31 May 2011

When the Shoe Does not Fit, Redesign the Foot

Economic is a dismal science, but one best served when frightened. The Greek ECB/IMF package is scary. I wrote most of this in bits and pieces almost a year ago.

When a small country loses its currency, it loses its monetary and exchange policy. When it cannot control its own money or exchange rates, it ultimately loses its fiscal policy. When it no longer has a say in what in can or cannot do, it is no longer a government but an administrator.

There is no example in history of a lasting monetary union that was not linked to one state.' (emphasis mine) Otmar Issuing, Chief Economist of the German Bundesbank Council,1991

When you don't own your own money, you borrow it. Its pay-back time.  Who and what is exactly being rescued in the ECB/IMF package?  Why isn't Greece allowed to default?  Let me give you a clue,  Keynes once said: “If you owe your bank manager a hundred pounds, you have a problem. If you owe a million, it has.” Greece is a small country.

The trading surpluses at the centre of the Euro Zone were built up at the expense of trading deficits in the periphery. The global recession affected the finances of those least able to cope, at the periphery of the Euro-zone, the hardest.  They had to borrow, as there was no European fiscal framework or funds to address the those worst hit in EU.

The global recession did not reveal very much about the structural problems of the Greek economy (these are not surprising anyway) but it does expose the deep rooted problems of the Euro. Hence a small economy that only represents 2% of overall Eurozone GDP can cause such a fuss.

Theoretical Background

The idea of monetary unions comes from the paper on Optimal Currency Areas, by R. Mundel in 1961 when capital was assumed fixed.  The prevailing view was that as markets do not work perfectly exchange rates can tidy up the mess. An optimal currency area would be one where economies share sufficiently similar characteristics in the sense that any external shocks to their economies would affect them equally.  Europe could not be in any sense described as such an area. Even the US was not regarded as an optimal area but, provided populations would move from one region to another, the currency area would adjust.

Euro-visionaries, however, were not to be deter by this and invented a modern version in the European Commission's “One Market, One Money” Report (1990).  Behind its vision was a perverse form of the Lucas Critique and even more perculiar neo-classical macroeconomic view of the world.  Thus, if governments were the causes of business cycles then their monetary impotence would bring benefits to the economies of the monetary zone. The European Central Bank was set up in a way that institutionally disallowed all other economic views of the world.

The 1990 report thus claimed that the mere act of joining a currency areas creates the conditions for the economies to converge towards an optimal currency zone.  A lot of wishful thinking, but the Maastricht and Lisbon Treaties set out rules for a European convergence process, the Growth and Stability Pact to ensure it and the ECB was designed to provide a stable currency area to encourage it.   Historically, I can't think any examples of monetary union without political union that have not resulted in disintegration or war.  Dangerous if there is no political feeling of unity or community.

The gap between fantasy and reality provides fertile grounds for speculators. There has been a gross misunderstanding of the relationship between money and debt. With the acceptance of money is an implied acceptance of debt. With the ECB refusing to accept responsibility of being a lender of last resort, and private rating agencies filling the void, the control of this debt and therefore of the money itself is lost.

In Practice:

Clearly convergence has not been happening.  The global financial crisis exposed a growing divergence between the large and small Euro economies who needed to finance their trade imbalance. 

A common currency and interest rate has a built-in bias and has meant that European economic policies are determined by the biggest players. Growing trade surpluses were balanced in the north by credit bubbles to sustained the deficits in the south.  This has been nicely disguised by European subsidies, grants and a blind eye to cheating.   As soon as the Global Crisis occurred, the 'cheats' are conveniently blamed, exposed, imprisoned and made to pay up. The one size (Euro) for all is in fact one size for the big and the big are always too big to fail.

Actually, the ONE solution to the trade imbalances, in the absence of an exchange rate, would be to re-allocate the surpluses to the deficit countries. This happened when West and East Germany unified.  That, of course, is too immoral for 'Europeans', who are reluctant to do anything that looks like a re-distribution of wealth on the basis that Germans are Germans and Greeks are Greeks.  So we have the ECB/IMF package for Greece that does the opposite on the basis it is a question of morals rather than sound economic principles.

Wrong Policies

The austerity measures are creating a  'death spiral'.  Cutting deficits ends up increasing them as output, income and employment, and therefore tax receipts all fall. Even if the Euro and the Greek economy survives these measures,  the crisis will keep on reappearing as the trade imbalance that the euro creates remain and surpluses and deficits will build again whenever Greek economy and the Euro economies try to grow.  Heroic sacrifices for Euro become more than a waste of time but a form of Euro masochism  (http://krugman.blogs.nytimes.com )

Policy 101

Here is a simple school exercise in numbers I borrowed that seems to be beyond the reach governments and accountants ( http://streetlightblog.blogspot.com/2011/05/some-simple-deficit-reduction.html )

A country has a very a large budget deficit and wants to reduce it. GDP is $100 and its budget deficit is 10% of GDP and it is told to reduce it to 5%.  So it cuts government spending by $5 and overall spending, GDP, falls by $5.  Now close the accounting book.

Someone's spending is someone's income, and they too are forced to spend less which in turn affects other incomes. After a small cycle of after-effects (the multiplier) overall spending falls by, for example, by 1.5 times the initial cut.  If the tax rate is 25%, then the following changes are

    -$5 the initial spending reduction
    -($5)(1.5) = $7.5 the overall fall in incomes and spending - as people loss jobs and spend less

     Old tax revenues = $25 ;
     new tax revenues = $( 100 – 7.5) x 25% = $23.125
    -$1.875 = Fall in tax revenues

The deficit falls from $10 to $6.875 (not to $5 as the accountant hoped for).

But what percentage is $6.875 of $95?   Hmmm its 7.4% not 5%. of GDP.  Someone's cheating, lets apply more cuts.

Surprise, surprise... the Greek government is missing its deficit targets.
So why do Governments do it?  Well you need to believe in market fairies as every time you don't believe in one, then one dies ... Now you do do believe in market fairies, don't you children... Behave and sit still.

The rating agencies can see through the logic of deficit reduction.  It a question of diminishing ability to pay the debt that increases the betting against the Euro surviving.

The Euro's Structural Flaw

There is very little being done about the causes and too much emphasis on the symptoms of the Euro Crisis.  Europe is standing on its head.  The financial crisis caused the deficits: not the other way around. It is the Euro, and trading imbalance it generates, that has destabilised Eurozone government accounts. Not the other way around.

This is best highlighted by the failings of the old Stability and Growth Pact. The Pact drew an arbitrary line on the percentage of debt/deficit to GDP allowed (why 2% or 3% ? Europe has a fixation on percentages). The Pact wrongly assumed that governments are masters of their destiny, in full control of their revenue and spending, and are therefore completely responsible for deficits and surplus and should be disciplined whenever they breaks the rules. Apart from cheating (which might benefit their own electorate), there are serious economic reasons why the rules cannot work anyway. Government budget outcomes depend largely on the business cycles and the global economy.

Without doing anything, in growth years, taxes revenues increase and spending on unemployment and welfare falls.  Without doing anything, the global recession means a drop in tax revenues and rises in spending on unemployment and welfare payments and automatically plunges a government into deficit and breaks the pact.

To keep to the Pact's budget limits means cutting back government spending and increasing taxes during a recession, making the business cycle worse. Not exactly the policies to keep an elected government in power.

Not surprisingly, in 2002 the former EU Commission President Prodi, was caught calling it the 'Stupidity' Pact (http://www.independent.co.uk/news/world/europe/analysis-stupidity-pact-crumbles-as-euros-foundation-stone-608287.html.)

So, to at least forestall both a recession and breaking its commitment to the pact, the hardest hit governments had not only to both borrow on the bond markets but also to disguise the extent of the debt by resorting to creative accounting and step into the dangerous waters of the derivative and  SWAPs markets ( let's swap debts with each other so we don't have to record them as our own).  Thus the difference between the UK debt and the Greek debt is that the Greek debt is very short term and demands more immediate higher and unsustainable interest payments.

(Debt is often a misconstrued concept. For example, 'our children's children will be paying the interest on this debt. Who gets this interests? The owners children's children.   Interesting in how the pronoun 'our' is often used.  Indebtedness is thus an issue concerning redistribution of wealth.  Money and finances can also be confusing.   Money itself is a form of debt.  The UK pound has "I promise to pay the bearer ,,,' on the note whilst the Euro just has nice pictures of European architecture.)   

Greece was not alone in having difficulties not breaking the rules. It was not the only country to indulge in creative accounting and play in SWAPs markets. Italy has done it on a bigger scale in 1999.   The following figures were taken before the Global financial crisis of 2007.

Stability and Growth Pact Violations Years


Germany 2003-2006
France 2003-2006
Italy 2003-2006
Netherlands 2004-2005
Portugal 2002; 2005-2006
Greece 2003-2006
Source: Public finance in the EMU - 2006 (European Commission, 2006)

The largest economies, France, Germany, and Italy, are among the most notable offenders. It seems that size matters. It meant that they could get together and change the budget limit rules in 2005.  Thus when it affected both Germany and France, the Pact and rules were changed.  With growth and power rules bend very easily.

When there was a drachma, even a corrupt, inefficient and bureaucratic economy like Greece could always inflate or devalue its way out its difficulties - inflation and devaluation being in a sense a form of defaulting or debt restructuring as the lenders get less value back.   The lack of a exit route, once the extent of the the Greek debt was openly publicised (were we really surprised?), sent the interest rates that Greece had to pay on its debt into an upward spiral, making it virtually impossible difficult for Greece to control its deficits.

What normally happens in the case of countries is that lenders accept their losses (poor decision making) and debts are restructure.  This does not happen in cases where lender can exert enormous political power. Instead they take the moral high ground.

The immoral use of moral hazard 

So an argument has been put forward based on the principle (found in the economics of cheating, information and insurance  markets)  of 'moral hazard'.   Basically, and in simplistic terms, it says that when one side of the market has more information than the other, it will take advantage of the other.  The Greek government, as a seller of bonds and by hiding the true extent of its debt, is accused of taking advantage of the poor lenders i.e. the banks.  And so we now have the argument circulating around Europe that elected governments should not be trusted, as in order to get elected they will have to break the fiscal rules, and so they must have their powers removed or be administrated by unelected officials.  Elected officials its seems are corrupted by the voters. Unelected officials are not.  Anyway, as the Greek government no longer has any power, it must concede the argument.

In reality, moral hazard is working the other way around.  Greece presented faulty information about its deficits in 2001 when attempting to secure membership of the European monetary union.  Ask any econometric student over the last 20 year over the difficulties of modeling the Greek economy and they will tell you that the data is unreliable and cannot be trusted. I don't remember, in the days of the drachma, a single occasion when the Greece government statistics and the OECD versions of the statistics ever agreed.  The rating agencies and the banks has more information than a Greek government department that doesn't even know how many employees its employs.  The rating agencies and lending institutions, remember,  were very heavily involved in both the 1997- 2000 Greek Stock boom and bust and government privatisations of that period.  Goldman and Saachs even arranged the Greek swaps to cover up the true picture.  Why was the PASOK government's announcement at the end of 2009 of the true extent of the debt such a surprise? Was coming clean or being honest such a surprising shock for them?

We face a situation where the principle of moral hazard applies to the buyers of the bonds rather than to the sellers.  Greek bonds, we are told pay out high rates because of the risk of default on debts, BUT, when known that a default or debt restructure will at all costs be politically prevented, they will return some very nice safe profits.  The European banks having been holding far too many of them, to such an extent that a Greek default on its debts would place these institutions in danger with serious repercussions for the French and German economies. Yet the $5bn sale of Greek bonds on the 4th March 2010 was oversubscribed by a factor of almost 3.  Being deemed 'too big to fail',  has meant that even more higher 'risk' debts have been accumulated than what would normally have occurred. It has encouraged Banks to be over-exposed.

Hence, I refuse to call the ECB/IMF package a Greek rescue package and I doubt if any Greek on the street is feeling rescued.  Greeks (and even German taxpayers and workers, as they have worked for more than what they have received for their efforts to produce a trade surplus) will be paying for some very nice profits being paid elsewhere on these bonds for years to come.  The ECB/IMF package IS a bank rescue package -  not a country's rescue package.  It does not matter that Greece will fail to restructure its economy; but it does buy time for banks to restructure their assets.  Somehow, we are sold the idea that the very people making very nice profits are doing Greeks a favour. If both Greeks and Germans are losing, then who is winning? 

From an economist point of view, preventing defaults at all cost is in many ways perverse.  It is perverse as one would usually expect the buyers of risk, not the sellers of risk, to suffer the losses. It rewards poor investment decisions. In such perverse conditions, the market collapses into a frenzy of speculative feeding. It is perverse, by Casino rules. The European Casino is saying come and play here. If you lose, don't worry our staff will pay. This is not sustainable. The global bets are that such casinos cannot stay in business for ever. Or put it another way, the frenzy of speculative feeding will continue all the way down to Ireland, Portugal, Spain, Italy and so on until some banking official somewhere presses a default button. The European response to this is to blame Anglo-Saxon (a European term I hate) speculators - or rather to blame sharks for behaving like sharks.

An Euro not Greek structural problem

For whom is the ECB and its monetary policy designed to serve? Its not elected. The Euro and European interest rate has no relation to the needs of most members' economies. It tends to be dominated the needs of the strongest economies at the expense of all other economies. One currency and one rate has caused an imbalance, with indebtedness in economies where money has become too cheap as European Banks fall over themselves in pressurising consumers, and anything that moves, to take up credit cards and loans. It is a financial markets equivalent of the Common Agriculture Policy; replace "butter mountains' and "wine lakes" with 'mountains of debt' to get the picture.  With money in southern European countries suddenly very cheap, the mountains of debt build up rapidly creating the construction, housing and property bubbles in the region.

On the other side of the imbalance and the accumulation of debts, has been the accumulation of trade surpluses in the core of the euro economies.  Germany is the largest economy in the Euro, accounting for about a quarter of its GDP.  The success Germany's growth from 1999 was maintained by a persistent trading surpluses with economies from the European periphery. A single interest rate based on the German Bank model meant high real interest rates, a lower aggregate domestic demand growth and thus a lower growth in real wages for German workers.  This, however, gave Germany companies a competitive dominance in the internal markets of the Euro and provided an export led growth that drove its GDP up.  Persistent German trade surpluses meant persistent trade deficits for its trading partners.  Countries like Greece, Portugal, Spain, and Italy were forced to accept huge and growing current account deficits that entailed borrowing.  At the same time, the lower real interest rates or cheaper money allowed the peripheral countries, as in Greece, to a both a high build-up of sovereign debt and consumer debt.  They were provided with the financial tools, loans and credit cards etc., to fuel this growth.

This structural imbalance at the heart of the monetary union and cannot be solved by trying to correct the structural problems that lie within one country.  There is very little that countries like Greece away from the core of the Eurozone, can do to correct this imbalance, The Euro disarms them.  Membership of the Euro implies a severe loss of sovereignty as two crucial policy tools are surrendered: exchange rate and monetary policy.  There is no option to devalue, or to print money and inflate, and offset the trade imbalance. They cannot even interfere with the interest rate to prevent increasing levels of consumer indebtedness of their populations.  Put simply, the surpluses in one country are matched debts of another. While one country persist in keeping it surplus, indebtedness will grow elsewhere.  Even more serious, without two key policy tools, any protection that could be done against the the global economic crisis of 2007, had to be done by fiddling the books. The sovereign debt crisis was inevitable.

It is misleading to see Euro problem in terms of one country being inherently more efficient than the other.  (Efficiency is another one of those misused economic terms that loses its meaning if disconnected from its welfare aspect - e.g. where benefit/gain in being the most efficient at making square wheel cars -  in this sense, efficient war machine is a contradiction in terms).  The problem with this is that economies can be just different because they are based on different geographical characteristics and resources.  For instance, I will never go to Germany to go sun-bathing no matter how efficient the Germans are at getting the sun beds out.  Neither will reducing everybody's wages solve the problem. Going for holiday in Greece will always be more expensive than going to Turkey. The Greek waiter has pay artificially high European food prices to survive, the Turkish counterpart does not. In a way, the imbalance in the economies starts much further down the food chain.

It not just a Greek structural but also a European structural problem. However, countries that are always on the 'plus' side of an imbalance never see themselves as having a structural problem.  The Euro has been described as "one size to fit all". Greek austerity measures say: "when the shoe does not fit, cut off the toes".

Can Greece say no to the Euro?   Ironically, on 'Οχι' day (the celebration of the day in 1940 when Greece refused to give in to Italian demands) there was an agreement to limit government budgets and debts with fines to be imposed on offending members.  It rules out an independent fiscal policy, any type of macroeconomic management of the Greek economy. Without control over monetary and fiscal policy, is there any point in electing a Government. To do what? It doesn't matter how transparent or less corrupt the government is, it is no longer of any significance.

Those betting on the Euro hold the believe that it is a means to an end, a centralised unelected fiscal and monetary authority - a type of dictatorship.  Writing in the Financial Times in December 2001, then EU Commission President Prodi declared  “I am sure the euro will oblige us to introduce a new set of economic policy instruments. It is politically impossible to propose that now. But some day there will be a crisis and new instruments will be created”.  Every time a crisis occurs a country loses more of its sovereignty.

No built-in Democracy

The lack of democratic control is embedded in the Eurozone system. The European Central Bank's president is appointed by governments but is accountable to none of them. The ECB publishes neither the minutes of its meetings nor its voting record, and sets its inflation targets and interest rates without any democratic consultation. PASOK won elections on the promise to make the rich pay more tax and provide more support for the low-paid and pensioners. Whether this possible is not the issue, but 'democracy' ought to imply the right to do what one wants with one's own resources. The Greek electorate and any other small economy don't matter that much. It only matters when unrest and protests affect the financial variables. Voting out national parliaments has far less, if any, effect.  Europe has become very undemocratic. 

There is no alternative” viewpoint is embedded into ant European agreements. Alternative schools of economic thought are not allowed. It is not possible, for instance, to do Post-Keynesian demand management and conduct deficit spending to fight off recession and unemployment. As in the 1930s, deficits are immoral and those in debt should be penalised. The default setting of the treaty is form of monetarism, whether or not the Eurozone governments choose to subscribe to it or not. The electorate cannot vote for governments that do not adhere to these values, unless they find some way of cheating and, just in case they do, they are now policed by ECB officials.  The electorate of small country cannot vote on  economics policies as it has no influence on the ECB. What it votes for is in effect it is a administrator of a product that is delivered from the ECB with labels translated into the different languages of the Euro zone.  The Euro-vision Song contest is probably a better example of European democracy.  Any government elected on the platform that disagrees with the ECB will by definition be dishonest. It will either need to cheat its electorate or cheat an unelected monetary authority.

Without any macro demand management, the government of a small eurozone is only left with managing its population, or rather crowd control. This is the supply-side economics of trade union and labour regulations, the use or misuse of immigrant labour, modernization and retraining of the police and of course privatizations. The ECB/IMF proposes a 'internal devaluation' and structural reforms to make the economy more competitive. Internal devalution', like an actual devaluation, works only if they act on both prices and wages. With monopoly and Cartels, they fail to work as costs are not absorbed but are passed on to consumers. Failing to directly address the power of monopolies and cartels, will only deepen the economy's structural problem.  Reforms might appear to work as the numbers add up in the government's account books but this is done by redistributing from those who don't have monopoly power to those who have. Small businesses, who tend to be more competitive, will be the first ones to disappear.  The monopolies and Cartels will survive. They will also be given other opportunities to make money, such as privatisations - what G Stiglitz (nobel prize winner and former chief economist of the World Bank) has more accurately described as 'Briberisations'. 

Without investment, or/and a dramatic structural change in the economy, to correct any trade imbalances everyone ends up working more for less. The promise is that this is for the short run. The reality is that, while the trade imbalance between the richer and poorer Euro members remain, it is for the very very long term. Under the austerity measures, the poorer states have even less resources to invest in structural changes to make their economies competitive. The ECB/IMF package is massive transfer of resources away from the poor.

Finally, is it possible for a Monetary Union to work when the member economies are completely different AND there is no mechanism to address the differences?  Currency transfers or exchanges rates prevented indefinite surpluses or deficits building up. Even the Romans transferred resources to the outer parts of their empire. In the US, the employed Californian pays taxes which goes to the unemployed Texan. When Germany unified in 1990, West Germany paid East Germany. In the 1980s, the former Yugoslavia republics argued and refuse transfers payments; nationalism rose and war eventually resulted.  For the Euro Zone to work, it has to be the surplus countries that gives to the deficit countries.

Monetary unions usually imply a sense of economic community which allow, as national economies do, via taxes and welfare payments for richer regions to indirectly subsidise economic disadvantaged regions. This would imply 'hard working' German workers being willing to subsidise 'very generous' Greek pensions, or, at least, cushion the effects of Greek austerity measures. For a national economy, taxes and unemployment benefits act as a macroeconomic stabiliser to external shocks. The problem is that fines and austerity measures on an offending members with debt problems do the exact opposite. The problem has been laid out in such a way, that it fosters racial and nationalistic tensions rather than solve them.

It has happened before

The theme is as old as the Keynes' criticism of the Treaty of Versailles (1919) which predicted that austere war reparations would produce drastic European instability
It is an extraordinary fact that the fundamental economic problems of a Europe starving and disintegrating before their eyes, was the one question in which it was impossible to arouse the interest of the Four. Reparation was their main excursion into the economic field, and they settled it as a problem of theology, of polities, of electoral chicane, from every point of view except that of the economic future of the States whose destiny they were handling” Ch VI, The Economic Consequences of the Peace
Right now everything is entirely the wrong way round. We argue about moral hazard - about penalising borrowers for over-borrowing and NOT about lenders for over-lending.  Preventing default prevents the markets from penalising over-lending and rewards them instead.  Trade surpluses are not reduce; but the debtor economies are reduced.  Morals, character, race, DNA, culture, etc are the public arguments.  Hard working Germans cannot give back their surpluses to indebted lazy Greeks, as they are sold on the idea that it is a moral rather than economic problem.  The reality is different.  The surpluses and deficits were built up, in the first place, because of the competitive advantages that the one currency persistently gave to certain members and a lack of a mechanism (like exchange rates) to address this imbalance. When each country has its exchange rate, this does not happen.

There is, finally, one mechanism that does allow the Greek economy and European economies to re-balance in the long-run. Unemployment and prosperity returns, not by the Government doing anything (it has no power anyway), but by the population leaving the economy. This tends to be the young and mobile. This, in turn, creates a problem of having a smaller tax-base to pay for pensions. This is probably how the IMF really sees the situation in Greece. The first measures in the the austerity packages had to do with pension schemes.

So it is not surprising that IMF officials issued warnings to the EC and ECB to get this Euro project finished with (with some centralised European authority). They are trying to do so, Fine, but who elects the ECB?  Are we being disenfranchised?

1 comment:

  1. Well, in the huge stack of opinions, here is finally a needle which deserves very careful reading. Warren Buffett recently phrased it in his own "simple-minded" way: “You know, 17 European countries gave up the right to print their own currency. That was an enormous decision!"

    EU-leaders are talking about the wrong deficit when it comes to understanding member countries’ problems: it is the current account balance which drives the shifting of wealth (and employment) among nations and not the budget deficit.

    A current account deficit must be financed through the inflow of money from outside the country. In Greece, that amounted to 199 billion EUR from 2001-10. Ideally, it should be financed through a mixture of debt/investment but even if it is 100% financed by debt, the end of the nation is not necessarily near. It all depends what the financing is used for.

    If a large current account deficit is financed through debt (as in Greece), it will either lead to a boom with the perspective of a Golden Age (if much of the debt is used for productive investment) or it will lead to a boom which is followed by a bust (if most of the debt is used for consumption). Guess in which category Greece falls...

    Greece, as a still developing economy, will have a current account deficit for many, many years. As a result, there are only 3 solutions to the Greek problem: foreign investment, foreign investment and, again, foreign investment. The banks quite obviously have had enough of making loans to Greece. Not only will foreign investment bring money but it will also transfer know-how, for the Greek economy just as important as money!

    Here are some blogposts which spell out the situation in more detail.

    http://klauskastner.blogspot.com/2011/10/letter-to-ekathimerini-on-foreign.html
    http://klauskastner.blogspot.com/2011/09/endgame-for-greece.html
    http://klauskastner.blogspot.com/2011/07/comparison-with-usa.html
    http://klauskastner.blogspot.com/2011/09/letter-to-prime-minister-george.html

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