Econ mom gyan on how Spain can stay inside the EU classroom

Lil One was UPSET. He came home from school, stormed inside, threw his bag to a corner, changed his clothes and sat, petulant and mutinous, refusing to eat, his face unusually troubled and angry. I realized Something must have happened in school and after a couple of minutes of artful probing, it all came out. “Our class teacher is always partial to some kids!” Oh, ok, so this is a teacher-does-not-like-me-but-likes-my-other-friends issue. “Why, you said yesterday you have the best class teacher in the world?” Well, yesterday, he had received remarks on how neat his work was, and hence, the teacher-is-the-new-cool sentiment had run high in our house just 24 hours ago. Sigh. “So, what happened?”

“Oh, she is always partial to Shreya and Nisa. She never ticks them off even if they talk. And she always sends Aditya and Amogh to stand outside the class for 2 minutes, because they are confirmed trouble makers.” Hmm. But I still could not figure out what had happened today to get him so upset. “But today was the HEIGHTS, mom!” For the innocent, uninitiated readers of this blog, “heights” is a completely wrong usage of an English noun used by 13 year olds whilst wanting to express plunging down some emotional “depths”. Really? That means it was hurting real badly. Ouch. “Today, there was general talking in the class because we finished the sums she had set us to do. And she didn’t really know who was talking. And so she decided to send Swapnil and me out of the class because she thought we were talking. And we really weren’t. It’s so unfair. How can you just punish people because you thought they were talking?”

Aaaaaaaaaaaaaah. How wonderful! Unwittingly, what Lil One was talking about is how the classroom “talkative children outcome model” experiences multiple equilibria situations. Reminds me of Maurice Obstfeld. A classic paper in currency crises. This paper was seen to be a fore-runner in “second generation crisis modelling” in the 1990s.

What is so special about Obstfeld’s paper? Before Obstfeld, all currency crisis literature (first generation models) used to focus on which fundamentals can cause a currency crisis once they deteriorate. So think of a Central Bank, say Mexico, which has a Fixed Exchange Rate model in place. Now, generally, whenever fixed exchange rates have been attacked by speculators, you’d have a story of fiscal indiscipline, wherein the Government monetizes the debt, creating inflation. This puts pressure on BOP and the FOREX reserves move into a decline. As the FOREX levels dip dangerously, the investors look to move away from the Mexcian Peso to some other alternative. A run on reserves or a reversal of capital usually follows and the Central Bank is forced to devalue the peg. Thus, first generation crisis models have mostly been about emphasizing the need for robust fundamentals, good FOREX levels and controlled inflation patterns in fixed exchange rate models.

Second generation models do something more wicked. Obstfeld’s paper for example, is a classic wherein he emphasizes not only the need for the fundamentals to be good, but more so to look good to the investors. Let me explain.

A country with bad fundamentals, he claims, will automatically always move towards crisis. Aditya and Amogh, the trouble makers, always head out of the classroom. The countries with rocksolid fundamentals will always move to a no-crisis scenario. Shreya and Nisa, the scholars, never talk and hence are never sent out.

It is in the country with the “middle set” of fundamentals (Lil One and Best Friend, unfortunately!) that multiple equilibria can actually exist, depending on what the market thinks of you. If the investors “feel” that the fixed exchange rate will be devalued sooner or later, then it makes sense for them to move out of the domestic currency into the dollar. What ensues is a speculative attack on the currency. However, if they are convinced that there is no threat of devaluation, no speculative attack occurs and the country continues on its Business-As-Usual (BAU) growth path. If teacher thinks you are talking, you get sent out. If she can be prevented from thinking so, you are in!

Now, this brings us to an interesting concept: Signalling. It is in the middle set of fundamentals that the role of a Central Bank becomes extremely important, not only from the perspective of controlling inflation, but equally importantly, from perspective of giving out the correct signals to the market. If the Bank behaviour gives a signal that the exchange rate parity will be protected, come hell or high water, it helps to calm the market and hence prevents the attack from happening.

Why is a multiple equilibria discussion relevant in today’s Eurozone context? It is not that relevant for Greece, which definitely has bad fundamentals and hence will witness very low sentiment in the next 2-3 years. Similarly, Italy, Portugal and Ireland with debt-GDP ratios of 133%, 129% and 123% are definitely high debt-bad fundamental economies.

But look at “middle set” of fundamentals such as those in Spain, with a 93% debt-GDP ratio. If investors believe in the growth story that Spain offers, they will continue to show confidence, the spreads would gradually reduce and Spain could have a smooth medium term growth trajectory. However, a minimum hint of trouble, a political conspiracy there, at the mere whiff of a problem, investors could flee the market sparking huge self fulfilling crisis issues in Spain.

The IMF has recently praised Madrid for its structural reforms and has revised the growth estimates for Spain upwards. However, reforms have meant lesser Government expenditure and there’s an all time high unemployment level that is sparking off concerns regarding political stability. If the existing party gets voted out of power in the upcoming elections and the new party in power believes in Syriza kind of zero austerity measures, this could well be the trigger that could throw Spain out of the classroom.

Spain needs to be careful, not only with what is does, but more importantly, with what it projects. If the Government can give a signal of stability and continuation of reforms, we may soon find Spain recovering much faster than the other members in its dubious PIIGS group.

Later that night “Heehee, mom. I know what I’ll do tomorrow. Swapnil and I will sit behind Shreya and Nisa tomorrow. That way, teacher won’t even think we were talking. Because these boring scholar girls NEVER talk.” Aww, my little economist. Does he sense that the solution to middle set of fundamentals is good signalling?

 

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8 thoughts on “Econ mom gyan on how Spain can stay inside the EU classroom

  1. “This is a really good way to learn.” 🙂
    Should signaling effect be directed related to credentials? Like in financial markets, the signals from a credible firm would be generally well perceived than signals from a non credible firm. But what if the credibility gets damaged somehow?
    Like in this example “Lil One” got sent out once. Now wouldn’t that reduce the chance that any positive signals coming from him being seriously perceived?

    Liked by 1 person

    • You are very right there, Paurakh. Central Bank can give an effective signal if and only if it maintains a good amount of credibility. Else, the market wouldn’t know how to read Bank movements and would move the market to crisis equilibrium all the time.

      Like

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