18 July 2011

Who cares as long as the Euro goes ping?

Eurocrats are fumbling through the pages. They are sure that the problem lurks darkly in the morality of those who commit sinful debts. A few magic words, a legal spell, a sprinkle of accounting and a curse on agencies ... but which page is it on?
This fantasy (as described by Yianis Varoufakis) and 'the one interest rate to rule them all' has this fate. Eurocrats and leaders are still only concerned with the problem of financing unfair terms of trade. As for moral hazard, a example could be taken from this German Insurance company and have colour-coded arm-bands issued to good and bad servicing countries.

A simple story of unfair terms of trade

The surpluses and deficits build up because of competitive advantages that the one currency and the interest rate persistently give to certain members.  There is still no mechanism to address this imbalance.

The Terms of Trade (the real exchange rate) is the price of foreign goods relative to domestic prices. Exporters and importers compare the prices of goods home and aboard. 
Let (EP) = Eurozone Prices      Let Pg = Greek prices

In the Never-Never-Land of European Convergence and market fairies, we would expect Eurozone and domestic prices to be equal and a real exchange rate equal to one. This a big assumption; there are too many goblins around.  When there are serious problems of competitiveness, market power and corrupt political structures the 'law of one price' breaks down.

Greek markets are smaller, easier to control, less competitive than their Euro counterparts. Monopolies, cartels, vested interests, corruption and bureaucracy  keeps domestic prices higher, with consumers experiencing higher rates of inflation, than elsewhere in the Eurozone.  With (EP) < Pg, imports rise, exports fall and Greece has a deficit relative to its Euro partners.

The ECB/IMF's structural reforms intend to internally deflate Pg, but on who?  This is the key difference between the Government and the 'Indignants' on the squares of Greece. Reforms fail when applied on just the weaker members, and on those who join vested interest groups in order to protect themselves against the stronger ones. The political structure, itself, needs changing. It is incapable of shooting itself. However, do-it-yourself structural reforms are, I suppose possible. Here's an example happening near me.

Contrast what happens with exchange rates.  Redefine (EP) into two components: E (exchange rate) and P (foreign price level).  (EP) < Pg, means that the excess demands for partners' goods now translates as excess demand for their currency causing E to rise.  Exchange rates, moving much faster than domestic prices, move to maintain the purchasing power parity, (EP) = Pg.  There are no persistent trading surpluses and deficits so even a corrupt, inefficient and bureaucratic economy can devalue its way out difficulty. 

Forward and speculation markets are attached to exchanges rates. Without a domestic currency (fixed exchange rates), speculation moves elsewhere, on to sovereign debts and the ability to service deficits. The Euro has swapped currency risk for sovereign debt risk. The ECB's failure as 'central bank' to provide Eurobonds and act as a lender of last resort has manufactured a very volatile market in sovereign debts. This failing will undo the Euro with every global recession.

Unfair terms of trade has meant persistent trade surpluses in the euro core economies and matching trade deficits in the periphery.  This problem means that a single interest rate and monetary policy does not have equal effects on surplus countries and deficit countries.  It cannot serve both. 

In the core, the real interest rates (prices were rising slower there) meant a lower aggregate domestic demand and a lower growth in real wages for their workers.  This, however, gave the core, Germany in particular,  a competitive dominance in the internal markets of the Euro and the basis for their export led growth rates. The price of this success was paid for in the periphery. Here, the lower real interest rates (as prices were rising higher)  meant money was cheaper and sovereign debt and consumer debt could be built up fuelling construction, housing and property bubbles in the region. Countries like Greece, Portugal, Spain, and Italy were forced to accept huge and growing current account deficits that entailed borrowing.

The global crisis not only exposed but accelerated the divergence between the surplus and deficit Euro economies.  The deficit economies not only had to finance existing trade deficits but also had to face an increasing Government budget deficit, as recession and rising unemployment implies falling tax incomes and more benefit payments. Without a monetary policy, and enforced limits on fiscal policy, they were extremely vulnerable to the global recession. 

It didn't take long for the international financial markets to see this weakness, raise interest rates on debt repayments and question the ability of the 'high' deficit countries to service their sovereign debts.  

Contractionary Fiscal Policy Makes the Long-Run Debt Problem Worse

Debt restructuring can reduce the long term debt / GDP ratio, but the primary object is to ensure that the country can service their debts.  This is one half of the story. With the interest rate on debt higher than its growth rate it is trapped a ‘vicious cycle’ of debt dynamics. The other half of the story is to encourage investment, not austerity, to increase Greece's ability to pay debts. 

To force trading accounts of countries to balance means taking from the poorest countries, reducing their ability to import (trading deficit falls), to give to the richest countries so they that can consume and import (trading surpluses falls). Not exactly Robin Hood

(The old fashion NX line. Those still using the old IS/LM-FX models will note that under fixed exchange rates and highly mobile capital markets, austerity measures are very dramatic in reducing the economy's output. To 'Euro economists', if that is not a contradiction, I would like to point out that Say's Law does not work for heavily indebted recession-hit economies) 

There must be quite a lot of magic in the idea that reducing an economy's output leads to increase in output.  Pain is good, right?  Austerity measures only exasperate the problem by reducing the debtors ability to pay, removing any remaining incentives for the electorate to support such a system.  If you want to encourage popular unrest, discontent and revolutions, austerity measures is the way to go.

A rapid economic recovery is the only thing that could materially reduce the burden of the debt over the next  years.  Reducing the burden of the debt is about making in investments in youth, not the wholesale dumping of them.  Its about investments in infrastructure, and making investments that allow all of the population to participate and be productive.  Without an expansion fiscal policy you can not restructure an economy without deepening existing injustices and creating lost generations, whose only fault was to be born at the wrong time in the wrong place 

Choices, but who chooses?

Well, as we are very sick patients, and doctors know best, is there any point in describing them. You probably won't be allowed to vote on them anyway,  You can just go straight to the video below. 

There are two main four main choices. (1) deficit countries leaving the Euro (2) surplus countries leaving the Euro, (3) insisting on default or debt restructuring (4) an European fiscal framework or investment funds to address the payments crisis called by trading imbalances.  As for the first two: it is always easier on surplus countries to leave the Euro than for deficit countries. So that's Germany's choice. As for the third, when countries can't devalue, what normally happens is that lenders accept their losses. They are not corporations that can have their assets seized.  But Greece is forced to conduct a fire sale of its assets. So is Greece still a country?

There are many styles of haircuts. One is to use the EFSF to provide Greece with funds to buy back its bonds.  Another one, proposed by Germany, is for Greece to exchange its bonds for ones that mature over a longer period.  Both are just bankers' debt servicing proposals with no hint of a mechanism, or collective action, to deal with removing permanent trading imbalance. To only focus on maintenance of debts becomes, in effect, a dictatorship by accounting books. One that leads to further austerity measures. As Paul Krugman complains: “Everything economists have spent the last three generations learning is brushed aside'. But 'you can't teach a dogma new tricks' (Dorothy Parker)

So the main focus has been on the European banking system's ability to maintain existing and future levels of indebtedness  and we are fed with wonderful stressed-out bank stress tests. Taking an analogy from an Economist blog 

'Imagine a patient clutching at his heart, complaining of sharp chest pains. A doctor arrives, examines him carefully and pronounces him healthy—provided he is not having a cardiac arrest.'

Or, rather the 'technician arrives, examines the equipment carefully, fiddles with the knobs until he can announce the results are healthy'.  But, who cares, as long as the Euro keeps going ping .....


As long as there no exchange rate, no transfer payments and no wholesale movement of populations, the only mechanism left in the Euro is through a wonderful disguised system of defaulting.  A default mechanism (a country buying back its own bonds) isn't sustainable and a poor substitute for an exchange mechanism.  

The fourth option is to engage in structure reforms by an expansionary European investment program.

Yianis Varoufakis and Stuart Holland have put forward the “Modest proposal.” which (1) recommends a large part of the Greek debt be taken on as ECB bonds, allowing a longer period to repay; (2) cleansing the banks of questionable public and private paper assets by a recapitalization through the EFSF; (3) for the European Investment Bank to launch a “New Deal” for Europe, using existing and new new Eurobonds, to drive investment.  Barry Eichengreen (niversity of California) adds his voice to a “New Marshall Plan.” which could help finance government support for the unemployed, indigent and elderly and the victims of the financial crisis. A good account of the above options is found here. 

However, there cannot be a fiscal authority without the democratic consent of the European electorate.  They didn’t vote for the system, and no one explained the system to them.  If Greeks, and the European electorate, are to accept the blame for the state that they are in, then they cannot be blamed and deprived of the right to change it.

An European Fiscal authority cannot exist with major democratic reforms.  We are back to square one.  The 'Indignants' are right to complain and demand changes.

1 comment:

  1. There is an old Irish joke about a man stopping and asking for directions. The person looks at him, scratches his head and says, "if I were you I wouldn't start from here". This is a perfect metaphor for the choices facing Greece and the Euro.

    This is a pretty good explanation of the Euro's structural failings. Any sign of elite politicians advocating reform though?

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