Monday, July 6, 2015

Calomiris and sticky prices

Charles Calomiris has a very interesting Forbes oped on Greece, with a much deeper insight.
My proposal begins with government action to write down the value of all euro-denominated contracts enforced within Greece. This “redenomination” would make all existing contracts – wages, pensions, deposits, and loans – legally worth only, say, 70% of their current nominal value. This policy would kill several birds with one stone. It would significantly reduce pensions, relieving fiscal pressure and satisfying troika demands for fiscal sustainability. It would do so in a way that would also mitigate the purchasing power consequences for pensioners, because an across-the-board redenomination would lower prices throughout the economy, making the reduction in nominal pensions more bearable. By applying redenomination to deposits and loans, banks’ health would be revived – their loans would now be payable and therefore more valuable, and their net worth would consequently rise. The 30% wage reduction would further reduce fiscal problems and make Greek producers competitive, and operate as an “internal devaluation” to raise demand for Greek products and tourism. Most importantly, this internal devaluation – by solving the problems of fiscal deficits, non-competitiveness and bank insolvency – would inspire confidence in Athens’ ability to stay within the eurozone, which should bring deposits back into the banking system to fuel a rebirth of lending.
I think this is about half right, but a very good idea lies in here.

"an across-the-board redenomination would lower prices throughout the economy"? Not necessarily. Why would any store lower prices just because it gets to lower wages and rent? Prices are not a "contract."

Thus, the redenomination should probably come with a (say) one week price control. Every price must be lowered 30% over what it was the previous day, for a week,  Just long enough for each store to see that its competitors and suppliers has also really lowered prices.  Then stores can do what they want.

The deeper issue here is just what is the price and wage stickiness that so infects macroeconomic thinking. Why is "internal devaluation" by price and wage adjustment so much harder than "external devaluation" by exchange rate adjustment? Our formal models have costs of changing prices. Yet the actual costs of changing prices are tiny.

I think a "coordination problem" is more likely. The baker doesn't want to lower his price because he still pays the same price for wheat and yeast; the farmer doesn't want to lower his price because he pays the same price for fuel, and so forth. This web of prices is of course thousands of times more complex than that story. That's why it takes so long for everyone to agree on lower prices together.

At times, however, prices and wages do change, overnight, with no cost at all. When countries join the euro, every store changes price -- and the symbol next to it -- overnight. That fact alone should tell us that menu costs, though a nice formalism, are not the real microeconomic foundation of price and wage stickiness. And there is a potential role for a government to coordinate price changes.

What Charles is proposing, then, is exactly the same sort of overnight price and wage change that happened on admission to the euro. If you think prices and wages are "overvalued" in Greece, and a "devaluation" is all it takes for Thessaloniki to start exporting Porsches to Stuttgart, then an overnight, coordinated, price and wage change is a very nice alternative policy that we might start taking more seriously.

This is a bit of a "thesis topic" suggestion. I think we need a model of price stickiness as a coordination failure that is as simple and tractable as the standard, but false, Calvo fairy or menu cost models. Coordination failure models might also result in the sort of backward-looking stickiness that Phillips curves in the data seem to show.

Why just a week? Well, the macroeconomic presumption here is that Greece is suffering some sort of "imbalance" or "overvaluation" or "sticky wage." If that's right, one week at the right prices and wages should stick. Each individual store or person would then be reluctant to raise prices without the others going along. If prices jump right back up again after a week, however, without the help of government coordination, then we weren't so imbalanced to begin with, and the problem is really structural not monetary.

I rather suspect that tourist prices are set by competition with Sicily, not local wage stickiness, but it would be interesting to see. Prices of imported goods will also likely jump right back up. Fine.

Charles doesn't mention prices, but he does mention debts. This is a lot harder, as a debt "redenomination" is not just a method to solve a coordination problem and lower all prices and wages relative to German ones going forward, it is a huge transfer of wealth and a technical default.

If you run a coffee shop and charged 2 euros for a cappuccino yesterday, having all the coffee shops change to 1.5 euros overnight (for a week) is one thing. But changing the mortgage payment is another. One is a price. The other is a default.

Charles sneaks off into the economic passive voice here  "By applying redenomination.." which is always a sign of trouble ahead.  Most lenders, especially international ones, will go straight to court on that one.

I also do not follow how "applying redenomination to deposits and loans, banks’ health would be revived – their loans would now be payable and therefore more valuable, and their net worth would consequently rise." Before redenomination: Assets: 50 euros mortgages, 50 euros greek government bonds. Liabilities: 99 euros deposits, 1 euro equity. After redenomination: all numbers cut by 1/3. How is the bank any healthier? All ratios (capital, leverage) are the same.

So I think the proposal has the right spirit but a slightly wrong focus.

Charles continues
Although redenomination would accomplish a great deal, by itself it is not enough. As simple economic theory (formally known as the the Balassa-Samuelson Theorem) tells us Greece will only be a viable long-term member of the eurozone if it can match the long-term productivity growth of Germany and other members. To do so requires it to undertake major reforms to labor laws and competition policies, and to wage a credible war on corruption. 
I disagree pretty strongly here. If "eurozone" means a free trade agreement and a common currency, that can survive just fine with vastly different productivity levels (it already does) and consequently different productivity growth rates. Productivity across locations in the US varies enormously. Ricardo and absolute vs. comparative advantage was all about free trade under the gold standard (common currency) between countries of different "competitiveness" or productivity levels. Perhaps he means eurozone as an area that promises fiscal transfers to produce an equal standard of living everywhere. If so, good luck.

But that Greece's only hope to avoid becoming the next Venezuela is  "major reforms to labor laws and competition policies, and to wage a credible war on corruption" is spot on. In or out of the euro, in our out of the EU, in the end money and trade freedom are small parts of economic growth.


  1. I agree with everything John has written here, but I think the one week is too short, and should be extended to a month to three months. Any longer's likely to create shortages. Most firms change the price of their major product once every three months or less.

  2. This is just more beating around the bush.

    The debt - not just Greek debt - isn't going to be repaid. It's time for everyone to put on their big boy/girl panties and face facts. Debts have to be forgiven and the southern countries (and France) have to do some serious economic restructuring.

    The template is the London Debt Agreement of 1953. A partial debt jubilee and restructuring.

    For Greece and its brethren that means cutting the size of its public sector, eliminating burdensome regs that inhibit business formation (e.g., reduce barriers to forming a business, raising the retirement age, pension reform, easier termination of an employee, reduced union power - perhaps elimination of public unions [fat chance], a flat tax that is ENFORCED, criminal prosecution of crooked politicians and recapture of the money they stole, dismantling the patronage system, and immediate termination of employment for those who try to extract "baksheesh").

    That's asking a lot from Greece but the Greeks are asking a lot from their creditors. It's a business transaction where both parties benefit. If the Greek people want to be free of the yoke of their creditors-in-perpetuity there's a price, and the price of freedom, as always, is responsibility.

    That is the approach that allowed Germany to make such an amazing post-war comeback, It is the path for Greece, Portugal, Spain, Italy, France, and other states. My preference would be to do this pre-emptively because the countries next in line are much bigger than Greece.

    I know that I'm asking a lot of politicians; being statesmen is not in their blood, except for those rare alignments of the stars that put Washington, Jefferson, Franklin, Madison, Adams, and Hamilton in the same room.

  3. There should be a way to redominate wage and debt contracts, bank deposits etc. automatically when necessary, and without disturbing spot prices too much. If it is automatic, then there is no coordination problem and no technical default.

  4. As always is so interesting to read your opinion, prices are indeed a sticky matter:, back in the 80s in the small mining partially state planned Peruvian Economy, we experienced economic chaos. Back then the IMF helped Peru by giving certain recommendations that resemble the ones that gave to Greece some years ago, I think about privatizations and how good they became for the current trend in Peru, back then Milton Friedmam and Jeffrey Sachs did a great job counseling south american governments. Now on the downside IMF recommendations didn't had the desired effect for Greece, projections can be such a feeble tool. Nowadays Austan Goolsbee gave some answers to the Washington post in june 29, Joseph Stiglitz also gave his to The Guardian, its such an exciting environment for me as an undergraduate economist. Now, if something was obvious about Peru's chaotic 80's economy was that prices went up the roof courtesy of lack of understanding from part of government officials about how prices work. I point at Peru, because back in those days, Peru's public debt was commonly referred as unpayable. Nowadays, Peru as of April 2014 has 13 billion dollars of U.S. treasury securities, not much but who would guess so many years after Peru's personal encounter with chaos would lead to such a different reality. I know Greece is a different scenario, however the similarities are so many, thanks for posting professor Cochrane.

  5. The biggest problem, I think, is the legal uncertainty in all this. If a sufficiently large number of agents in the economy believe that this sort of law is illegal and refuse to change their prices, we could easily find ourselves in a situation where the state would be required to use drastic forms of enforcement (i.e., the police) to make sure that firms are complying, or, even worse, they may well nationalize any non-compliant firms.

    And that's just prices, we're not even thinking about the issues of legal contracts and the like.

    And there's no real precedent, at least none that I can think off, for collective reducing prices like that. I mean, examples of price controls abound in history, but that's merely stopping firms from changing prices; forcing all the firms in a economy to reduce prices, and making sure that this is enforced, would be much harder, even with IT being what it is today.

    I say this mainly because price controls tend to be popular when implemented (in high or hyperinflation situations), which means that they get a lot of support from the populace in monitoring the situation and enforcing the rules; I'm not at all sure that most people would understand, or accept, that this 'internal devaluation' would be to their personal benefit (as opposed to being beneficial to the economy as a whole).

    Finally, as you say, foreign investors may very well object, further complicating the aforementioned issues of uncertainty (and if you think that others won't comply, then you're surely not going to either).

    Don't get me wrong, it is an interesting idea, but I think there might be better ways of going about this... maybe something like the Real plan from Brazil (but with a different end goal)?

  6. If the hope in Brussels was to either replace the current Greek government with something more willing to reform Greece's economy, or failing that, have an excuse to cut their losses and pin the blame for the ensuing chaos on Syriza, well, they may yet get their regime change. The real question is whether whatever replaces Syriza will be that interested in free market reforms.

    I seriously doubt it. Consider that the mainstream opposition parties are now backing Syriza's renewed efforts to make a deal. The only holdouts are Golden Dawn and the KKE, the most important groups most likely to benefit from continuing economic chaos. Their approaches to rooting out corruption can be expected to be rather rough and ready.

    (Of the two only Golden Dawn backed the OXI. May the reader make of that what he will.)

  7. If account balances were cut by 30%, people would take their remaining money out of the banks, fearing further redenominations in the future. Banks would fail.

    1. Good point. In fact, Greece cannot reopen banks without either a flood of Euros, or going off Euro. The second the bank doors open, Greeks will pull every cent out they can get.

  8. I admit to being a bit confused with regard to the one-week price freeze at a 30% lower level. I understand how this would work for olive oil and hotels. But how does it work for imported goods such as gasoline. A gas station would go out of business if forced to sell gas at a 30% lower price. (Perhaps that is what your one-week limit is for -- but even during that week the station would likely stay closed.) You also have goods where imports are a large part of the cost. For example, ferries might have 50% of their cost be fuel and 50% be labor -- so their price should only go down by 15%. What is nice about a currency devaluation is that it takes care of all this. Using an input-output matrix would be way too complicated. Any help here?

    1. That really is a great feature of currency devaluation. It would be wonderful if we could get the benefits of redenomination of contracts without disturbing spot prices too much. I think that the answer lies in the thinking of your colleague at Yale, who writes about the possibility of changing the unit of account for contracts. It would be a radical change, but there is no way to maintain the status quo in Europe.

  9. Interesting. Calomiris's idea sounds very much like Roosevelt's removal of the gold clause in debt contracts in 1933, which somehow survived the courts.

  10. Jose Romeu RobazziJuly 7, 2015 at 10:59 PM

    Prof. Cochrane,
    Great post. But my understanding of the problem is very simple. No need to change private sector prices or contracts. The greek government has only to pay its local expenses with euro denominated IOUs, and allow for their free circulation. Of course, they have to accept these IOUs as tax payments, in face value. The private sector will accept those at a discount. This simple scheme, if politically feasible, would unlock liquidity for the private sector and devalue what has to be devalued: public workers salaries and pensions. Unfortunately, there is no magic, the Greek are already, and will become even pooerer in the short term ....

  11. If changing prices is a "coordination problem" in a market economy, then a market economy is not up for its only task, which is to solve the coordination problem via changing prices...

    1. Market economies still solve the co-ordination problem better than centrally planned economies. But in a market economy with billions of separate relationships in a vast dynamic web of production and consumption which involves both current and capital transactions price signals can diffuse slowly.

      Negative changes diffuse slowly but so do positive changes - it can take 25 to 50 years for a technological advance to fully diffuse through the economy.

  12. Everyone seems to agree that Greek real wages and pensions need to fall. There are four choices: (1) inflate Germany and have relative Greek wages and pensions fall to the necessary level over five or ten years; (2) do nothing and let wages and pensions in Greece grind down over 10 or 20 years (or Greece suffers a complete collapse and wages become unsticky in the chaos); exit the Euro, re-introduce the drachma, let the exchange rate collapse and reduce all wages and pensions in Greece relative to Germany overnight; or (4) re-denominate.

    Germany inflating to let the Greeks avoid hard choices is probably a non-starter.

    The fastest, least disruptive, most effective solution is probably to re-denominate with a focus on just those prices that are sticky - wages, state pensions, long term rents. There is no point in trying to cut the price of gasoline or Mercedes cars or other imported goods by 30%. The whole point here is to achieve a significant drop in the real standard of living for the Greeks to bring consumption in line with production. You would need to include a ban on labor strikes for a year or three and probably a provision that all leases could be renegotiated after a year.

  13. "This is a bit of a "thesis topic" suggestion. I think we need a model of price stickiness as a coordination failure that is as simple and tractable as the standard, but false, Calvo fairy or menu cost models. "

    Although I am a Keynesian while you are a Chicago school guy (so we have little in common) I totally agree with you on this one . Back in the 70s and 80s, before the New Keynesians began to dominate macro, before the Woodfordians took Blanchard/Kiyotaki & Mankiw too literally, before there was only one game in town, coordination failure was actually one of many ways to think about underemployment equilibria and price rigidity.

    Nothing against the basic DSGE framework but overall the New Keynesian, pardon the pun rigidity and narrow focus has overall led to technological regression (sometimes it does exist!) in macro.


Comments are welcome. Keep it short, polite, and on topic.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.