public choice issues. After taking them into account, the answer might be “no, just get the euro as fast as you can”.

  3. Gravatar of 123 123
    16. May 2009 at 14:21

    Many thoughts about this long post:

    1. NGDP figures are needed to understand the actual magnitude of change in Estonia and Latvia. Q1 figures are not yet available, but 2008 Q4 NGDP in Latvia fell 0.4%, in 2007 Q4 NGDP growth was 29%. In Estonia the figures are – 2008 Q4 NGDP decreased by 5%, in Q4 2007 NGDP growth was +17%.

    2. Estonia and Latvia operate currency board systems (100% foreign reserve backed peg to Euro), and these NGDP swings are a result of the peg. Bill, you are advocating a switch to a currency float, but such a switch would instantly bankrupt a third (if not a half) of companies and bankruptcy related unemployment would be even larger than wage-stickiness induced unemployment now.

    3. We can also discuss what would happen if Latvia and Estonia had NGDP targeting from the start. In Latvia that would mean that 10% RGDP growth in 2007 would have translated into 5% NGDP growth, 5% deflation and 25% currency appreciation in 2007. There is a huge risk that such currency appreciation would have attracted even higher non-FDI capital inflows in 2007 together with a sharp reversal in 2008 that could cause Iceland style collapse.

    4. Scott asked if NGDP targeting in a recession is fair for to savers who bought government bonds. If bonds were issued when NDGP targeting was operating, everything is fair. If there is a sudden switch, we can call it Obama-fairness (remember GM secured bondholders).

    5. “Jane Jacobs argued that each city should have its own currency.” Public choice issues are very important here. Bill would argue that if Detroit had its own currency, it would be booming with 4% unemployment rate. Maybe, but there was already plenty of time for wage level adjustment needed to have full employment. Also there is a big risk that due to political dysfunction Detroit would have NGDP targeting in theory and Zimbabwe level inflation in practice.

    6. Scott, you are right to emphasize Mundellian optimal currency zone analysis for small countries.

    7. Scott, you had some questions about Estonia. Flat tax on corporate profits is paid on distributed earnings only, so retained earnings have zero taxation. The culture is Nordic. Social security taxes are high. Russian culture is not a problem for the economic growth. Economic slowdown reflects less construction and manufacturing. Unemployment is much higher than in the past. Construction workers who lost jobs are mostly local, not foreign. Nominal wage adjustments are also happening, instead of explosive wage growth of 2007 three quarters of employees in Latvia had their nominal wages reduced in Q1 2009.

    8. Scott, would you recommend NGDP targeting for major oil producers that have USD pegs?

  4. Gravatar of TGGP TGGP
    16. May 2009 at 14:22

    Estonians speak a Finno-Ugric language (like Hungary and Finland), though for whatever it’s worth they are not accordingly more similar genetically to their co-linguists relative to neighbors. It might be for that reason that you concluded they had a culture like Finland’s. I would have assumed it was more like other eastern european baltic states, but I don’t actually know.

  5. Gravatar of happyjuggler0 happyjuggler0
    16. May 2009 at 14:24


    It is worth mentioning that not all taxes are created equal, something that your favorite countries listed have all figured out.

    Specifically, I am referring to the fact that they all have low or moderate corporate income tax rates, at least compared to countries like France, Germany, Italy, the US, and Japan, amongst others.

    European countries really get a huge amount of their tax revenues from their VAT’s, a consumption tax. Sweden, Norway, Finland, Denmark all also have high headline income tax rates, on all levels of income, not just high wage earners. Only time will tell if the latter is sustainable in an area (i.e. the EU) with high availability of international labor mobility, especially amongst high productivity workers.

    P.S. There is a blog by a Swedish economist (in English) who belongs to the Austrian School who covers the region (including Estonia and Latvia) a lot on his blog. He also had some good things to say about your NGDP targeting notion, although he had reservations about you.

    You might want to check out his blog if you really want to learn more about the region’s economics from a libertarian economist who has a good prediction track record.

    P.P.S. I had to uncheck my adblocker to access his archives for some reason. Hopefully that is merely a recent glitch between Blogger and Firefox that will disappear soon.

  6. Gravatar of ssumner ssumner
    16. May 2009 at 18:36

    Thanks for all the great info–I was out all day today and will answer comments tomorrow.

  7. Gravatar of ssumner ssumner
    17. May 2009 at 07:05

    Bill, You said:

    “Jane Jacobs argued that each city should have its own currency.”

    I’d hate to sit between Jane Jacobs and Robert Mundell at a dinner party! Seriously, I have trouble with the idea that the optimal currency zones are that small. But I certainly find your argument for NGDP targeting to be very persuasive.

    Your point about debts is a good one. It suggests the real issue is optimal currency areas. You either go for a single currency, or a floating exchange rate. Of course there may be special reasons for a currency peg. In HK they seem to think it instills confidence in their international banking system. And less developed countries lacking a sophisticated policymaking apparatus can outsource their monetary policy to the US or Eurozone.

    Giedrius, Thanks for the comment. I agree with you that from a public choice perspective the euro option is probably best. The other discussion of NGDP targeting was more hypothetical, thinking about how it would work in small open economies. You are right about the 12% payroll tax. My guess is that the total tax rate is still much lower than Denmark. BTW, the U.S. (and UK) is moving toward a 50% top rate (state and local), if Estonia gets to a 18% flat tax and 12% payroll tax, that would still be pretty good.

    Any country that is serious about moving in Singapore’s direction must create a large forced saving program. I just don’t see any other feasible way (that would be politically acceptable.)

    123, The 2009 Q1 RGDP numbers are out; I believe RGDP was down 15.6% in Estonia and 18% in Latvia. I am virtually certain that the NGDP numbers were much worse than Q4 2008, but I lack the data.

    2. I don’t understand the relationship between real exchange rates, nominal exchange rates, real output, and foreign debts well enough to comment on your dispute with Bill. I do understand both of your points, and I think Bill’s argument is often overlooked. But I don’t have a sense of the relative magnitudes of each side’s argument.

    3. Similar to my previous answer in the sense that I don’t know a lot about this issue. Bill could respond that yes, the lat (is that their currency?) would rise at 5% a year, but also the appreciation in Latvian assets in lat terms would be 5% less. So for foreign investors it might have been a wash.

    4. Nice analogy (also FDR fairness)

    5. There is a hidden weakness in Bill’s argument: He is sort of assuming an optimal policy by the small country. But the decision is not fundamentally about a currency peg vs NGDP targeting, it is a currency peg vs a floating rate. Can we assume the little country would have better monetary policy than the large region? Remember that if the U.S. and Eurozone had had NGDP targeting, there would have been no crash in the first place (in my view.) So the Baltic states aren’t suffering so much from a currency peg, as from a worldwide lack of understanding of how to run fiat money regimes at near zero rates.

    7. Your comments about the economic data are very interesting. Sounds like they have a better corporate tax system than we do. BTW, wouldn’t the complexity of our corporate tax code be MASSIVELY simplified if we merely taxed dividends and other payouts? Are there good arguments against doing this?
    If most Latvians are taking nominal pay cuts, then this suggests easier money is needed. So if we were talking about New Zealand (a country not planning to join the euro), then that data would lead me to push for more currency depreciation.
    BTW, I do realize that small countries probably have more nominal wage flexibility that big countries—and they need it. But consider Hong Kong. It must have quite a bit of nominal wage flexibility, and yet is has the most traditional Phillips curve of any major developed economy (since 1983.) Even in HK, deflation raises unemployment sharply.

    8. The oil producer/exchange rate issue is beyond my area of expertise. But could someone explain to me one single reason why it matters that “oil is priced in dollars.” I keep hearing that phrase. I could see why it would matter if OPEC was setting oil prices. But they don’t, the market does. So nominal oil prices fluctuate daily in ALL currencies. And while I am at it, I don’t understand the fixation on dollars as international reserves. We are not really talking about dollars, we are talking about dollar debt. Why would a country care whether dollars are the traditional reserve currency? Why not hold eurobonds? If the Chinese get very rich and keep saving a lot, then they will inevitably buy lots of US and Eurozone bonds.

    TGGP, I did know about the language angle. I vaguely recall reading that heavy Swedish and Finnish investment in Estonia was partly cultural–there was some sort of cultural affinity. But I am not really sure. If true, it would be very interesting, as Estonia has become much more free market-oriented than any other formerly communist country. All of those languages started near Mongolia. BTW, I wasn’t suggesting any important genetic differences, and indeed even culture can change fairly rapidly. So no one should interpret my cultural musings as indicating that one nationality is “better” than another. At best one could argue that a particular culture, at this point in time, might be better at neoliberalism than another culture, (but worse at lots of other things.)

    happy juggler0, Yes, I did discuss corporate tax rates in another post. The US and Japan are falling further and further behind the rest of the world in getting to a more competitive corporate tax system. Some have argued that the huge welfare states require a somewhat regressive consumption tax regime, as it is the only way they can raise enough revenue, without severely hurting their economy’s efficiency.

    Thanks for the tip about the Swedish blogger. I’ll take a look. I had planned to abandon monetary economics and research neoliberalism in Northern Europe. And I started the project last summer. But the economic crisis pulled me back to monetary economics.

  8. Gravatar of 123 123
    17. May 2009 at 08:42

    3. Lat appreciation would be 25%, not 5% – a big difference for investors in latvian nominal assets.

    4. FDR mostly fair – I think there were no gold denominated loans then, though some peolple perhaps had foreign currency denominated liabilities (=liabilities linked to gold)

    7. Estonian system could distort efficient allocation of capital. Tax on dividends would generate much less revenue than current corporate profit tax in the US.

    New Zealand – I think floating exchange rate regime is the best for small countries if two conditions are satisfied – there is no obvious larger optimal currency area, and there are no big public choice problems. NZ passes both conditions with flying colours.

    8. ” But could someone explain to me one single reason why it matters that “oil is priced in dollars.”” It is 99% of propaganda and 1% of fight for seignorage income.
    China did not diversify bond holdings in time and has a legacy usd asset problem (if they shifted their portfolio now they would increase their losses on usd holdings)

    “I vaguely recall reading that heavy Swedish and Finnish investment in Estonia was partly cultural-there was some sort of cultural affinity. ” Lots of cultural affinity between Estonia and Finland. Links with Sweden are based more on geography.

    “All of those languages started near Mongolia.” Estonian culture is 100% European with no Asian elements.

  9. Gravatar of Giedrius Giedrius
    17. May 2009 at 22:03

    Estonian culture does have a streak of pragmatism compared to their southern neighbours. The relevant cause of the difference is perhaps the religion – Latvia and Estonia were historically Protestant. Ironically, their pragmatism turned against them after World war II, when Lithuania saw by far the largest arguably irrational armed resistance to Soviets movement, which certainly contributed to relatively smaller scale of Russification.

  10. Gravatar of 123 123
    18. May 2009 at 01:25

    I have this classification of small countries
    A. floating currencies with targeting of nominal indicators AND reasonable supervision of domestic financial sector (New Zealand)
    B. currency board system and financial sector dominated by reasonably strong foreign entities (Estonia)
    C. adoption of foreign currency, weak domestic financial sector (Ecuador)
    D. floating currency with poor execution of central banking functions, bad supervision of local banking system (Iceland, Zimbabwe)

    A countries might outperform B countries but with a higher risk of D scenario. C is a natural progression from D. C countries would do better by moving to B.

    Forex flexibility is not the only available mechanism to stabilize the economy of small countries. Bryan Caplan some time ago wrote about Singapore where employers share of payroll tax is adjusted to achieve the desired effect.

  11. Gravatar of Bill Woolsey Bill Woolsey
    18. May 2009 at 01:46


    Politicians can move from B to D with a stroke of a pen.

    Politiicans can move from C to D with an order of banknotes from an international vendor and a stroke of a pen.

    Could you explain to me exactly why a deprecisation of the currency would cause most Baltic firms to fail?


    The key element of an “optimal” currency area is labor market freedom. Assuming that the optimal currency area has something close to an optimal policy, and currency depreciation would be the “best” policy for region, an even better approach would be for some of the people to move to places where there is a higher demand for labor.

    The problem for Latvia and Estonia is that the Europeans are not running an optimal monetary policy.

  12. Gravatar of 123 123
    18. May 2009 at 03:51

    “Politicians can move from B to D with a stroke of a pen.”
    Hong Kong in 1998 and Estonia now are good examples that politicians successfully resist such temptation.

    “Politiicans can move from C to D with an order of banknotes from an international vendor and a stroke of a pen.”
    Montenegro and Bosnia use euro and there is no risk of a move to D there.

    “Could you explain to me exactly why a deprecisation of the currency would cause most Baltic firms to fail?”
    If half of loans are euro denominated, most of them would fail. There would be a total destruction of banking sector, as real gains for local currency borrowers would not be shared with banks, and losses of euro borrowers would be absorbed mostly by the banks.

  13. Gravatar of ssumner ssumner
    18. May 2009 at 04:47

    123, 3. Yes I was thinking of the problem in the wrong way. I was looking at the steady state equilibrium. But I don’t know if your way is right either. It seems to me that the only way you could get 25% expected appreciation was with a fixed rate that is expected to be devalued. With a floating rate the exchange rate immediately goes to the proper position, and then there is no arbitrage possibility.

    4. There were lots of gold bonds, including U.S. Treasury bonds. The U.S. defaulted on those obligations.

    7. Yes, I see your point. But couldn’t firms invest in other firms, and avoid the tax? I suppose the answer is that there is an agency problem. The obvious solution is to get rid of all income taxes, corporate and personal. If you want a progressive tax, make the payroll tax progressive.

    I agree about New Zealand.

    Of course the Gulf states could price the oil in euros and use the money to buy U.S. T-bonds. I guess that transaction would use euros, and is presumably what you mean by 1% seignorage.

    I agree about China. Of course the real issue is why do they buy up so many foreign assets in the first place, especially given China’s low income and fast growth potential. It may partly reflect the problems with internal governance (they do this because they lack the ability or political will to set up optimal private savings mechanisms)—or it may be a big mistake. South Korea ran persistent trade deficits during its rapid growth phase.

    Yes, my comment on Estonian related to the language’s origin, not culture.

    Thanks Giedrius.

    Bill, Your point about the euro monetary policy is a good one. My point is that it is hard to decide long run policy on that basis. Most people think they are above average drivers, but they are not. Most countries probably think they can run an above average monetary policy, but they can’t. On the other hand I just read that Eurozone GDP fell at a 10% annual rate in the first quarter—which supports your point. What is astounding about that number is that the Eurozone was not in a liquidity trap last fall and winter. When the crisis hit they had enormous slack to cut rates, and they didn’t until much too late. They argued that they wanted to save ammunition for when they really needed it. Of course now that they really need it the ammo is no good.

    123, Milton Friedman predicted that real exchange rates would be just as stable under floating rates as under fixed rates. If I had been old enough to make predictions back then, I would have made the same prediction. He was wrong, although I am still not sure why he was wrong. In any case his error supports your point. The choice is not between 25% currency depreciation and 25% deflation, it is often a choice between 25% currency depreciation and 1% deflation.

  14. Gravatar of Rob Rob
    19. May 2009 at 06:08

    For what it’s worth, page 159 of the WEF Global Competitiveness report (based on models developed by Porter and others) ranks Estonia versus 133 other countries on dozens detailed economic indicators indicators (based on a combination of hard data and survey data). Free market: CHECK. Low taxes: ??

  15. Gravatar of ssumner ssumner
    19. May 2009 at 18:02

    Rob, Yes, Estonia may be in the “medium taxes” category, not low taxes.

  16. Gravatar of 123 123
    21. May 2009 at 09:58

    “It seems to me that the only way you could get 25% expected appreciation was with a fixed rate that is expected to be devalued. With a floating rate the exchange rate immediately goes to the proper position, and then there is no arbitrage possibility.”
    I wasn’t talking about expected 25% appreciation, but about 25% realized appreciation.

  17. Gravatar of JTapp JTapp
    21. May 2009 at 11:29

    Fistful of Euros has been chronicling the recession’s effects on Estonia for several months. It’s been noted by several economists because Estonia has had to reduce government spending in the middle of the crisis (to keep budget balanced) and it can’t devalue its currency because it uses a currency board. Those are typically not recipes for alleviating a downturn in the business cycle.

  18. Gravatar of ssumner ssumner
    21. May 2009 at 15:14

    123, The quote of mine that you used was all garbled. I meant 25% expected appreciation. But if you were talking about actual appreciation, would that lead to a capital inflow? I had thought it was expected appreciation that mattered.

    JTapp, If Estonia is serious about the euro peg (and I think it is) then fiscal policy can’t do much anyway. I hate to say this but I think they might need some wage cuts. Normally I would recommended monetary expansion rather than wage cuts, but they seem pretty committed to the euro. Someone mentioned that Latvia has already cut wages. I don’t know about Estonia.
    I don’t know if people realize this, but the Keynesian argument against wage cuts that people like Krugman talk about (i.e. that it reduces AD) is not really applicable to small countries with currency boards. So wage cuts seem a more feasible option than in a country like the U.S.

  19. Gravatar of 123 123
    22. May 2009 at 13:05

    Scott, in practice 25% (per year) realized appreciations are usually associated with capital inflows. How does it work in ratex theory? Maybe expectations are changing???

    Iceland is the strongest example for those who argue that inflation targeting is a bad policy and that central bankers should fight bubbles (credit bubble in case of Iceland). In case of Iceland NGDP targeting would have almost the same consequences.

  20. Gravatar of ssumner ssumner
    22. May 2009 at 16:41

    123, Two comments:

    1. Doesn’t that reverse cause an effect. International macro’s not my area, but I thought the capital inflows could cause the higher realized exchange rate.

    2. Iceland screwed up its bank regulation policy. They let banks expand massively into Europe, without realizing that a country of only 300,000 was on the hook for deposit insurance of an industry serving millions. That was madness (and I think many of us free market types underestimated the size of the problem.) Having said that, a small country like Iceland may not want to do NGDP targeting, for some of the same reasons I mentioned for Estonia. I think they’ll join the euro.

  21. Gravatar of 123 123
    23. May 2009 at 03:15

    Iceland is also a good counterexample for EMH (for credit markets).

  22. Gravatar of ssumner ssumner
    23. May 2009 at 05:20

    123, But what is the EMH really supposed to be about? That’s what is so puzzling. It doesn’t say people and banks can’t make mistakes. It says in some sense that the mistakes should not be systematic and predictable. I don’t think we (as economists) have ever come up with a good way to distinguish between perfect foresight and Ratex. Suppose the EMH was completely true but we lived in a world with all sorts of uncertainty on every level. We didn’t know the shocks, we didn’t even know the underlying model that was creating shocks, we couldn’t predict the political environment, etc. How many mistakes would we observe, ex post, in that world? And how would the number of mistakes compare to what we observe in this world. I’m willing to believe that this world has more mistakes that a perfect EMH world with massive uncertainty (perhaps including Iceland), but I really don’t know how many more. And I also wonder if most people don’t underestimate how many mistakes we’d observe in even a perfect EMH world. Does that make any sense?

    I consider myself as “rational” as the next person, but I didn’t see this severe crisis coming.

  23. Gravatar of Bill Woolsey Bill Woolsey
    25. May 2009 at 03:49

    Thinking of the Iceland situation as a credit bubble _in Iceland_ that should have been avoided by their central bank is wrong headed.

    Icelandic banks were accepting foreign deposits and using the funds to make foreign loans. They were making profits on the difference between rates charged and paid. A few Icelanders (in absolute numbers) got rich. But this was a large portion of the population. The entire country would be like Wall Street writ small. The other Icelanders became well off providing services to those who got rich on providing financial services to the world.

    The loans of the banks were bad (much like the investment banks on Wall Street.) The foreign depositors abandoned the banks. The profits went away. Collapse.

    Suppose your country grows acai berries and suddenly the whole world thinks they are the secret to good health. Everyone in the country begins growing them or else providing $500 haircuts to the berry kings. We are rich.

    Then the Fad passes, and we are all poor.

    But the “good” provided by Iceland was banking.

  24. Gravatar of ssumner ssumner
    25. May 2009 at 16:49

    Bill, That’s right. And I see deposit insurance as the key “market failure” in Iceland. It was madness for the government to insure millions of foreign deposits–they were inviting risk-taking. It would be like Warren Buffett loaning me $24,000,000 for a weekend in Vegas. I’d put one million each on numbers 1-24 in roulette, and I’d have almost a 2 in 3 chance of walking away with $12,000,000 in my pocket after I repaid my loan to Warren. Of course if numbers 1-24 didn’t come up . . .

    Unfortunately for Iceland, they got a 00.

  25. Gravatar of 123 123
    26. May 2009 at 12:55

    “It was madness for the government to insure millions of foreign deposits-they were inviting risk-taking.”

    And it was madness for the global bond markets to underprice the credit risk of Icelandic banks. And this madness is not compatible with EMH.

  26. Gravatar of ssumner ssumner
    27. May 2009 at 06:16

    123, Those are different types of errors. Just because a government makes an ex ante policy error, doesn’t mean markets have made an ex ante error. That is what the EMH debate is all about. The bond market might have thought Icelandic banks were good investments, and yet the public policy still might have been all wrong, even ex ante. Of course ex post the bond market looks foolish, but ex post isn’t it always that way, with all markets?

  27. Gravatar of 123 123
    27. May 2009 at 08:52

    I don’t understand why the same foolishness is an error when government does it but is an efficient investment when bond market does it.
    I also think that Krugman has EGH (efficient government hypothesis) somewhere in the back of his mind.

  28. Gravatar of ssumner ssumner
    27. May 2009 at 16:53

    123, It is not at all the same kind foolishness. Deposit insurance creates moral hazard–we know that. It encourages banks to take too much risk. The banks were doing what they were supposed to do according to market forces. There is a difference between instituting a public policy that you know is wrong, ex ante, and making a bad forecast. The cases are not in the slightest analogous.

    Given the facts available at the time, I would have easily spotted the moral hazard problem. Given the same facts I would have had no idea that Icelandic bank bonds were miss-priced. How would I know that?

  29. Gravatar of 123 123
    28. May 2009 at 10:55

    Banks were doing what they were supposed to, but bond marked completely ignored moral hazard issue for a long time. Risk of moral hazard issue implied by prices of Icelandic bank bonds was zero for a long time.

  30. Gravatar of Thruth Thruth
    28. May 2009 at 11:04

    123: The moral hazard in question is the fact that bond holders don’t have the risk of loss, taxpayers do. Thus, why should they price it?

  31. Gravatar of ssumner ssumner
    28. May 2009 at 17:06

    123 and Thruth, I agree with Thruth. I’m not saying the bond buyers didn’t make a mistake, ex post, but you’d have to show that it the ex ante risk of bank default was not priced into the bonds, and that would not be easy to do.

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