Often economics is about finding the right chart to express a certain phenomena. Take a look at the 3 distinct periods above:
- Before 1999 and the creation of the Euro: Yields on the Greek, Spanish, Italian and Portuguese are much higher than the ones of France and Germany.
- From 1999 to 2008: Yields of all Euro countries converge dramatically. To get a sense of the reason for this, read the first paragraph of Part 3 of my note on the Euro Crisis.
- From 2008 and the onset of the crisis onward: Yields diverge dramatically again, but this time with the same currency across all Euro countries!
I find this to be quite a good illustration of what was happening.
Part 3: Disappearance of Currency Risk & the Animal Spirits
One Unified Rock Solid Currency Across Heterogeneous Economies
In addition to the factors explained in Part 1 and 2 of this note, one should note the role that the disappearance of currency risk played on the movements of assets within the Eurozone. To simplify, the creation of a unique currency made it possible for assets and liabilities to be matched across borders like never before. German investors could own Italian assets and Spanish investors could own French assets without risk of currency loss. With the flick of a switch, currency risk disappeared. As a consequence, investors who wanted to hold Euros and who have the choice to hold either German Euro debt or Spanish Euro debt for example naturally went for the safer and more prosperous economy. In such a case, what should normally happen is that yields on Spanish debt should rise, but they didn’t, and the reason to that is that the northern European nations were willing to lend to the periphery at relatively low interest rates, as the surpluses generated by Germany were recycled into real estate booms in Spain and elsewhere. The growing imbalances were as much the fault of the creditors – northern European financial institutions and their regulators – as of the debtors.
Part 2: The Mercedes and the Feta Cheese
As we have seen in part 1, debt in the periphery of the Eurozone has climbed to allegedly unsustainable levels as a consequence of the crisis more than as a cause of it. So if it’s not debt, then what are the underlying causes of the fault lines in Europe? Part 2 of this note will explore the consequences of productivity imbalances within the members of a monetary union.
Setting the Frame
The Global Financial Crisis that started in 2008 and shook the world is now considered one of the longest since the Great Depression of the 1930’s. While the US are experiencing a mild growth which is making them see the light at the end of the tunnel, and while the emerging markets are pulling themselves out of the mess, the 3rd major player in the global economy, namely Europe, is still trapped in quicksand dragging the other two and the entire world with them into worrying about the strength of their parachutes. More simply, investors all around the world have their eyes on Europe, and precisely nowadays Athens, since an earthquake there could potentially engender a devastating Tsunami from the coasts of California to Beijing.
When the Titanic sank in 1912 in the North Atlantic frozen ocean, historians attributed a substantial share of the responsibility of the disaster to its captain who allegedly maintained a high cruising speed despite warnings about the presence of icebergs ahead. When Princess Diana died in 1998 while trying to avoid paparazzi that were following her by speeding up, the whole British people had a rant at paparazzi and their profession, blaming them for playing a role in the death of their Princess. I can go on with countless examples like these, where our immediate search for causality among random events that happened in the past, make us construct a narrative fallacy about the reason they happened, and more dramatically, make us view the future while looking in the rear view mirror. How many times did the captain of the Titanic get warnings about presence of icebergs which were exaggerated and generated by people who are only looking to protect their back side? How many tabloid superstars have been chased by paparazzi and didn’t die trying to avoid them? But do we think about these?
If you’re a soccer fan, how would you feel if you had to miss watching the world cup final and watch it on replay the next day? This is sort of the feeling I have now that I am trying to dig into the causes and consequences of the Global Financial Crisis (GFC): I regret not having been able to understand anything when it was unravelling. To some extent, I found out I was not the only one. Henry Paulson, Secretary of the US Treasury, declared in May 2008 that ‘The Worst is Behind Us.’ Four Years Later, People are not even sure if this statement could hold true now. Learning in hindsight might not have been such a bad thing in the end, since it looks like in 2008, not many people understood what was happening anyways.
It was one of those nights when I was doing a web research on how humans make choices, that I stumbled upon a TED Talk by a psychologist who was explaining the riddle of experience versus memory. The Talk led me to Daniel Kahneman’s Thinking Fast and Slow, one of those books that shake the foundations of a discipline, and prepare the grounds for a paradigm shift and a new direction for the research of generations of academicians to come.
What I am about to summarize might not make sense to many of you. Kahneman’s work was not short of raising controversy in the social science that’s psychology. What I admire on the other hand, is Kahneman’s dissection of the odd behavior of our brain under certain conditions, which makes us make choices that, seen under another angle, simply do not make sense. Our brain is not the rational agent many imagine.
Now why a book review? Because books’ principle quickly falter into oblivion in one’s memory if no written synthesis is made. Also, explaining the concepts in simple terms will help me make sure I understand them myself. And who knows, a few of you might be intrigued as well. Kahneman’s book is not a “how to become happy in 10 lessons” book. By enriching our awareness on the shortcuts our brain takes to make decisions, Kahneman tries to raise our awareness in the unlikely hope of making us make more informed choices. This is my first book review, most probably not the last one, and I leave you to enjoy a summary of a selection of a few concepts laid out.