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Dear Clients,

Lyric Hughes Hale has written an article for Yale Press, “’Sturm und Drang’ and Rational Expectations,” which chronicles some of the key developments that took place during the World Bank/IMF meetings in Washington DC this past weekend, including how many European officials spent the weekend on the defensive about their policy decisions.

The article can be accessed by clicking on the following link: http://yalebooks.wordpress.com/2011/09/28/author-article-by-lyric-hale-sturm-und-drang-and-rational-expectations/

Additionally, the German vote today on expanding the EFSF is a welcome development that should help to mitigate contagion risks and improve short-term confidence, but many hurdles still need to be cleared before the crisis situation is resolved in the euro area

Finally, our New York area clients might be interested in attending an event this Monday, October 3rd, at the Japan Society where both David and Lyric will be speaking. The event, “What’s Next? Change in Tokyo & the World Economy,” will take place from 12-2 at the Japan Society’s offices on 333 East 47th Street. Additional information about the event, including a link to register for it, can be found at the following link: http://www.japansociety.org/event_detail?eid=5d628c35

As always, we welcome any comments or feedback you may have.

Sincerely,
Mark Zoff
Director of Research

DAVID HALE GLOBAL ECONOMICS INC.
546 Lincoln Ave #2A
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Tel: 847-386-6009
Fax: 847-386-6011
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E-mail: markzoff@davidhaleweb.com
Website: www.davidhaleweb.com

We are pleased to announce that What's Next: Unconventional Wisdom on the Future of the World Economy, a compendium of economic forecasts from pre-eminent independent economists, is available for purchase.

Copyright 2011, David Hale Global Economics Inc. All rights reserved. Please do not forward the attached document to individuals not authorized by David Hale Global Economics to receive it. It contains confidential information and is intended only for the individual named. This document is not for attribution in any publication, and you should not disseminate, distribute or copy this e-mail without the explicit written consent of David Hale Global Economics.


‘Sturm und Drang’ and Rational Expectations

By Lyric Hughes Hale

Monday night was a sea of convivial calm at an awards dinner for New York University economist Thomas Sargent. The Chicago Mercantile Exchange Group and the Mathematical Sciences Research Institute recognized Dr Sargent for innovation in quantitative research, in particular regarding the theory of rational expectations.

This theory holds that people make reasoned economic decisions based on their expectations of the future. They cannot be fooled by policy choices that seem okay now, but that will leave them poorer in the future. One oft-cited example: fiscal stimulus. If the government is spending money to try to boost consumption, people might reasonably expect that this will lead to higher taxes in the future. This will cause them to save, rather than consume, nullifying the intended effect.

Before dinner, there was a two-hour discussion on sovereign debt (the subject matter was chosen a year ago) and the loss of its risk-free debt status. But there was no panicked open outcry about the current crisis. Instead, the panelists offered comparisons with sovereign debt crises during the French and American Revolutions. The solace of economic history is that everything bad has happened before, and we are still standing.

How does Sargent’s theory apply to today’s crisis? Not at all obliquely. I spent the weekend in Washington, where the World Bank/IMF meetings were held. As Larry Summers intoned, this was one of the most serious annual meetings in the history of these organizations. Summer’s key message was that if the Europeans signal austerity, people would rationally decrease demand, expecting a long period of slow growth, which would then feed upon itself and create a downwards spiral. He spoke of the need for the group’s leaders to create a resumption of confidence instead, and in fact many speakers spoke of the need for leadership in foster positive behaviors rather than engage in policy discounting. His mantra was that the world’s economic leaders needed to create alarm, but not panic.

In response, Jean-Claude Trichet, the head of the European Central Bank and not quite a Keynesian, threw out his prepared remarks. Whenever someone does that, you know that something meaningful will be said.

Trichet has devoted his life to the creation and preservation of the European Monetary Union, which is now under direct attack. He responded to Summers “we are not blind” and seemed to blame the crisis on those who “behaved improperly” i.e. the Greeks. Summers called Greece, “a broken ankle, in the face of multiple organ failure.” You don’t usually have this much fun listening to central bankers.

My reaction in the end was that Summers was correct—you can’t just focus on the past, or deal with facts, you need to deal with expectations in order to create demand and a way out from the edge of a deflationary spiral. Summers also won the debate by saying that policymakers who take incremental steps and say that they cannot reference the future basically don’t know what they are doing. I winced as Trichet, ignoring this fair warning, said later that he could only deal with today. “The day after tomorrow, I don’t want to talk about that!” Scary.

The entire weekend was extremely uncomfortable for most of the Europeans. Jürgen Stark, who recently resigned from the ECB, was on the defensive throughout. There is some sort of regime change going on in European banks at all levels, including the UBS bombshell that was announced in the midst of the meeting. Merkel has lost three key allies. In addition to Jürgen Stark, Jens Weidmann, president of the Bundesbank, and Axel Weber, who stood down from his expected promotion to head up the ECB, have gone over to the other side. Sturm und Drang without a doubt!

I was reminded of all of this when Thomas Sargent remarked that government debt crises have in the past led to revolution. (See Macroeconomic Features of the French Revolution). Sargent talks about “unpleasant arithmetic” which he defines in the following way: “Government budget constraints and the arithmetic of compound interest impose restrictions on government deficits and debt. “ In other words, there is an upper limit to the debt that governments can take on without the risk of eventual default. Default can lead to political change.

Default by one or more member countries might also end the European Monetary Union. In Washington, I ran into another Yale University Press author, David Marsh, who has written a book specifically on the Euro. In an article on MarketWatch yesterday, he draws a comparison with 1931, when Britain left the gold standard. Marsh makes the point that although this might have helped Britain, there were eventually very unpleasant contagion effects that damaged Europe as a whole. Britain could make this move, as the pound was in fact a reserve currency at the time. However, the drachma has not been a reserve currency for a couple of thousand years.

The Germans are very unhappy, yet they still seem committed to the Euro, even though it wasn’t their idea. For that, we can blame Francois Mitterrand. As the price for allowing German reunification, he extracted from Helmut Kohl the promise of a currency union, at the price of dropping the Deutschmark. It is ironic that the weakness of the Euro in the current environment helps German exporters probably more than any other country. But what can Europeans rationally expect in the future? A load of debt, albeit at low interest rates, and even higher taxes in the future. So don’t look for demand in Europe to rise anytime soon. The longer this crisis lingers without a clear resolution, the longer the recovery will take. Sargent talks about human capital, which gets lost when people lose their job. A country cannot lose a job, but it can lose the confidence of its citizens. Larry Summers said it well—it is ironic that confidence got us into this mess, and confidence is also what will allow us to recover. That however, requires leadership at the highest level. Less Sturm und Drang, and more rational expectations.


What’s Next? Unconventional Wisdom on the Future of the World Economy by David Hale and Lyric Hale is available now from Yale University Press. Anatole Kaletsky, who contributes to the book is Editor-at-Large and Principal Economic Commentator of The Times, where he writes a thrice-fortnightly column on economics, politics and financial markets.