EclectEcon

The Spiraling Euro

When the Euro was created, I was one of the skeptics who wondered how long it would survive. As the Euro flourished and gained strength on international markets, I figured there must be something about it that I just didn't understand.

And now I think maybe I understood it pretty well in general but didn't (and still don't) understand the time lags and dimensions.

My early concern was the same as my ongoing concern about the Euro: How can a central monetary union survive if the members of the union cannot discipline or force fiscal responsibility upon its more profligate members? 

Der Spiegel has an excellent 5-part series about the Euro crisis [h/t MA] that seems pretty comprehensive. Some highlights:

The monetary union is a fair-weather construct, as a number of economists said from the beginning. American economist Milton Friedman, for example, predicted that the euro would not survive its first major crisis, and later, in 2002, he added: "Euroland will collapse in five to 15 years."

The reason for the skepticism by Friedman and others was that the monetary union has little or no way to force countries to adopt fiscally responsible policies. Countries like Greece (though I confess I expected Italy to be the most flagrant borrower) can run up massive debts and play "chicken" with the rest of the members of the union. At that point, the solid members must decide what will hurt worse, bailing out Greece (and others to follow) or watching the disruptions emerge as Greece (and others?) default and/or withdraw from the currency union.

 In the end, a country with a large deficit has three options. First, it can declare itself insolvent and, after restructuring its debt, attempt to rebuild its economy. Second, it can also withdraw from the monetary union and reintroduce its national currency. Third, it can convince the creditor countries to keep issuing new loans, thereby providing it with permanent financing.

For more than a year now, European governments have been trying out a fourth option: muddling through.

And I fear that "muddling through" will do little more than make the agony worse in the future.

I might be wrong. Politicians in Greece, Spain, and Portugal might eventually be able to use enough force to implement the requisite austerity programmes. Voters in those countries might eventually come to recognize that their politicians and financial managers had (mis)led them down a path that was unsustainable. 

For the sake of the people holding Greek bonds, I hope these "muddling through" scenarios can work. But meanwhile, I have little interest in holding the debt or equity of financial institutions heavily invested in Greek, Spanish, or Portuguese gubmnt bonds.

In the case of Greece, it looks as if many financial institutions are bailing out.... themselves:

German banks and insurance companies have systematically reduced their holdings of Greek government bonds. Since the beginning of 2010, they have reduced their total exposure from €34.8 billion to €17.3 billion, not including debt held by the state-owned development bank KfW. Insurance companies have reduced their investment in Greek bonds from €5.8 billion to only €2.8 billion in the last year.

This seems like a sensible strategy. What surprises me, though, is that many financial institutions have not unloaded all their potentially bad debt. I suspect there are two (and probably many more) types of explanations for holding onto the Greek and other debt:

• The firms that continue to hold Greek debt expect the taxpayers of other countries to bail out Greece....again. They are betting that Greece will be deemed "too large to fail" in the eyes and wallets of many European politicians and bankers.
• The firms that continue to hold Greek debt are under immense political pressure to sacrifice potential soundness of their investments for the sake of possibly holding the Euro together.

Part 5 of the article sets out some possible outcomes:

[W]hat happens if a country can no longer meet its payment obligations or if a member leaves the monetary union? And how can imbalances in a common currency zone be averted?

There are essentially two alternatives. The first is a radical one, in which the governments pull the plug and leave the beleaguered countries to fend for themselves. The second, more pragmatic solution is to continue muddling along, though somewhat more efficiently, and to hope that things improve. Neither option will be cheap.

 

 

Olympic Tickets: Yet Another Example of Scarcity, Rationing, and Disappointment

According to this recent article in the Evening Standard [h/t Josh] people in the UK must submit applications or bids (i.e. they must join a lottery) if they want to buy tickets for Olympic events in the summer of 2012. And, as most economists would predict, because the prices were set below the market-clearing levels, many people are and will be disappointed.

Almost two thirds of applicants for Olympic tickets were left empty-handed after the public ballot, official figures revealed today.

Games chiefs admitted for the first time that 1.2 million of the 1.9 million applications for London 2012 seats did not get a single ticket - an even lower success rate than feared.

There is a very simple solution to this "problem": raise the ticket prices. At higher prices, the quantity demanded of tickets would decline, and the disappointment among people who don't have tickets will be that they aren't wealthy enough to feel comfortable spending buckets of money on tickets to these events.

When more people want tickets than are available, those tickets must be rationed somehow. For most major events, the rationing scheme involves some combination of the price system, a lottery, favouritism, etc. With prices set up at or near the market-clearing level, people with less wealth or less desire to use their limited wealth to buy Olympics event tickets will feel squeezed out. But that happens all the time: they are also squeezed out of the market for large houses, BMWs, RVs, tickets to other major events, etc., too.

There are two good things about using the price system to ration the tickets to Olympic events:

1. Those most willing to pay (i.e. those most willing to give up comparably valued stuff) will receive the tickets. In this sense, those who value the tickets the most will be the ones who receive them.
2. Those who attend the events and pay market-clearing prices for their tickets will be bearing a much greater share of the costs of putting on the Olympics. If the ticket prices are kept low, then the Brit taxpayers in general will be picking up a larger share of the tab for the Olympics, a result which flies in the face of user-pay public finance policies.

The Economics of Endowed Chairs

Over the many years of my career, I have served on several committees that had to deal with donations for allegedly endowed chairs in the university. The economic illiteracy of those who are on these committees is disturbing.

Here is the situation, as I see it:

If the university wants a fully endowed chair and wants to attract a noted scholar to fill the chair on an ongoing basis, they need to receive a donation that will generate an annual income of between $100,000 and $200,000, depending on the supply and demand conditions of the discipline. To keep the numbers easy, suppose the university can attract a noted scholar and provide some minor research funds for only $100,000 (impossible in business, engineering, or economics, but perhaps within reach in some other fields). 

If this chair is to be fully endowed, in perpetuity, then allowances must be made for expected future inflation. It is extremely unlikely that $100,000 would attract anyone, even in sociology from York University, in 2050. Hence, the endowment must draw no more than 2% (maybe no more than 2.5%) per year from the initial donation, and must reinvest whatever is left over to allow the fund to grow in anticipation of future inflation. In economics jargon, the chair should depend only on the real interest rate, not the nominal interest rate.

Furthermore, if the funding is provided initally during a period when interest rates appear to be less than the expected rate of inflation, as seems to be the case these days, even more will be required if the chair is to be fully endowed.

With these conditions, in mind, fully endowing a chair would require at a minimum $5 million, for the most modest of chairs. Anything less will mean that the chair will be dependent on the university for partial funding and/or that the holder of the chair will be expected to do additional fund-raising.

And yet I have seen several examples of endowed chairs that simply do not seem to understand these simple economics. One chair was funded with a grant of $500,000, to be matched by the university itself; what's worse, the donor was promising only $50,000 a year for ten years. So (over my objections) the department concerned hired someone, spent the money, and then became dependent on the university to fund the position thereafter. One might think this is a shrewd strategy to follow, but of course the department then was forced to cut a position elsewhere once the funding for the chair was exhausted. That's not an endowment; that's temporary funding.

In the most recent example, outside funding of $2million has tentatively been offered to fund a chair at Huron College (see this and this). At today's interest rates, that amount would fund no more than $20,000 - $40,000 of the money required for the chair. The remaining amount would have to come from the college's general funds.

I guess it is possible to partially endow a chair (as seems typical: see this). Just donate a chunk of money, specify a name, and specify the discipline and sub-discipline. But that is a partial endowment, leaving the university on the hook for the rest of the funds. 

Update: Eva points out in private correspondence that with benefits and other costs, she thinks there is no way to fully fund a chair for less than $200,000, and probably more like $250,000 per year. She is likely correct, and if so, with a real rate of interest at 2% - 2.5%, then fully endowing a chair would require $10m, not $5m, and certainly much more than $2m.

More on Islamic Studies at Huron College

I hope I have made it clear in my previous postings on this subject that I do not oppose free and open inquiry into any religion. The concern we raised in our initial letter, and which we continue to emphasize, is about the source of the funding for the proposed chair in Islamic Studies at Huron College, which is affiliated with The University of Western Ontario.

Because I was the primary signer of the initial letter, my name appears in this article quite a bit. Let me make clear, though, that even the initial letter was a group effort. 

From the article,

The UWO-affiliated college is caught in the crossfire of a decision to accept money from Muslim groups -- one local, one international -- to help fund a new chair in Islamic studies. Critics say there's a link to violent jihadism there and the $2 million could influence school courses and choice of chair. Huron College insists neither is true.

Based on numerous items, I am concerned about the quality of the "due diligence" performed by Huron College in their investigation into the nature of the source of funding for this endowed chair. I really hope they will re-open the question for discussion and additional input.

Ann Coulter on Mob Riots versus Political Movements

From a Townhall article, quoting Ann Coulter,

The high-water mark of mob behavior, she believes, was the French Revolution. "The American Revolution was a revolution of ideas," she explains. "The idea of a constitutional, representative democracy, based on the consent of the governed, in the form of three competing branches, was revolutionary. The French Revolution -- which hardly deserves to be mentioned in the same breath as the American Revolution! -- was a protracted mob action, which mostly consisted of some French people mindlessly beheading other French people. The French Revolution was not inspired by some groundbreaking political manifesto like the Declaration of Independence. It was more like a street riot that got out of control and went on for years because they let it.

This distinction is probably important for understanding the Arab Spring. On the one hand, the revolution of ideas might help many protestors win support from the West; on the other hand, much of the protest action seems more like mob rule, an attempt by a different gang to wrest control from the encumbent gang. I would like to think the US State Department is at least considering this distinction.