Tuesday, November 23, 2010

Correspondence

FLG has received a couple of emails asking his thoughts on the Irish crisis.

Basically, it followed the same path as most financial crises. Low interest rates->real estate market bubble->unrealistic expectations of future real estate prices->lots of leverage->bubble pops->leveraging occurring->everybody pretty much screwed->government steps in to pick up the pieces. Although, in this case, there are two interesting wrinkles -- the scale relative to the government and the euro.

One bank's losses, Anglo-Irish Bank, were about 1/5th of GDP. (That was a old story, and FLG thinks the tally might have gone up.) Ireland just isn't big enough to swallow that pill.

Then there's the euro issue. This is the more interesting one The low eurozone interest rates fueled the real estate bubble in Ireland, just like it did in Spain and Portugal. And they almost certain exacerbated, or at the very least delayed the reckoning, of the fiscal problems in Greece. And now that the shit has hit the fan they cannot devalue their way out of the problem. FLG does wonder whether the euro will hold up long-term.

On the other hand, FLG isn't sure that limiting devaluation is necessarily a bad thing. Liberals, like Krugman and Yglesias, have written posts lamenting the inability of Greece to devalue its way out of the problem.* But if Greece devalued, then it would've just sped up the dominoes and Ireland, Italy, Spain, Portugal, France, and the UK would all have to eventually devalue and you're back where you started to some extent.


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* In case you are wondering, FLG has identified two reasons why Krugman and Yglesias are so keen on devaluation. The first is philosophical. It would've allowed Greece to maintain much of its government size. The second is epistemological -- time horizons. They see the short-term, and so the pain from austerity to them is irrational. Instead, just devalue. However, there are long run implications from devaluation, such as inflation and an increased risk premium for future government borrowing.

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