09 June 2012

Krugman vs Estonian President: Logic of Finance vs Common Sense

On 6 June 2012 the American economist and the Nobel Prize winner Paul Krugman posted in his blog (as a part of his debate for economic stimulus, I suppose) a short article entitled “Estonian Rhapsody” where he is expressing his disappointment about “Estonia suddenly becoming the poster child for austerity defenders”. The Estonian President Toomas Hendrik Ilves made headlines by tweeting as a response: “Let's write about something we know nothing about & be smug, overbearing & patronizing: after all, they're just wogs: http://krugman.blogs.nytimes.com/2012/06/06/estonian-rhapsdoy/

While this incident might be considered either as an insult to a small country (which I believe, it really is not) or as part of the broader argument over austerity vs accommodative monetary policies combined with the economic stimulus (Estonia is simply an example here, even though not always used appropriately), for me it is really a question of the logic of finance vs common sense. As a side note, the later is apparently what the two Pauls, Ron Paul and Paul Krugman, are actually keeping in mind when expressing their opposing economic thoughts – not simply whether the government should spend more or less. Let me explain.

The discussion over austerity vs accommodative monetary policies (i.e. quantitative easing or in one or another way “printing” more money) plus spending has become especially actual concerning the future of eurozone (label it Germany’s way vs the expectations of Mr. Market, if you like). As I have indicated in my earlier blog posts, both sides are right in the sense that the way proposed by the other side would not work. Ironically, the capitalistic economy constructed so that in a closed system (and in terms of the monetary system, the capitalistic economies when taken together still form quite a closed system) the approach of “printing money” still is more viable, even if encouraging reckless spending and living on the expense of the future. Only if a country can steadily export more and more, it can ultimately succeed with the austerity – but this assumes that there are some other countries who are importing more and more, and this obviously creates imbalances such as Northern Europe vs Southern Europe or ChinAmerica.

The devilish formula

Why is that? Why we almost inevitably end up in “printing money” also in Europe? Well, to answer that question, we have to visit the “periphery of monetary theory” and add to this the innovative structures, schemes and risk management practices. Indeed, the word “theory” most probably sounds boring to the practically minded people. Yet this same “boring stuff” is the very reason of the current economic and financial trap, and affects the lives of so many people. There are plenty of nice videos (Zeitgeist movies, for example), articles and blog posts on this (e.g. one of my readers has submitted the link to the blog post entitled How to Own Everything – sounds emotional rather than professional, yet perhaps much more illustrative than any of my own numerical calculations). Yet still, apparently the problem is not being recognised by the vast majority of our leaders. So think about the real issue for a moment before starting debating on whether to implement the next round of quantitative easing or not. 

First and foremost, consider the implications of money being debt. In Money Creation – Basic Principle I illustrate this principle for the old-fashioned traditional banking. Basically by definition, the total money supply (when defined as cash plus deposits) would decline as soon as more debts are being repaid than issued unless the central bank starts massively “printing” more base money. Apparently, less money means more strains.

The problem is being amplified by the fact that by definition, there is always a deficit of money. This deficit results from the interests, which can only be paid when new money is being created. Find a simplified illustration of this effect in the article Compound Interest and Loan Growth. One does not need to be a genius, in order to understand: if money supply remains unchanged, none of the interests can be paid, and hence defaults would occur. Now, when money supply declines because everyone attempts to deleverage, there is simply no other way than more defaults.

Of course, even inevitable defaults can be hidden and postponed for quite some time. For example, banks can restructure and refinance loans in a way that interest payments are either added to the principal amount (i.e. capitalised) or paid from the additionally granted loan amounts; this enables to report profits instead of losses. Yet ultimately, if deleveraging continues, all these hidden defaults become very real.

The above is applicable even to the most traditional way of banking; it is the very fundament of our monetary system.

Banking innovations have immensely increased the deficit of money supply. For example:
* Securitisation has basically enabled creating vast amounts of debt without creating money incredibly fast. (Covered bonds are not much better in that sense.)
* Flexible loan repayment terms up to the point where the loans do not amortise at all (i.e. principal amounts are not being repaid by the borrowers) have increased demand for the loans, and enabled displaying artificially low default rates for years. Note that I’m even not talking about the deceptive lending practices which have been not rare either.
* The “advanced” risk management practices and instruments such as credit default swaps have “helped” to make risks seem low, even though the losses caused by the deficit of money supply cannot just be diversified away; they have enabled running banks almost with no capital while at the same time displaying fairly sound capital adequacy ratios (only recently, the Bank of England came out with a wake-up call).
Apparently, this has resulted in an enormous amount of debt for repaying of which there simply is no money. Accumulating interests are increasing the overall deficit in the money supply.

Logic of finance vs common sense

From this position, the economists such as Krugman argue for quantitative easing combined with increasing government spending. (The latter is necessary because otherwise the freshly “printed” money would not contribute to increasing demand for real goods and services, for boosting economic growth, for creating jobs etc.) And they are right because of the above devilish formula underlying our financial system: if there would be an attempt to repay all the debts without covering the deficit in money supply with the freshly “printed” money, then no one really knows how many defaults we had. Yet one thing is sure: the financial system as a whole would collapse.

Apparently, all suggestions in this direction are against the common sense and sense of fairness:
* How can it be, that spending more and living on the expense of the future generations is preferred to living within one’s means? (The answer: the above described devilish formula.)
* Why should the people who have worked hard and saved, lose their savings because of the inflation which sooner or later would follow the accommodative monetary policies? (Note that no matter what is being said, there is actually no way to prevent the value of money going down.)
* Why should borrowers be on a more favourable position either because part of the debts is being forgiven (as in case of Greece’s government) or because inflation will reduce the real value of debts? 

From the above explanation of the “formula”, it also becomes obvious why quantitative easing is not a solution either even if we forget about the fairness/unfairness: the result is a temporary deleverage thanks to the fresh money that enables writing off part of the old debts, but then the cycle of building up debts and leverage is bound to start all over again. The thing is that because of the current huge hole (the size of which is even not known), we are most probably back to the crisis far too soon.

So stop wasting time for debating about the austerity vs “printing” + spending. Instead, think about how to get out of this cycle of building up debts -> defaults -> printing more money and deleveraging -> starting all over again.

Concerning Estonia

In any case, austerity defenders should be very careful when using Estonia as an example of a country that is “booming” thanks to the austerity measures and the “internal devaluation” – and not because of the graph in the Krugman’s blog post.

At the peak, in 2007 the loan-to-deposit ratio of credit institutions operating in Estonia was approximately 170%, i.e. per each unit of deposits there were 1.7 units of debts. The “generous creditors” had mostly been the major Swedish banks, and Estonians had been borrowing because understandably they wanted to live better sooner. By the end of Q1 2012, this ratio had improved to ca. 125% (data from Bank of Estonia and from Finantsinspektsioon).

The deleveraging has been achieved mainly as a result of:
* Writing off many bad debts, and injecting fresh capital into the local banks by their Swedish parents;
* Cutting back imports and (even though with a delay) increasing exports as a result of which the balance of payments improved considerably (from approximately -16% of GDP in 2007 to +2% in 2011); this in turn made possible at least some of the deleveraging.

Of course, the process has meant austerity for the local people as well as to the government; obviously the demand declined and the GDP fell dramatically during the crisis years, and the recovery can have been only partial since that (even though the growth is healthier now). Yet importantly, note that Estonia is a small country: the Swedish parent banks actually were able to re-capitalise its banking sector (even though with some temporary assistance by the Riksbank), and there has been a market for its exports. The same strategy is most probably not applicable to the eurozone as a whole.

The adjustment process from the lending-based growth to the healthier growth has not been easy for the many Estonians, and any talks about bailing out those who are in fact living much better, cause strong emotional reactions. Considering that “printing money” is, besides being unfair for the people that are saving for the future, not really a solution to the current troubles of the eurozone nor any other country, rightfully so.


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