Greece: negotiating without trust

The Eurozone and Greece are going through the last hours of a negotiation to ensure release of additional funds from the previous agreement and possibly setting the basis for the next one.

The leaked details of the latest Greek proposal and the Eurozone counterproposal is full of details and discussions around technical issues (for example, whether the pension reform is effective from October 31 or July 1st). But what the technical discussions reveal is a negotiation that can only lead to an outcome that will not satisfy any of the parties.

Reading between the lines of the technical details we see the Eurozone asking Greece for a strong package of front loaded fiscal measures many of which are exactly the ones the Greek government wanted to avoid as they go against the electoral platform under which they were elected.

It would be very easy to criticize Germany, Brussels (and the IMF) for failing to see that we are possibly doing again the same mistakes as in previous agreements and that this one is also bound to fail. But the reality is that it is very difficult to imagine any other type of agreement give the lack of trust between the two parties.

Many argue that this government should not be asked to pay for the mistakes of previous governments. After all Syriza was not in power when the Greek government and the Greek economy were running very large deficits. This is correct but it is also true that Syriza was not elected on a platform of economic reform, even if some of the economic reforms being discussed are not contrary to their ideas.

I am very sympathetic to the logic that the Greek finance minister Varoufakis has very well expressed that Greece needs growth first and that insisting on fiscal austerity will not deliver the necessary growth. But I also understand the view of the Eurozone when negotiating with a Greek government that was elected on a platform that is not clear that will deliver sustainable growth. Because of the lack of trust, what the Eurozone is looking for in this negotiation is a strong early commitment that the Greek government is willing to take steps that might go against its own electoral platform. In an ideal world those steps would all be about making growth happen: reforms in an environment where demand is not a constraint for growth. But many reforms cannot be implemented in the short run so the only way to get a signal of commitment is to put on a table a set of fiscal measures to improve primary balances, what the Greek government wanted to avoid.

So we are back to a proposal that looks too much like the previous ones and it is very likely that, even if there is an agreement over the coming hours or days, we will witness again in the near future yet another negotiation between Greece and the Eurozone once it is clear that the current plan will not work.

This is the unfortunate outcome of a negotiation that started without trust between the two parties and where the only possible outcomes where both suboptimal: either another unrealistic agreement or a break up of the negotiations that leads to a Greek default and possibly exit from the Euro area. In the next days we will see which of the two (bad) scenarios turns into reality.

Antonio Fatás

Interest rates: natural or artificial?

The debate about who is responsible for the low level of interest rates that has prevailed in most economies over the last years heated up when Ben Bernanke wrote a series of blog posts on what determines interest rates. He argued, once again, that it is the global dynamics of saving and investment the one that created a downward trend in interest rates starting in the mid 90s and that it accelerated as a result of the crisis. In his story, central banks are simply reacting to economic conditions rather than driving the interest rate (always refreshing to see a former central banker explaining how powerless central banks are). What Bernanke described can be interpreted as a decrease in what economists called the natural real interest rate.

There are, however, those who have a very different interpretation of the persistent low levels of interest rates. They see central banks as the main drivers of this trend and they think about current levels of interest rates as being artificially low and forced on us by central banks. The popular press is full of references to artificially low interest rates causing bubbles, imbalances, hurting savers and being the seed of the future crisis (about 1 million results if you do a Google search).

From the academic world, John Taylor has been very vocal about the negative effects of artificially low interest rates. He stresses the fact that interest rates have been below what a Taylor rule indicates, a sign that there is a mispricing created by central banks. In a recent blog post he refers to the the results of a paper by Fitwi, Hein and Mercer that tests whether Bernanke or Taylor are right when it comes to explaining interest rates. The paper shows that both theories are possibly right. That low interest rates are the result of both a saving glut (Bernanke's explanation) and central banks pushing rates below the Taylor rule level. I find the evidence that the paper presents very weak but my main issue is much more on the interpretation of the hypothesis of artificially low interest rates.

The first question is how can central banks be seen as so powerful as to control and distort a market price for such a long period of time? Typically, the models where central banks are powerful enough to do this are those with nominal rigidities in prices and wages. But these rigidities are assumed to be temporary as prices and contracts adjust. How can it be that central bank have managed to affect a real price (the real interest rate) for more than a decade? I cannot think of an accepted model that would support this. What is more paradoxical is that those who tend to support this view are in some cases those who are critical of models with price rigidities. So on hand they dislike models where central banks are powerful and on the other hand they argue that central banks have been super powerful over the last 10 or 15 years. This is very inconsistent.

The second question is how can it be that such a low level of artificially low interest rates has not had any effect on inflation. The original interpretation of the Taylor rule was always about the level of interest rates that was consistent with a stable inflation rate. How can we explain a deviation from the Taylor rule that lasts for many years and that instead of causing an increase in inflation it is producing a low level of inflation everywhere where interest rates are low? Once again, not sure what model can explain this.

Finally, the view of those who talk about artificially low interest rates tends to be driven by an analysis of the US economy in isolation. Interest rates are low at a global level, they are at low record levels everywhere in the world. What type of coordination exists between all central banks in the world to keep artificially low interest rates everywhere without generating inflation anywhere? The paper by Fitwi, Hein and Mercer tries to look into this issue by analyzing capital inflows to the US and its potential influence in interest rates (as a test of the Bernanke hypothesis) but this is not a good test. If you take the world, there are no capital inflows from other planets but a shift towards higher saving will still cause lower interest rates. 

In summary, there are two very simple facts that provide strong support to the Bernanke hypothesis on why interest rates are (naturally) low:

1. Interest rates are low everywhere in the world.

2. Inflation remains low everywhere in the world.

These two facts are very difficult to square with a world where the US federal reserve is keeping interest rates artificially low for many years. 

Antonio Fatás