Matthew Klein on Greece, Optimal Currency Areas, and Safe Assets

Greece has faced a major debt crisis, and leaving the Eurozone may have been the preferable solution.

Matthew Klein is a columnist for the Financial Times and blogger at FT Alphaville. He joins Macro Musings to discuss his work on the Eurozone, optimal currency areas, and safe assets. David and Matt examine the monetary policy problems and debt burdens facing the Eurozone area and Greece, in particular. They also chat about the possibility of the United States becoming less of an optimal currency, which would make Fed policy more challenging.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Matt, welcome to the show.

Matthew Klein: Thanks for having me, David.

Beckworth: Glad to have you on. We have a relationship that goes back a few years, going, I believe, back to the Economist magazine and we'll talk about that later in the show and have a fun discussion on safe assets. It's a real treat to actually bring you on and have a conversation now. Now, I like to ask all my guests that I get into this show, how did you get into this field? In your case, how did you get into economic and financial journalism?

Klein: Sure. So it was a bit of a circuitous route to be honest. When I was in college, I didn't really know what specifically I wanted to do. I had a range of mentors. I took classes in a lot of fields, I didn't really know. And when I was a junior, I had a couple of internship offers that were available. One was the Defense Intelligence Agency and one was for Bridgewater. And basically I started as an intern in the summer of 2008, which turned out to be a really interesting time for someone who didn't know a lot about economics or finance to be getting into those fields.

Beckworth: No kidding.

Klein: And ended up getting, it was just fascinating, sort of both an abstract ... At that point, it was really just sort of an abstract and sort of a set of puzzles to figure out what is going on and trying to understand it. I hadn't studied those particular things before but I was always attracted to that kind of stuff. I did music theory and philosophy and that kind of thing was sort of related to it. Then the crisis got a lot worse. I was fortunate enough that I was able to go back to Bridgewater for a full-time position after I graduated, and I realized that it wasn't just a set of interesting puzzles. For example, when I… intern things like Swiss franc mortgages in Poland, there's significant consequences for real people and questions about how the economy should ... what policies are best, and what kinds of things put people at risk.

Klein: And just the sense that there's a lot of things that can affect people that they might not necessarily understand. And so the extent that I thought I could understand it better than most people even if I couldn't necessarily understand it as well as the best people, if I could understand that and convey it to an audience and try to help educate people about what was happening around them and how they can better protect themselves against these kinds of cycles, then I thought that would be helpful. And so that was the point when I started thinking about eventually moving into the role that I have now from what I was doing then. It took a bunch of stages. I ended up at one point doing research on a book about Alan Greenspan for a couple years, which was a really great experience. But eventually, I was able to get an internship at The Economist and then once you get that, it's then a lot easier to get other jobs in journalism so that's basically how I got into it.

Beckworth: I have to ask since you worked at Bridgewater Associates, what was it like working there? Because it's legendary, right? There's this great myth, maybe it's the truth, about how intense and transparent it is to work there. So tell us what it really is like to be at Bridgewater Associates.

Klein: So with the caveat that at this point it's been more than seven years.

Beckworth: Okay.

Klein: And it was my first job so I didn't have a lot of perspective or contrast. I didn't think it was that strange while I was there. The way it was conveyed to me at the time, which made sense, was people are going to be talking about you either way. In most places, they'll talk about you behind your back and then you'll wonder why you didn't get that promotion you wanted or why you got laid off. But it's better, if that's option A, to go with option B where they actually tell you at the time what it is they think you're doing badly and what you could do better. And so from that perspective, I think it makes a lot of sense. In terms of some of the things that I read in the press, I just know as much, quite frankly, as you do because, as I said, it's been a long time and not all those things were there when I was there. But it didn't strike me as someone straight out of college as being something that's particularly weird.

Beckworth: Okay. So you handled the whole transparency thing pretty well then, it sounds like.

Klein: Yeah. I guess it's the kind of situation where ... I think in many ways it's actually good for this sort of industry where if you say something that you can't back up, people will call you out for it. In my line of work nowadays, if someone's going to write an article or they're going to say something on Twitter about how I don't know what I'm talking about. So in that sense, that's just life. You don't want to…

Beckworth: Right, it helps. Right. Okay, well let's move on to some of your interesting work and I encourage our listeners to go check out FT Alphaville if they haven't already. We've had some of your colleagues on here, so I'm sure they're familiar with it, but to check out Matt's work in particular. But some of the recent articles I saw that were fascinating I thought we'd take a stab at today. Let's start with several pieces you've written on the Greek crisis. So you had an article about the expectations the Eurogroup is asking Greece to fulfill in terms of its debt burden. So can you speak to that?

Greek Debt Burden Expectations

Klein: Sure. So this has been an ongoing issue for years, basically ever since you have the IMF and the other members of the Euro area lend money to Greece. There's been a question about whether the terms that were expected of repayment of those loans were reasonable. And what's happened over and over again is that the Greek economy has not recovered the way people have hoped, and this has led to changes on the terms of the loans to make them somewhat easier for Greece, but also changes in saying, "Well, Greece now has to do more things in the future to sort of offset and compensate lenders for that." And so the post you're referring to is based on a paper that was published by the Peterson Institute, and one of the things that's interesting about it from my perspective is that one of the coauthors actually is an economist within the German economy ministry.

Klein: So this represents, I don't think it's a house view, but it represents at least opinions that is affecting real German policymakers and I found that particularly interesting because their argument is that the kinds of things that are being said by people like the German finance minister, Wolfgang Schauble, and the European Commission are not reasonable and that there have to be adjustments made because the expectations about how much Greece is going to have to tighten its budget and maintain that tight budget position for a period of decades, it's never been done before. And the piece basically, they did a couple of interesting things that hadn't been done in the past where they looked essentially at what are the kinds of, what they call primary surpluses, in other words if you exclude interest payments. Because right now, if you exclude interest payments, the Greek budget is already balanced. But they have to keep borrowing in order to repay existing debts that they've had in the past including debts that the Europeans had made to them in the past. So the Europeans lend them more money so they can repay old money and keep up interest, which you could argue is sort of silly, but that's what they've been up to.

Klein: So the question is given that, what kind of surplus do they need to make the debt stock go down over time? And they ran the numbers and basically concluded they would have to be somewhere in the order, depending on your assumption, something on the order 2-3% of output every year for decades, potentially more than 3%. And then they looked at a database of other countries, both developed and emerging market countries over time, saying what's the track record of these countries of doing that under different circumstances? And they basically found that it's never happened or almost never happened and that there's really no precedent for it. And the countries where it has happened, generally speaking, sort of things have been different than the previous ... So what they looked at was, they calculated that depending upon what assumptions and demands you place on the Greek government, they would have to have a budget surplus of around 3.5%, or at least 3.5%, before interest, every year for decades.

Klein: And when they looked at their whole database of countries, many, many countries both developed and emerging market countries, they found this basically never happened. They said that their implied odds of success were probably about 15 to 20% of doing this but in those situations it wasn't what you have now where the Greek economy is still in a situation where essentially it collapsed about a quarter in the past 10 years and has not recovered at all and you have mass unemployment. And so the question is, is it reasonable given that situation to expect them to A, impose additional austerity and B, sustain that for decades to service debt that's particularly owed to foreigners when they don't have any kind of a medium…so their argument is basically that doesn't make sense.

Klein: And they kind of outlined, I mean, they don't go so far as to say that therefore there should be big write downs, but they do make an interesting and I would say it's a pretty controversial claim, especially, again, given that one of the authors works for the German economy ministry, which is that what the Europeans should do is lend even more money than they've already agreed and essentially roll, extend the terms of the loans further out and if they can also refinance some debt that's currently relatively expensive. So for example, the IMF charges comparatively high interest rates on its debt compared to what the European's stability mechanism charges, or, for that matter, there aren't a lot of private sector bonds that are outstanding that are owed by the Greek government but those are also much higher interest rates.

Klein: Similarly, the European Central Bank owns Greek bonds, and one of the things that perpetually is sort of an issue of the crisis is that those bonds have relatively high interest payments due. They get the interest payments sent back to the Greek government, but there's a lag. So there's always an issue of they have to borrow a lot of money to redeem the debt that's held by the ECB to get the money back. And that creates crises seemingly every six months. So to the extent that they can smooth that out, that's what the paper recommends. But they're careful to say that this is not by itself going to fix an underlying problem, but it's striking that it gives you a sense of the scale of the challenge that Greece has and lack of realism embedded in a lot of the requests that are being made of the Greek government by some of its European partners.

Beckworth: So the expectation is it will run these budget surpluses for 10 years even though-

Klein: More than that. More than that.

Beckworth: ... More than that, even though it's been mired in a Great Depression for many years, seemingly-

Klein: That's right.

Beckworth: In fact, let's just go back and trace it out. So 2010 is when the Eurozone crisis begins, right?

Klein: That's right.

Beckworth: And so basically since then, Greece has been in a deep recession and now they're asking them to pony up and pay 3% surplus, which is a tough task in normal times, let alone in a time of deep depression. I guess one of my questions, why not just write off some of that debt? I mean realistically, even if you extend it, you're just rolling it over. Is that kind of embedded in the rollover or is there any talk of just cutting the debt, writing it down, having the creditors kind of bail in, to some extent, the Greeks?

Klein: So it depends who you ask. The IMF has actually suggested in one of their proposals because they also recognize that this is not something that is sustainable. They've said one option would be to just cut the number that's owed. There's been a lot of resistance to that, I think probably because it politically looks bad when, for example, a lot of regular German workers have not had pay raises in a meaningful way in 20 years. So when someone tells them that their tax money was effectively used to lend to the Greek government, it wasn't even lent to the Greek government, right, it was really to lend, to essentially bail out French bankers, et cetera. You can understand why they'd be annoyed. In the long run, it would probably better off for them too, but that's a fuzzier claim to make. So I think that's the big obstacle and it's a lot easier to just do these things that reduce the current value of the debt by just extending it forever than by actually writing it down, whether that's effective ...

Klein: I think reasonable people can disagree on that. Michael Pettis has written a lot about how even if the terms are very lenient, the stock of debt creates this overhead that discourages investment. I'm not inclined to disagree with him, I don't know if he's necessarily right but I think it's a reasonable plan especially when you combine it with the way they've done this in practice where they agree these big bailouts and it sounds like a lot of money that's going to last for a long time, 86 billion Euros, for example. But then they only disburse little bits of it at a time and they negotiate every few months to get the next tranche of payments. And then while they wait, they have to hope they get that little bit of bailout money in time to make their debt service payments on their previous debt.

Klein: And so they're kind of locked in this cycle. Again, you can argue that the reason Europeans like this is it gives them a hammer to hold over the Greeks to make sure they keep up with reforms. But on the other hand, it also means that this is extreme levels of uncertainty that you're just imposing on this economy so it's not a surprise that business investment has been so lackluster. And as I said, Greek output has fallen by a quarter in real terms. That's not completely unprecedented, but the precedents that exist are really bad. It's like the US Great Depression, Ukraine recently, which has also lost a large chunk of its country because of either annexation by Russia and Crimea or through the civil war in the east.

Klein: This is a post I did a couple of years ago where some people at Oxford Economics, they did this comparison with the IMF data and they looked at the Greek economy in longer terms of the scale of the draw down and the slow pace of the recovery and there were only a few, like five cases I think that had done worse than Greece and they were all basically civil war cases or countries that had extreme commodity ... I think one of them was Ghana in the '80s or something like that, but it was basically the Congo and Ukraine and things like that, and then Greece. So it's a staggering failure of policymakers across the board that this has happened, and so I think it suggests that they should probably do something different. But at the same time you can understand why it's hard to justify this, kind of the straightforward debt haircuts.

Beckworth: At some point, though, the whole point of bankruptcy is acknowledging that this plan isn't working, that bad decisions were made in the past and at some point the best path forward for both the creditor and the debtor is simply to write down some of that debt. I like this point that you raise about Greece's staggering decline in output. I don't like it, but it's interesting in the sense that it's the greatest great depression, it's the greatest non-civil war policy failure in the sense that it's gone on longer than the US Great Depression. Let me put it this way, it's the longest recession induced by macroeconomic policy, is that fair to say?

Klein: That's probably right. As I said, I think that is probably correct. I mean, there was a situation, which again, it's not just macro policy, but there was a situation in Argentina in the early '80s, which was not civil war, but there was lot of commodity stuff involved. But yeah, I mean, that's probably a fair statement to make, especially for a country of its size, and especially for a rich country that's integrated into the modern economy, that's not something that should happen like this.

Beckworth: Right, it's a part of the advanced economy framework that makes up the Eurozone. Well, let's move, on that point, to another post you've written, and you wrote about an IMF article or some research that implied that it would've been far better for Greece to have left the euro than to have gone through this. So explain to our listeners why leaving the euro would have eased the pain?

Should Greece Have Left the Euro?

Klein: So this is my sort of reading of IMF research, they didn't literally make that claim. But it was a chart they put in, which as we were talking about, it puts the draw down of Greek output in context, and basically it's a pretty simple chart, just showing Greece, the US in the Great Depression, the Asian countries in the 1990s, which included some pretty severe crises, and Europe as a whole. And basically that the US Great Depression and the Greek depression were pretty comparable in terms of the downturn, but the US Great Depression turns around, they have it by year, and so after year four, the US Great Depression hits bottom, and by year seven or so you're back to where you started, which literally if you thought there was a trend upward, back to where you started after seven years is bad, but on the other hand, compared to Greece, which is still 25% below where it was, it looks good.

Klein: And so I noted that, well, what happened in year four? US Great Depression starts In 1929, year four is 1933. 1933 is when, among other things, the US left the gold standard and engaged in a significant loosening of monetary policy and the beginning of inflation, which worked. Now, interestingly the chart cuts off when the US then tightens policy in 1937 and things go back down, but it's still the case that that, it leads to an interesting implication, which is that in the 1930s the gold standard was, in in the 1920s for that matter, the gold standard was viewed as this indissoluble anchor ... That's a weird phrase. The gold standard was this essential anchor of stability for civilized countries, that if you weren't on gold, there was something that was wrong with you, maybe that there was question of your country's moral stature, something like that. And countries were extremely resistant to leaving gold, even though it would have given them the ability to loosen monetary conditions, which the US did in 1933, the UK and Japan had done it a little earlier, France waited until I think '36.

Klein: So the euro and gold are not perfect analogies, but they're actually pretty good analogies in a lot of ways in terms of the constraints that they impose on individual countries, and so my simple point was that insofar as the membership in the euro area prevents Greece from doing the kinds of things that other countries could do if faced with these kinds of downturns, then leaving the euro would've been helpful for them. At least it would've been helpful five, six years ago. Whether it's still helpful now is a more interesting question. I think you could argue that it would still be helpful, but it's a tricky question.

Klein: And basically the thing is, the way I think of it is that of all the countries in the world, any point in time, you look at a place where monetary policy is probably too tight, it would really help if you'd use your monetary policy. Greece right now seems like a clear, and back then, seems like a very clear case where easier monetary policy would be useful. But they can't implement easier monetary policy, because they're a member of a single currency zone, and that currency zone ... They're a tiny part of it. I mean, you're a country of 11 million people in a bloc of hundreds of millions, I think they're, what, like maybe two or 3% or something of the total output of the euro area, it's not reasonable to expect that the ECB would necessarily set policy in a way that's optimal for Greece. It wasn't reasonable during the boom when Greece was expanding way more than the euro average, it's not reasonable now.

Klein: But, the problem is, we have a situation in Greece now where your real interest rates are in double digits. We have asset prices at massive discounts, you have 25% unemployment, it would be helpful if they had the means to ease monetary conditions. Unfortunately they don't, and so that's where leaving the euro would have been helpful.

Klein: Now, the difference between leaving the euro and leaving gold is that it's a lot easier to leave gold, because gold, essentially the way it worked was you had contracts that were linked to gold and you had currency that was pegged to gold and you could just essentially change the peg, whereas there is no substitute for the euro that's readily available. The kinds of things you'd have to do to make it work well unfortunately are probably beyond the institutional capacities of the Greek government. It'd be tough for any government to do, you'd essentially have to shut down all the banks over a long weekend, we'd have to have, somehow secretly assemble a whole bunch of printing presses to create the new currency and stop all the banks and keep it all secret, and then swap everything out, which would be a real hassle to do logistically, even if you were really good at that sort of thing and you have dual bank runs.

Klein: On the other hand, if you're on the situation like Greece was in 2011 or 2012, you're already having bank runs, and people are already pulling all their money out, there's relatively less of a cost, I would think, to just saying "Let's go for this." So they've sort of missed that window, so doing it now might be a lot more destabilizing. But that's the basic logic. And who knows? There could easily be, in the next five years or whatever, another situation where that pops up, unfortunately, and then it will seem a reasonable choice to do that.

Klein: I mean, that happened in 2015. I remember, I was there when they, I was there actually on vacation, it was a sort of coincidence, but when they had the capital controls. I mean that could have been a situation where if they already were shutting down ATMs and things like that, they could have potentially made the switch. They didn't, but they could have.

Beckworth: So this really speaks to a deeper problem, and that is whether the Eurozone is a sustainable monetary union. Because you mentioned Greece is such a small part of the Eurozone, there's no realistic expectation that monetary policy will be set just for it. It'll be set for the aggregate, for the average of the whole, which will be more in tune with Germany and France's needs than with poor little Greece. So this kind of begs the question, did it make sense in the beginning for them all to come together? Maybe more specifically for Greece to join the Eurozone. So what is your take? Is the Eurozone a fundamentally flawed currency union?

Evaluating the Eurozone as a Currency Union

Klein: That's a big question. I'm sometimes inclined to think that the answer is yes, that there's nothing that can be done to make it work in its current size and shape. But I also think that when we think about what can make a currency work, ultimately it involves a level of political commitment and a willingness by some regions to essentially bear some costs for the benefit of others.

Klein: Because if you're targeting an average, you're going to have some kind of variation across that average, and the question is… this can work, and if we're not ... And so far, the burden… has fallen continually on the Greeces and the Spains, the Italies and so forth, the Portugals, not on, we haven't had a commensurate inflationary boom, for example, in Germany that would offset it.

Klein: So that suggests, as long as that stays the case, then yeah, it probably is unsustainable. If Germany and other northern Europeans are not willing to do things that quite frankly would be in their own interest in terms of having a more inflationary policy and higher domestic consumption, then that suggests that sooner or later, even though the euro has lasted a lot longer than I would have thought, that sooner or later it's going to break.

Klein: But, it's possible that could change. So I mean one thing that's interesting is, look at Italy as a unit. As a unit, Italy makes just as little sense from a sort of strict economic perspective to have Italy as a single unit as opposed for Europe. The difference between southern Italy and northern Italy is at least as big as between western Germany and Greece. It's about the same. It may be a little bigger, because southern Italy, in terms of institutional quality, in terms of living standard, productivity, all those things.

Klein: But Italy is, for better ... It's sort of made it work ever since the unification of Italy because there's been a political commitment. That political commitment is not permanent, and there's a relatively popular separatist movement in the north of Italy that wants to get rid of the south, but it's not a majority or anything like that. So it's not impossible to imagine the sort of idea of a common European identity that would create more solidarity and to create institutions that would help, but in retrospect, clearly Greece, it did not work out well for them.

Klein: But it didn't work out for others, too. Like I mean, if you look at Spain, for example, I think in many ways Greece is a fascinating case to discuss just because what happened there has been so utterly painful and the policy mistakes by the Europeans and by the Greeks in terms of refusing to default on debt immediately were so significant. But in a lot of ways I think it makes more sense to look at Spain for answering this question, because Spain, in Greece it's easy to tell stories about government corruption, and it's a tiny country, and it was, government budget deficits and they're lying about things.

Klein: But you look at Spain, that's not what happened there. Spain, they were running budget surpluses, all sort of the orthodox things you're supposed to do. They ran budget surpluses, they were proactively raising bank capital requirements because they were worried about the risk to stability. They since the crisis have implemented reasonably successfully a lot of productivity enhancing reforms, basically the only people who've actually done that, no other country's done that. But they still have this massive inflow of capital … massive outflow on the way out, and that was very painful for them.

Klein: So the question is, are they willing to endure that? And I mean, so far the answer's been yes, I'm kind of surprised to be honest. But that seems to have been their choice, and I guess you look further back in time and they, I think it's not unreasonable that people in places like Greece and Spain maybe think "Well, before joining the euro there was a long period where there was continual high inflation and there were authoritarian regimes," and they're thinking that if you're willing to commit yourself to low inflation and to being really part of Europe, things are going to be better for you longer term. I guess, I'm American, this is sort of me ventriloquizing, but I think that that might be something along the lines of why it's held together. But from a strict economic perspective it does not necessarily make sense. Not because of differences of living standards, but because of the sort of lack of political commitment of combined benefit.

Beckworth: Right, there's a long history that would speak against this working out in the long run. But the fact is, as you mention, Greece has stuck this out for seven years of deep recession. So that's an amazing amount of endurance despite all that pain, and I think Paul Krugman even said this, he was surprised that the Eurozone has stuck together this long despite what it's gone through, particularly on the periphery. So it will be interesting to see what happens as we continue to move forward.

Beckworth: But let's segue across the Atlantic to the US, right? So the US in theory could have the same problem, it's a one-size-fits-all monetary policy, the Federal Reserve applied to many different regions, many different economies. You think what happens in Michigan might be very different than what happens in Texas, and yet we somehow make it through. So the standard story, as I think you alluded to earlier is, in the US we've got a federal treasury that sends tax dollars from Texas when that economy's doing well and becomes unemployment check in Michigan.

Beckworth: It also has labor mobility, you can leave Michigan, go down to Texas. There's also common identity, we're all American. But you did a post recently that suggests the US as an optimal currency area might be under strain, and you point to Nevada. Speak to why Nevada might be speaking to some potential issues with the US as an optimal currency area.

State Objections to a US Optimal Currency Area

Klein: Sure. So I think you would agree that the extent that there's not necessarily direct agreement on what exactly are the conditions for an optimal currency area, in general, it's something along the lines of the business cycle's synchronized enough that you can have sort of a monetary policy that works pretty well across the board. And if you use that as your benchmark, the US clearly fails, and Nevada is one striking example of this, where if you look at the decline in the real output and the decline in employment following their…it's basically, the only place that's really comparable now is Greece.

Klein: Now, Nevada is tiny. It's even smaller relative to the US than Greece is to the euro area, but it's still remarkable what happened there. That we have, essentially, if you adjust for the number of people, in other words, GDP per capita, in real terms is currently about 21% below where it was at the peak in 2006, which is staggering. Now, there are a couple reasons for this. One obviously is the collapse of the housing bust, which is particularly severe in Nevada, where housing prices fell like over 50%. They … probably around 50%. They rebounded a lot since the trough, but they're still way below their peak. And there is an incredible amount of consumer debt, or household borrowing against that housing that went with that, and people couldn't pay, and ever since that's been incredibly painful for them.

Klein: In addition, there's a separate issue where casino gambling revenues in Nevada have never recovered over the past 10 years because gambling is legal in more places, and so they've kind of offset that with entertainment, but that's a big part of the local economy there. So, and that effect is just remarkable. They're more than 10% worse off than they were 20 years ago, which is-

Beckworth: Wow.

Klein: ... I mean, yeah, wow is-

Beckworth: Yeah, that's amazing.

Klein: ... It's staggering. And so there are two basic ... I think the household debt and housing boom and bust story's a lot more important than the casino revenue story. The casino thing is not nothing, but that's really striking. And it's particularly interesting I think because, there's… a couple years ago about Spain, which I promise is connected to this, where I was looking at just Spanish job losses and GDP, and just looking at components of it and saying "Well, how does this compare to certain parts of the US?" Because I knew that Nevada had a huge housing boom, so did Arizona and Florida. Spain did, Spain was actually a little bigger.

Klein: So I thought "Well, what's the comparison?" Maybe this would be an interesting way to see what the value is of the fact that there's a national banking system in the US unlike in Europe and there's no risk of sovereign and essentially currency crisis without the currency breaking. And turns out actually, Spain did better than these places, relative to that. Which was really surprising for me, I wasn't expecting that answer and I was really intrigued by what the implication is, because essentially, for all we talk about how great the US does in currency and Europe should be more like the US, at the end of the day, if you live in Nevada, the amount of construction employment, the draw down in construction employment was the same as it was in Spain. The collapse in non-construction employment was worse than in Spain, and the decline in GDP was worse than it was in Spain, in Nevada.

Klein: The other thing that Spain had that was, Spain had sort of a two for one special, in addition to construction they also had a big manufacturing sector that also lost a lot of jobs. So basically if you take sort of the ... Basically, Spain has the kind of automotive vehicle sector that we have in Ohio or Michigan plus the housing bubble that was bigger than Nevada, so that's why their outcome was so bad overall. But if you look at, you take those out, Spain actually did a lot better than the non-manufacturing, non-construction economies of Florida, Arizona, or Nevada. Which kind of makes you wonder what is it that makes the US currency work?

Klein: As far as I can tell, it works, as you mentioned, with this ability to move. Now we all speak the same language, we all use the same stores. There are some issues with occupational licensing at the local level, but in general it's not that hard to move from one place to another. So you have ... Which isn't really how it's supposed to work, I don't think, where if you had a localized recession everyone just leaves. I don't think that makes sense for the euro area, because it would be weird if the response for a recession in Portugal is just the evacuation of Portugal and everyone in Portugal move to Germany, that doesn't seem like a sustainable answer, but in the US it's essentially what we've come up with. And if you look at past recessions in the US, I've done some other posts on this in the past, that asynchronous business cycles in the US is a pretty common thing.

Klein: Like, for example, in the early 2000s you had a situation where with the tech bust, the collapsing employment in the San Francisco Bay Area was significantly worse than the collapse of employment at the national level we had during the Great Recession. So everyone thinks, or not everyone, but a lot of people think that "Oh, the 2000 recession was pretty mild." But if you lived in the San Francisco Bay Area, it was actually a lot worse than what we had 10 years ago.

Klein: For example, or early 1990s is another great example, where they had incredibly severe recessions in Southern California and in the northeast, but other parts of the country were booming. And so the question is how do you set policy that's appropriate for that? It's hard. Fiscal transfers can help a little bit with that, but those fiscal transfers are not as big as maybe you could say ideally and they don't necessarily work the other way as well, like it's not like they're fully taking on all the, offsetting the bubbles that were going on in, I mean, there were housing bubbles back then too in the '80s, taking that out.

Klein: So it's just a challenge that we have in this country, that we tend to offset a lot of through migration, and you see these huge shifts in population, New York and Texas, since the past 10 of financial crisis. That's a great example of a situation where for a variety of idiosyncratic reasons, including the way the state constitution was written almost 200 years ago, it was very hard for them to have the kind of home equity driven debt bubble that a lot of other rest of the country had, so they missed that, and then easy monetary policy that we had in response to a national problem led to a Texas boom, and so everyone moved to Texas.

Klein: So you can understand a little bit like someone like Richard… would be so hawkish in that period relative to everyone else, because from his perspective it… very well, sort of like if you're one of the Germans over at the ECB complaining about easy monetary policy to help Spain and Italy. So in that sense, you talk about the optimal currency area of the United States, United States is not an optimal currency area. I don't know how you would rejigger it, but it's not in sort of the classical sense of business cycle sync-up, it works because people can move, people don't mind moving, and there's sort of enough of a political consensus to hold it together, but ...

Beckworth: I think many people would view the OCA criteria as a multifactor approach. So you can think, on one dimension, yes, if you're going to have a shared currency union, you want to have your business cycles aligned, right? You want the economy of Michigan and Texas to be at a similar boom and bust cycle, because then it makes sense for the Fed to apply the same monetary policy to both.

Beckworth: However, you can still be an optimal currency area even if that's not the case if you have these shock absorbers in place. So yeah, if you have labor mobility, if you have fiscal transfers, if you have price flexibility, so you can kind of think of a trade-off between those two things, you either got to have a lot of synchronicity of your business cycle with the rest of the country, or you got to have really ample shock absorbers in place, some combination, some trade-off between the two. And if you do, then you should be in the currency union, but if you don't, then you shouldn't be.

Beckworth: So you can think of, there's some threshold where you don't have enough of both or one that you shouldn't be in it. So places like Michigan maybe might have been better outside the dollar zone. We recently interviewed Yale Law professor David Schleicher and he has an article, he actually touches on this very thing that you're talking about, is the US an optimal currency area? And one of the interesting observations he makes, and Tyler Cowen makes this in his book is that labor mobility has actually declined, interstate labor mobility has declined since the 1980s, so fewer people are actually moving across states, which was kind of the big shock absorber that did make us loosely an optimal currency area, because of the very things you mentioned, occupational licensing, land restriction, other local state regulations that have made our labor market less dynamic.

Beckworth: So there is some worry that we are moving in the wrong direction, we're moving farther away from the US being an optimal currency area. Well, those are very interesting things, let's move on to some of your other interesting pieces you've done. Let's delve into secular stagnation, and this is the idea that there's this perennial demand deficit that's been going on since the crisis, or maybe even it would have occurred before had it been for the housing bubble and the tech bubble, but at least the argument is since 2008, there's been a shortfall of demand, and people like Larry Summers has promoted that. And as a consequence of the shortfall of demand, natural rates are low and it creates all kind of problems.

Beckworth: And the BIS, Bank for International Settlements, and Claudio Borio has pushed back against this view. What is his argument, and how is it different than Larry Summers' argument?

Secular Stagnation and Its Counterarguments

Klein: So secular stagnation is one of those things that I think you did a good job outlining. I think there's a lot of different interpretations of what it means. The observed point is that real interest rates have gone down steadily over time across the rich world, and that this hasn't been associated with either faster growth or more inflation, which is normally what people think of as one of the impact… so the question of what is happening?

Klein: And so I think, my understanding of the Larry Summers view is that this is because for whatever reason, people… to save more. Maybe there's a change in the distribution of wealth and income, I think that actually has a certain amount of persuasive power that people who have more money are going to save more and more of income, so people who already have more money, then you're going to have this change in propensity to save. That's part of it. Maybe that there's fewer worthwhile things to invest in.

Klein: Borio's, I think that actually makes a lot of sense, and I don't think that necessarily contradicts what Borio says, but Borio has a slightly different point, which is that part of the reason why we've seen changes in the distribution of income and why we've seen a decline in the number of attractive investment opportunities, which Summers has observed, could be partly due to policy choices by central banks, and so there's this reinforcing element there. That would be sort of my sympathies. I don't think that we have to … this thing, but his point is essentially that central banks might be a lot more responsible for this observed change than we let on, and so when you hear an argument like "Oh, we're just lowering interest rates because that's what's needed to keep unemployment and inflation on target," what he's saying is "Well, you're not a passive observer, you're actually an actor that's affecting this."

Klein: And the argument he makes, there are a couple things, but as I understand it, there are basically, there are two main points. One is that consumer price inflation, which is the normal benchmark of whether monetary policy's set appropriately or not over time, is flawed. And that's part one, and part two is that monetary policy works, to the extent that it stimulates the economy. It does so by encouraging people to take out debt. And his point is how you put these two things together, you end up with a situation where, or you can end up with a situation, where you get a misleading signal from the CPI side of things, the consumer price inflation, for whatever reason, it could be a temporary technological innovation, it could be a temporary commodity price decline, it could be some other sort of freak event.

Klein: In the '90s, for example, in the US, this happened in a variety of ways. You could have a situation where a billion people join the mobile labor force because of the collapse of the Soviet Union and the entry of China in the world economy. Whatever it is, that keeps inflation down at least temporarily, and then the central bank an respond, perhaps inappropriately, by cutting interest rates to keep inflation on target, and then what that does, because of this transmission mechanism of encouraging people to take out debt, people borrow a lot more and they spend more. They end up keeping inflation back at target, but the cost is that they now owe a lot.

Klein: And so then you have things, that in connection to recession you have this big overhang of debt. And his argument is that this in turn means that the next recession after that, you are going to have to cut rates even further, because this overhang of debt is a constraint on the ability of monetary policy to work in the future. You can make it work once, pretty well. If no one has any debt, you say "Oh, we're going to make debt really cheap," people will borrow and spend.

Klein: Once they've done that and they still have a lot of debt, it's marginally more difficult to get them to borrow and spend even more the next time you want them to do that when you do a market… that's his argument. And so that, the interaction of these forces of, on the one hand, sort of the head fake from the inflation signal, and then the way that monetary policy boosts the economy by encouraging to go borrow, and then the role that debt plays or constrains in terms of the effectiveness of future monetary policy, these things interact so that we get the secular stagnation that we've observed. And he's arguing essentially that central banks shouldn't just point and say "Oh, it's not our fault," they should acknowledge that they have played a role in this phenomenon they're observing and are being puzzled by.

Beckworth: So I like this point that they make about price stability not being enough, in fact there was a paper they had out I think early in the 2000s by William White and I forget the other author, but Claudio-

Klein: And Borio, it was Borio and White.

Beckworth: ... Okay, was it Borio too? Okay. So the thing is, price inflation is flawed for I think a reason that's, I think, more fundamental than just a temporary supply shock, that it's the wrong signal period. And that's the view I would take. Price stability makes complete sense when it's just pure demand-driven shocks to the economy, but if you have changes in productivity growth, for example, I think their point is, and one that I'm very sympathetic to, if, for example, between 2002 and 2004 when we had that productivity boost, what happens is more rapid productivity growth tends to push up this natural interest rate, tends to push up interest rates, and it tends to put downward pressure on inflation.

Beckworth: And as you mentioned, the Fed does not like that low inflation, so it would offset that, and in order to offset it to keep inflation up, it has to lower rates. So the Fed's doing exactly opposite of what would be implied by the rapid productivity growth. So rapid productivity growth, higher rates, lower inflation. The Fed does the opposite of that, lower rates to get higher inflation. And I think that's the point they're making, is ...

Klein: That's part of it, yeah. I think one caveat is that this could be productivity ... Productivity's important, but there could be other things that are just occurring outside the country, and that's part of …

Beckworth: Oh, absolutely. No-

Klein: In the US case, sort of the stereotypical case I think you're describing, which is I think half-legitimate, I think really describes that … well, the situation you'd expect is that the productivity growth which was showing up to a degree in US employment or US jobs one way or the other, if it's something because of abroad, if you're talking about the Fed, for the sake of argument, you're not benefiting from that, so you're just having low inflation and weaker employment or something, and that's where it gets tricky what you do.

Beckworth: Well, I think I've seen him mention this as well, but you mentioned the opening up of Asia, right?

Klein: Yeah.

Beckworth: In fact, if you just, here's how I would frame it. Step back from the US. Look at the global economy, and there's a massive positive supply shock, China, India opening up, entering the global economy, the big labor force. That's also in some ways very similar to a productivity shock. Now, it's from the labor side, but if you imagine increase in the labor supply, it increases the marginal productive capital, it too in a sense is raising the return to capital, which would all else equal higher rates, and it's putting downward pressure on prices.

Beckworth: So the point of all this is my solution is tolerate some mild inflation, maybe even mild deflation. And to the extent you do that, that's a better ... As long as it's accommodated by positive supply shocks, which is increasing the real side of the economy, that's a much better path to go than the path that they ... Pretty much artificially low, leading to debt accumulation. What are your thoughts on that?

Klein: Right. No, I mean, I think that's, I have a lot of sympathy with that view, the only thing I would just say that's tricky is I think it's a lot easier to say that in the case of, say, the US in the second half of the '90s where there’s… in the US in the first half of the 2000s, where in the first half of the 2000s, supposedly one of the benefits that the Fed has for the dual mandate, the fact that they look at both inflation and unemployment is that you capture some of this real side stuff in terms of ... I mean, unemployment isn't the perfect measure, but it should get some of that, I would think.

Klein: But the economy, yeah, like productivity was doing really well and GDP was doing pretty well, but in terms of jobs the US economy was doing incredibly badly in the early 2000s. Private employment I think it took like five years to get back to where it was in terms of the ... It peaked in 2000, went way down until like 2003 and then slowly got back by 2005 as the population was growing. So you can understand why they're following the dual mandate seriously, even if they weren't necessarily panicking about inflation, they still might have done what they did.

Klein: I think personally the thing that's less excusable is what happened in the '90s where we had very low inflation then as well, but you also had 3.8% unemployment, you had business investment that was booming at a rate that had not happened outside of a recovery in a really long time. That seems to me is more clear-cut, because I think by the time we get to the 2000s it's a lot trickier and I have a lot of sympathy for the trade-offs they have, because I agree with …. that CPI is not a great signal, and if there's something that captures more about what the right policy should be, but it gets tough because you have situations like you did in 2000 where your economy is just weak all-around and the tool you have encourages a set of behaviors that turned out really badly, where the only thing you really have to make the economy work better is encourage people to borrow and spend, and they do that, and then you have the housing debt bubble. So I don't have a good answer to that, if I did I would have written it out.

Beckworth: Okay. Well let's move on to a topic, we're running out of time here sadly, last few minutes of the show, but I want to get to the topic I mentioned at the top of the show and that is our discussion about safe assets. So back when you were at the Economist, I was blogging, we had this protracted discussion on safe assets, and why don't you summarize it for us, tell our listeners what was the debate about and what was anything that we learned from it?

The Safe Asset Debate and Lessons Learned

Klein: Oh, sure. Well there was this big topic, basically the question is what counts as safe? And what was capable of making something safe? So the idea of a safe asset is that, very broadly, there are two ways of, if you have money and you don't want to spend all of it, there are two things you can do that are very, very simple. You can just sort of hold onto it in something that you can keep for a rainy day, and then there's stuff you can afford to take some risk with in the hopes that it will grow over time.

Klein: And these two things are pretty different from each other. At a very basic level, the safe stuff, the rainy day stuff should be things that you can actually count on when you need it. So, for example, if you lose your job, you want to make sure that the stuff you put in the rainy day fund has not also lost a lot of value. So, for example, putting your rainy day fund in equities is not useful, because stocks tend to go down when people tend to lose their jobs, that's not a good thing.

Klein: So the question is, you want something, really ideally, you want to put your money in a rainy day fund in something that will actually appreciate in value when you need it. And so the question is who's capable of creating these kinds of things? And there's an economist named Gary Gordon who, I know you know him well, and if you haven't got him on the podcast could be potentially fun to reach out, but he's written a lot of real interesting stuff on this, on the history of it.

Klein: And his argument is basically that the total stock of things that are approximately safe, he doesn't say approximately, that's my… but approximately safe, the total stock tends to be pretty constant over time relative to economic output. And the question is what the mix is. And so the thing that you and I discussed is what should be counted as genuinely safe versus mostly safe? So bank deposits, for example, is a really interesting sort of threshold case, where if it were not for the guarantee provided by the federal government, bank deposits would not be truly safe. Because essentially a bank deposit is a short term loan to an extremely leveraged company that's betting on fixed income instruments, on risky fixed income instruments.

Klein: So it might work most of the time, but without some kind of federal guarantee, a federal guarantee that's backed by the central bank, I don't think they would count as being safe. And what you see throughout history in different amounts and different ways is the private financial sector creating things that are mostly safe as substitutes for, or complements, depending on your point of view, for the genuinely safe stuff that's provided by the government, either literal government assets like a treasury bill, or things that are guaranteed explicitly by the government like an FDIC-insured bank deposit. And so the question is, clearly if you use the sort of broader definition of things people thought were safe, it's fair to describe the crisis of 2007-2008 and the euro crisis a couple years later as a situation where the supply of safe assets collapsed, because a lot of things people thought were safe suddenly became less safe.

Klein: The alternative interpretation, which isn't that different, but it's slightly different, is that people were deluded into thinking lots of things that were not safe were safe, and then they figured out that they had been wrong, and this led to a dramatic change in expectations and behavior, and that affected credit supply in both directions. So that's my interpretation of the disagreement, which I don't think there's a huge distance between us in terms of-

Beckworth: Oh, yeah. And I guess kind of the phenomenon itself is interesting, maybe even surprising that it's gone on this long, that there still seems to be a shortage, at least as revealed by low interest rates, that there's still not enough safe assets out there. And of course that's also tied to the lack of robust recovery as well. So I guess the question is, there will always be this demand for safe assets. Who's going to provide it? And clearly the government is one way to do that, and the question is can the government provide a sufficient amount enough in a manner that's not too costly?

Beckworth: So yes, the government can provide more, I've even argued more recently that maybe there's a place for the government to maybe even set up a sovereign wealth fund, at least to consider that possibility. But the question is, it always comes at a cost, it's not a costless endeavor for the government to back up more checking accounts, to create more treasury bills. So there's some margin there where you have to make trade-offs between providing more safe assets and not getting to the point where you provide too many that you actually lose that risk-free status

Klein: Yeah, I mean, I guess the question, this is a maturity thing. When we talk about risk-free, I think, I mean it would be unreasonable to say there's no risk whatsoever in any way, shape, or form.

Beckworth: Sure.

Klein: It's just impossible, even ... The closest thing you could get would be something along the lines of an inflation index bond issued by the government, because there you're protected from inflation risk. But you're not protected from duration risk. So the real interest rates can move and you can move money, I mean you hold the maturity defined, but at points in time there's still some risk.

Klein: I think what it is that people are concerned about, and I get this from Gordon, because the way he phrased it is the nominal risk, that essentially, you think you have $100 in your bank account and then you walk in one day and you have 50. And I think the reason that that matters is because people's obligations are also nominal rather than real. So if I have a lease that says I have to pay X number of dollars in rent a month, or a car payment or whatever, that's not indexed to inflation, so that's where a situation where the nominal protection really does matter.

Klein: And I think the government actually can, maybe we can disagree on this, but I think the government can provide essentially, I don't know about unlimited, but I think the limit is very, very far away in terms of nominal protection. On the inflation side, yeah, that's tougher, I mean there's a reason why inflation-indexed debt is generally a small part of the issue index, because you want to, might need some flexibility there.

Beckworth: There's no doubt what we've seen in the interest rates suggests there's a very strong appetite for treasury bills, and arguably more could be issued without much change. And also even from a monetarist perspective, I think there's an argument to be made here that these assets effectively function as money for institutional investors, therefore this is really, you could frame this from a monetarist perspective, there's a shortage of money assets out there that could be provided through the government. What makes it awkward or tough is it's the government issuing debt as opposed to the fed issuing liabilities, which at the end of the day should be no different because they're one consolidated entity, but it's just harder to sell that. Maybe a sovereign wealth fund would be a more palatable way to do it, I don't know.

Klein: Yeah, I mean, I guess… I know you've posted in the past... the M4, I think… essentially it's looking at kind of the very broad measure of things that look and/or use kind of like money, and essentially you can attribute a lot of the shortfall in spending in this country to what happened there. I think it's totally fair. I don't think it's sustainable, given what the composition of that was, though, before the crisis, I don't think it's unreasonable to expect to get back where it was with the same mix. I think you have to have some kind of change, because a lot of that was essentially very clever financial engineering where they put a lot of lipstick on a pig is where I insulted people, that didn't work out well.

Klein: So I think, maybe I'm being over-optimistic here, but I think, given the way a lot of pension funds, for example, in the US are organized, and especially relevant the way a lot of pension funds are regulated in the UK, I think impossible to imagine a situation where you could accumulate, we could have funds accruing a lot more long-term government debt, and the government could issue that debt without having the yields go particularly high or anything like that, and then that would be overall a useful adjustment, especially if the concern these days is yields are so low. On the one hand, the 30 year bond yield's like what, 3% or something right now? I mean that's-

Beckworth: Mm-hmm (affirmative).

Klein: The idea of someone even 10 years ago thinking that would be considered sort of a normal situation is kind of peculiar, so I think there's clearly room, if there were more debt issuance, and that led to even more growth and higher yields, I think on the whole that would make people a lot better off and people will generally be happy with that. How you sell that sort of politically is a different question, that's not my area, but I think that it seems a lot more reasonable than saying we should get banks to be creative about issuing things that will work kind of like those instruments, rather than the real deal.

Beckworth: Now this also has implications for the Fed's balance sheet, right? If it continues to stay large, the Fed's balance sheet is going to be providing some of those safe assets to the public, and as long as the Fed's balance sheet is open to more institutions, the reverse repos. I mean, on the margins it's providing that very thing, it's allowing institutions to deposit their funds at the Fed, it's super safe, basically they're getting kind of like the Fed's own T bill of sorts by depositing their funds there.

Beckworth: And so I know Jeremy Stein has argued, and others, to keep the Fed's balance sheet large for this very reason. If you shrink it you're going to be putting more pressure back under the private sector. And I guess I'll leave it at this. I think no one hand, given the world's appetite for US debt, yes, we can handle more T bills. But on the other hand, I'm not ready yet to pass judgment that the private sector's not able to provide some more safe assets in the future given the right regulatory framework and everything else. It's uncertain to me. It's clear, I think the government could do more, but it's also not clear to me that the private sector is not also able to do more.

Klein: Yeah, that's totally fair. I guess, one thing I would just say on the Fed though is to the extent that they're buying federal government debt and creating reserves to do that, that's not, at least in my view, really creating safe assets, it's just sort of reallocating who's holding which ones. Because, I mean, when they buy mortgage bonds it's a different story, when they're doing other things it's a different story. But when they're buying something that [inaudible 01:00:58] you buy a five year Treasury bill. That's basically, reserves are safe, five year Treasury's safe. I mean, I think the stuff you were saying about the reverse repo in terms of the short term money is definitely a risk-

Beckworth: Yeah, that's more my emphasis there is basically the point of opening up the Fed's balance sheet more broadly. I've had this discussion with a number of guests, some like it, some don't. And the concern is if you take that too far, in the limit you end up with some of these banks like you have in China, state owned enterprises with banks that have nonperforming loans on them. The issue is can government really provide quality financial intermediation services? And I do get a little leery there, but I do see the argument on the other side as well. So it's a little uncertain in my mind what the optimal mix is.

Klein: Yeah. Just to be clear, I agree that when it comes to sort of the asset allocation lending side, I don't have a lot of confidence either. I think it's just more of a question of if you're capable of issuing a liability where you can guarantee the nominal payments, like if the government is always going to have an advantage over the private sector. The government's asset side, who knows. That's a different story. But…

Beckworth: No, you're absolutely right. I mean, the government will be the last institution to go bankrupt, right? So it has the most secure nominal liabilities on the planet. All right, well our time is up. Our guest today has been Matt Klein. Matt, thank you for being a guest on the show.

Klein: Thank you very much for having me.

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.