Euro Zone Debt Crisis

I think this picture says a lot about what is being discussed in the main stream media about the Euro Zone Crisis. High Debt to GDP is only an issue when the GDP is not growing fast enough to pay for the Debt. IMHO, that should be the discussion and not the level of debt. The second important point and I think this is more relevant that anything else is how are we going to grow the GDP? Iceland did it by devaluing their currency. How is Greece going to increase its competitiveness in the global market place? There is no short term answer, GDP growth always takes time to implement and structurally change the economy. It took India 12 to 15 years to get GDP growth at a rate that would make an impact in the economy and it took China over 25 years to attain the rate of growth of around 10%. If the political machine in Europe can implement policies that would get Europe to grow at 3 to 5% again the crisis can be averted. Of course there is going to be hick ups in the short term, it depends a lot of how bad of a hick up we have or a major heart attack. I am certain the policy decision of ECB is very important, they need to cut the interest rates to make the Euro economies to grow again and also stand behind supporting the confidence in the market. Failure to achieve either of those things we are going to have a deep and severe recession in the Euro Zone and the above Debt to GDP ratio is going to get worse.

Policy implications if we use Power Law distribution

I have been working on my first paper with the title "Can Power Law help us avoid highly improbable tail events?" the premise of the argument is that if some economic variables fall in the Power Law distribution then policies associated with those economic variables need to be handled differently. For example, I am taking the problem of the Icelandic Krona, I have written about the Icelandic Krona before and I am convinced that it follows a Power Law distribution.

If we know that ISK follows a power law distribution and future fluctuations in ISK are going to follow the Power Law distribution should the Icelandic state still use the currency in its current form? or should it switch over to a more stable currency say the Euro? this debate is on-going in Iceland and I am afraid people are viewing this decision with their political lense and not the economic lense.

Just a simple switch in the probability distribution of the ISK has some serious policy implications. Lets do a simple thought experiment: The Financial Supervisory Authority of Iceland used a 20% devaluation of the ISK as a basis to stress test the banks in Iceland, why did they choose 20% because they thought ISK followed a Gaussian Normal Distribution and a 20% devaluation is a 2 or 3 sigma event or a very low probability of occurance, however if we change the distribution to Power Law a 20% devaluation of the ISK has a much higher probability therefore they would have chosen a much higher deviation for the stress test say 50% this would have shown the true color of the Icelandic banks capital adequacy and vulnerability to wholesale funding. The question is if the stress test had been done in 2006 when Iceland had a mini crisis, the FSA could have put a stop to the aggressive borrowing by the Icelandic banks which in turn would have reduced the leverage of the companies in Iceland and the citizens.

So choosing the right probability distribution matters! atleast that is the basis for my PhD thesis lets hope the thesis could influence some policy choices.