Scott Sumner  

Greece: What are the markets telling us?

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The Greeks have voted no in today's referendum, which makes it more likely (though not certain) that Greece will leave the euro. Some economists believe that this action would help the Greek economy. Devaluation would be an expansionary monetary shock, raising both nominal and real GDP. I have some sympathy for this view, although in the end I favored a yes vote, out of fear of where Syriza was taking Greece.

When economic shocks are very complex, I tend to look to the markets for guidance. In my research on the 1930s, I noticed that markets seemed to understand the implications of policy shocks much earlier and more accurately than pundits and politicians. Ironically, the closest parallel to the current crisis was the German economic crisis of 1931, where Germany was the beleaguered debtor nation, struggling to stay on the gold standard (which was the eurosystem of the interwar years.)

There's a news story that US stock futures dropped about 1.5% on news of the no vote, and tomorrow morning most asset prices are expected to fall sharply all over the world. But why is that? Greece is a very small economy and is already deeply depressed. Its GDP probably won't decline much further, and in any case the US exports only a trivial amount of goods to Greece. What's the mechanism for the stock decline?

One popular answer is "uncertainty". Sorry, but that's a cop out. Uncertainty has to be about something important. There's uncertainty over who will win the World Series in baseball, but it doesn't affect stock prices. It turns out that the interwar period might give us a clue.

In 1931, even Germany was much too small to have a major impact on US stock prices. And German troubles did not affect US stocks until mid-1931, when the Germany financial crisis began to threaten the international gold standard. And then when the US left gold in early 1933, German difficulties no longer correlated with US stock prices. This sort of "time varying correlation" is a powerful tool for understanding causality.

In the 1930s, actual devaluation was expansionary, and helped countries recover. However expectations of devaluation were often contractionary. This was because fear of devaluation led people to hoard gold, which increased the value of gold and reduced prices in all gold standard countries. Greece is important not because of Greece itself, but because of fears that it could lead to turmoil in other much larger southern European countries, and lead to a run on their bonds. The public might choose to hoard safer assets like US dollars, putting deflationary pressure on the US.

The one asset price that seems to respond positively to Greek turmoil is safe bonds. The price of these bonds rises, as their yields fall on eurozone turmoil. This is a good indication that Greece's no vote was a significant deflationary shock to the world economy. I choose the term 'significant' for a reason. It's not a major shock of the sort that is likely to lead to another global recession. But it's also not trivial. Recall that stocks were already somewhat depressed by fears of a no vote, so the total impact on US stock prices is certainly more than 1.5%. Of course European stocks are affected much more significantly.

Let's suppose that economists like Paul Krugman are completely correct. The no vote was the right move. Let's also assume it leads Greece out of the eurozone. Let's also assume that next year Greece begins to recover strongly with a devalued currency. None of this is certain, but let's assume it's all true. It still remains true that today's vote was a deflationary shock to the global economy. It still remains true that several years from today the global unemployment problem will probably be worse than if there had been a yes vote. The no vote will probably have a net negative effect on the global economy.

Now of course Greek citizens were fed up with the rest of the world, and I can't blame them. Average people don't have a sophisticated understanding of economics (indeed I'm not sure I understand all this stuff). All they know is that they keep doing things the EU tells them to do, and Greece keeps getting worse off. Perhaps Greek voters could be blamed for electing corrupt politicians in previous decades, but that's not how they would view the current crisis. So I'm not surprised that Greeks would vote in the way that they thought was best for Greece.

Indeed in my forthcoming book on the Great Depression I praised FDR for devaluing the dollar in 1933, even though his actions may have worsened conditions in Europe. I suppose I could reconcile that view with my "yes" view on this referendum, by arguing that it was far easier to leave the gold standard than to leave the euro. The gold standard was clearly on the way out, and the sooner it collapsed the better. If the eurosystem eventually collapses, those pundits who suggested a no vote will be proved right and I will be proved wrong this time around. If it survives, as I think it will, then the Greek vote will turn out to harm the global economy, and was regrettable on utilitarian grounds.


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COMMENTS (18 to date)
BC writes:

If the Greek "no" vote is causing deflationary pressure on the US due to hoarding of dollars, does that mean that markets don't expect the Fed to offset it? (Perhaps a reasonable assumption given the Fed's apparent eagerness to raise interest rates.) If the Fed (and ECB) can offset any deflationary impact of the Greek vote but chooses not to, can we really attribute global deflation to the Greek vote anymore than we could attribute deflation to fiscal austerity? The central bank determines nominal stability, right?

Also, what is the mechanism by which the Greek vote could lead to turmoil in other southern European countries? The Euros "give in" to Greece, inspiring those other countries to elect Left-wing, Syriza-like governments? If so, that would also seem to be an ex-Greek factor.

Given Greece's size, can Greece really have much of an impact on the global economy unless the rest of the world allows it?

Harold Cockerill writes:

Given the Great Depression lasted another thirteen years isn't it possible that Roosevelt's theft of all that gold also worsened conditions in America?

ThomasH writes:

Why does your analysis of the US sequester not apply here? [Maybe I still do not understand that analysis.] If the Fed and ECB are happy with their inflation/price level/NGDP/whatever-they-target policy, why would they allow a small shock to change the outcome? If the Greek vote would tend to be deflationary, can't the Fed and ECB just ratchet up its purchases of longer term assets? ECB is already doing QE and the Fed could restart.

[I see that BC has asked the same question. Is it that markets just do not trust the Fed and the ECB to hold to hold to whatever target they supposedly had?]

It's odd that you would seem to leave out the role of monetary policy in determining the effects of this event. What am I missing?

Grant Gould writes:

I think the big surprise markets are reacting to is more the enormous magnitude of the 'no' vote, not its particular outcome which was already widely and correctly predicted.

The large margin of 'no' makes all other countries' anti-eurozone parties more credible, and makes the Greek government firmly pre-committed in subsequent negotiations in a way that a just-barely-no vote would not have. Those are both deflationary signs, both because of hoarding and because they suggest future reduction of pressure on the ECB to inflate.

Scott Sumner writes:

BC, It certainly suggests that they don't plan to fully offset the shock.

As far as transmission mechanisms: Consider if other southern Europeans begin to believe there is a chance that they will follow similar policies. There could be a run on the banks, as depositors fear devaluation. Interest rates on loans could rise, due to extra risk.

Harold, Possibly, but I believe the NIRA delayed the recovery. (Actually the economy recovered in late 1941.)

Thomas, That's a good point. It does seem the offset is less that 100% in this case, unless there is a mechanism that I am missing. Like some sort of "real shock". Perhaps the ECB would not offset the nominal shock to southern Europe, and the recession there would be a real shock for the global economy. But I'm more inclined to believe it's less than 100% monetary offset. Certainly with Lehman there was less than 100% offset. Sudden shocks may be harder to offset than fiscal shocks, which have long lead times.

Grant, Very good point.

Anon writes:

Grant - betting markets were predicting a "Yes" win - this certainly wasn't "widely and correctly predicted".

Jose Romeu Robazzi writes:

If we take the oil market reaction to the news, if any, Prof. Sumner it seems you are right about the deflationary effect ...

Travis Allison writes:

Scott, if people expected a devaluation in the 1930s, why not buy a car or washing machine instead of gold? Shouldn't the prices of goods increase soon after devaluation? People in Greece are currently trying to prepay their bills as much as possible.

Gordon writes:

"All they know is that they keep doing things the EU tells them to do, and Greece keeps getting worse off."

What I find tragic about the whole situation is that before Syriza came to power is that Greece had a primary budget surplus, a current account surplus, and an increase in the money supply in 2014. Syriza reversed all those things. It makes me wonder if Syriza had not come to power if the Greek public would have noticed a turn around in economic conditions by the end of 2015.

Arthur_500 writes:

Our media tells a story of the suffering Greek people. Our economic prognosticators tell of how it is not "their" fault. I disagree. I would refer to it as Tough Love without direction.

What is necessary is direction. Without direction the politicians have nothing to fall back on. The media feels sorry for those because they have no direction (after all they are reporters not journalists).

Marketplace did an article on how aspirin needs to be purchased through a pharmacist in order to protect the pharmacists. Are you kidding? You wonder why costs are so high. In reality Greeks eat lots of vegetables because meat is so expensive. These people ARE responsible for their own mess. The Europeans ARE responsible for the mess in Europe and they are afraid to demand open markets as the pot may not call the kettle black.

However, as the US carries much of the world economy on its back our debt situation is not much different from that of Greece. When will we start defaulting on promises? Oh yeah we already have been doing that.

Uncertainty in the markets comes from worry over the freedom this gives to other countries to default on their promises.

khodge writes:

I agree with your "Uncertainty has to be about something important" paragraph. There's really nothing important going on here; it is likely that there are other factors driving the market, such as bull market corrections or "out in May, stay away," or a recognition that the Fed is going to start acting rationally and end its easy-money policy.

Scott Sumner writes:

Travis, Very difficult question. My view is that the probability of devaluation was not high enough to cause much buying of goods, but was high enough (say 2%) to cause a lot of hoarding of gold.

Gordon, Good point.

Arthur, Yes, Greece has lots of counterproductive policies. I'm less worried than you about US debt.

khodge, Maybe, but some of the market moves are clearly linked to Greek news.

Mr. Econotarian writes:

Greece's problem is not monetary or fiscal, it is regulatory.

Why did Ireland turn around with austerity and leave its bail-out so rapidly?

Compare the economic freedom levels: Ireland is near the top of the Eurozone, Greece is near the bottom. Ireland has attracted the overseas corporate headquarters of Google, Amazon and eBay. Greece could never do this given their high level of labor & business regulation, as well as Eurozone-leading corruption rating.

Greece has not done everything the EU has asked - it has refused major key regulatory reforms and privatizations of SOEs.

I concur that FDR did the right thing with the Gold Clause Ban and the devaluation, which cleaned up the Fed's highly deflationary activity leading up to the 1929 crash, and ended the worst part of the Depression. Then FDR regulated and scared the heck out of private business (court packing, NRA, etc.). The private economy did not come back to normal until he was dead.

But if there was really a horrible deflationary problem in Europe, it would be affecting all Eurozone countries, not just the most highly regulated ones as it is today.

ThomasH writes:

@Mr. Econotarian

I agree that much of FDR's microeconomic policies -- NRA, AAA, Wagner Act -- were misguided (although Social Security and deposit insurance were not. I think you are mistaken about the amount of damage done, at least in the short run. Business investment and GDP were recovering quite rapidly until the misguided "austerity" of '38 (I count the high marginal income tax rates and financing SS with a wage tax as a microeconomic mistakes but with macroeconomic consequences).

Scott Sumner writes:

Mr. Econotarian, Ireland is doing better than Greece, but still not all that well. The entire eurozone was hit by a negative demand shock, with falling NGDP in 2008-09, and then flat NGDP after 2011.

Where I agree with you is that the relative performance of the various eurozone countries reflects the structure of the economy, with the statist economies doing more poorly than the neoliberal economies.

Thomas. There was no growth in industrial production between July 1933 and May 1935, when the NIRA's high wage policy was in effect.

Mr. Econotarian writes:

Scott, NGDP is an interesting statistic, but the key statistic that is felt by normal people is that Irish unemployment has dropped to a six-year low and is now down to 9.7%, which is also the EU average.

Perhaps the Euro in general is too tight? But I don't believe there is anything special about Greece from a monetary standpoint that doesn't apply to the rest of the Eurozone.

Back to FDR and 1938, we have to remember that the world was preparing to go to war that year, so I would not be surprised if economies were a bit concerned. FDR's chilling "Quarantine Speech" October 5, 1937 said:

"If those things come to pass in other parts of the world, let no one imagine that America will escape, that America may expect mercy, that this Western Hemisphere will not be attacked and that it will continue tranquilly and peacefully to carry on the ethics and the arts of civilization.

If those days come "there will be no safety by arms, no help from authority, no answer in science. The storm will rage till every flower of culture is trampled and all human beings are leveled in a vast chaos."

Jim Glass writes:

In my research on the 1930s, I noticed that markets seemed to understand the implications of policy shocks much earlier and more accurately than pundits and politicians.

In remembrance of the 100 years since World War I, I've recently read a number of new books about it.

One thing very notable about the very first days as the conflict was starting is how much startlingly more the financial markets "knew" about coming events than did the government leaders, diplomats and generals whose job it was to direct them. And how the best (least bad) human sources for information about what was happening on the ground, viewed in hindsight, were the financial journalists.

Hazel Meade writes:

I may be wrong, but my understanding is that neither krugman nor Syriza thinks the "no" vote is a vote to leave the Eurozone, and neither are they advocating that it do so. Both seem to believe that a no vote is going to lead to looser loan conditions, which means there would not be a devaluation of the Greek currency, but rather a continued transfer of wealth from Germany to Greece.

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