Paul Krugman says, politics aside:
Cyprus should leave the euro. Now.
Paul Krugman says, politics aside:
Cyprus should leave the euro. Now.
The end of an era:
Hot Money Blues, by Paul Krugman, Commentary, NY Times: Whatever the final outcome in the Cyprus crisis — we know it’s going to be ugly; we just don’t know exactly what form the ugliness will take — one thing seems certain:... the island nation will have to maintain fairly draconian controls on the movement of capital in and out of the country. ... And ... Cypriot capital controls may well have the blessing of the International Monetary Fund, which has already supported such controls in Iceland.
That’s quite a remarkable development. It will mark the end of an era ... when unrestricted movement of capital was taken as a desirable norm around the world. ... To some extent this reflected the ... rise of free-market ideology, the assumption that if financial markets want to move money across borders, there must be a good reason, and bureaucrats shouldn’t stand in their way. ...
But the truth, hard as it may be for ideologues to accept, is that unrestricted movement of capital is looking more and more like a failed experiment.
It’s hard to imagine now, but for more than three decades after World War II financial crises of the kind we’ve lately become so familiar with hardly ever happened. Since 1980, however, the roster has been impressive: Mexico, Brazil, Argentina and Chile in 1982. Sweden and Finland in 1991. Mexico again in 1995. Thailand, Malaysia, Indonesia and Korea in 1998. Argentina again in 2002. And, of course...: Iceland, Ireland, Greece, Portugal, Spain, Italy, Cyprus.
What’s the common theme...? Conventional wisdom blames fiscal profligacy — but ... that story fits only one country, Greece. Runaway bankers are a better story... But the best predictor of crisis is large inflows of foreign money: in all but a couple of the cases I just mentioned, the foundation for crisis was laid by a rush of foreign investors into a country, followed by a sudden rush out. ...
Now what? I don’t expect to see a wholesale, sudden rejection of the idea that money should be free to go wherever it wants, whenever it wants. There may well, however, be a process of erosion, as governments intervene to limit both the pace at which money comes in and the rate at which it goes out. Global capitalism is, arguably, on track to become substantially less global.
And that’s O.K. Right now, the bad old days when it wasn’t that easy to move lots of money across borders are looking pretty good.
This is from Francesco Saraceno, "an Italian born economist working in France":
Cyprus. Been There, Seen That: A small country is on the verge of bankruptcy. It is so small that the amount of money needed to save it (17bn euros) amounts to less than 0.12 per cent of the eurozone GDP (no typos here. It is around 30 euros per European citizen).
Been there, seen that. Just three years ago in another small country, Greece. At the time, procrastination, self interest, ineptitude, unpreparedness, made the small problem become huge. And we are all still paying the bill. The Greek crisis management was so successful that our leaders are happily embarking in the same dynamics: improvised, dangerous, half-baked solutions, supposedly designed to avoid free riding (the protestant syndrome, once again) and in fact destabilizing the whole system.
There is no need for me to repeat what has been understood everywhere except, as usual, in Berlin, Frankfurt and Brussels...
Here I just want to cite a few paragraphs from an excellent piece by Nick Malkoutzis...
There is really very little to add to this. Except maybe that Nick Malkoutzis is even too nice to Germany. It is interesting to notice that most of the time, in battered countries, Germany’s banks are among the top creditors. In this particular case, the exposure of German banks is 5.8 billions, exactly the amount that the tax should levy. Certainly a coincidence, but still…
I remember, a few years back, Joe Stiglitz accusing the IMF and the American treasury of imposing unnecessary austerity to crisis countries, in Latin America and in East Asia, with the objective to buy time for their banks to minimize their losses (or often times to cash their profits). The resemblance with the current situation in Europe, is worrisome. Very.
Cyprus Set to Reject Bailout, Citing Tax on Bank Deposits: Cyprus’s Parliament is likely to reject an international bailout package that involves taxing ordinary depositors to pay part of the bill, President Nicos Anastasiades said Tuesday, despite a revision that would remove some objections by exempting small bank accounts from the levies. ...
Should the measure fail in Parliament, Mr. Anastasiades and his E.U. partners would have to return to the negotiating table. Analysts have also raised the possibility of bank runs and a halt in liquidity to Cypriot banks from the European Central Bank if the measure did not pass.
The bailout plan, negotiated over the weekend, has aroused harsh criticism in many quarters for its unprecedented inclusion of ordinary bank depositors — including those with insured accounts — among those who would have to bear part of the cost. ...
The managing director of the International Monetary Fund, Christine Lagarde, said Tuesday she was in favor of modifying the agreement to put a lower burden on ordinary depositors. ... She urged leaders in Cyprus to quickly approve the plan... She complained that critics have not recognized how much the agreement will force Cyprus banks to restructure and become healthier. ...
Neil Irwin with the latest on Cyprus:
Financial markets haven’t freaked out over Cyprus. That doesn’t mean we’re in the clear, by Neil Irwin: First the good news: Financial markets have been relatively stable ... over international authorities’ decision to force losses on those with deposits in Cyprus’s banks. ... [There are] signs of an adverse market reaction to the weekend’s news — but not evidence that a broader run on Europe is underway. ...
The modest declines in financial markets Monday are a sign that global investors are betting that the losses being forced upon Cypriot bank deposits will be a one-off situation, and not form a precedent for future aid to banks in Greece, Spain, Portugal and beyond. ...
After outcry from the people of Cyprus and anyone who cares about financial markets and worries about the implications of a government suddenly seizing a chunk of the money people kept in supposedly safe bank accounts, the terms of the rescue deal were being renegotiated Monday. The most likely outcome is a new deal that protects Cypriots’ deposits up to 100,000 euros, though details were murky Monday. ...
The international negotiators ... are right that they have principle on their side. It is unfair for the rest of the world to come to the rescue of Cyprus at a time when the Russian oligarchs who have used the country’s banking system to squirrel away money pay nothing. But sometimes it’s better to have a policy that is unfair than one that is destructive. Europe has spent the past three years trying to persuade global investors and ordinary citizens that their money is safe in European banks. They had finally succeeded in the last several months. But the punitive approach to depositors in Cyprus throws that success into new question. ...
See also his discussion in the article about “Deauville,” and the delayed reaction of financial markets to this somewhat similar event. His point is that despite today's relatively calm reaction, we are not yet in the clear.
European policy seems to follow a common path. There is some sort of crisis that results in one group or another having to take a large loss, and the moralizing and fighting over who that should be leads to brinksmanship until, just before things really fall apart, someone steps in with a temporary, kick-the can down the road fix of some sort. This is starting to look similar -- I hope -- but one of these times they are going to misjudge where the brink actually is.
The War on Common Sense Continues, by Time Duy: This weekend, European policymakers opened up a new front in their ongoing war on common sense. The details of the Cyprus bailout included a bail-in of bank depositors, small and large alike. As should have been expected, chaos ensued as Cypriots rushed to ATMs in a desperate attempt to withdraw their savings, the initial stages of what is likely to become a run on the nation's banks. Shocking, I know. Who could have predicted that the populous would react poorly to an assault on depositors?
Everyone. Everyone would have predicted this. Everyone except, apparently, European policymakers.
The situation remains fluid, with even the final hit to depositors still unknown. The Financial Times is reporting that authorities are considering altering the plan to shift the burden on the tax away from smaller depositors. Moreover, at this point it is not clear is the parliment will concede to the measures despite a last minute push by ECB officials to affirm the deal before markets open Monday. And the impact on other nations in the European periphery remains unknown.
At this point, I would imagine the damage is done, regardless of any modification of the plan. Cypriots know that their savings are now on the bargaining table. To be sure, there will be repeated reassurances that this is a one-off event, but how trustworthy are such assurances? Indeed, if Greece is any example, this will not be the last bailout, and thus plenty of time for the European policymakers to insist on another bite at the apple. Perhaps if authorities completely backtrack on the plan could they stave off a bank run, but even on that I am not confident. Trust is easy to lose and hard to earn.
The bigger question is what does this mean for the European financial system as a whole? Will depositors across the Eurozone view Cyprus as a unique situation? Or will Greek citizens come to believe that the next tranche of bailout funds might come with a new conditions to shore up government finances? Will taxes on deposits be an element of any future bailouts? If so, Italian and Spanish depositors might come to view their mattresses as safer than the bank.
Perhaps expectations of a broader bank run are premature. Early reports from Spain claim that no such run is in the making (of course, what else would they say?). But I suspect this is still a game-changing event, sure to make the financial system more unstable by aggravating the negative feedback loop that surrounds financial crises. What else could be the case when you remove a basic safeguard against panic in the banking system?
I can only sample the amazing amount of excellent commentary in response to this new development. Frances Coppola, in a must read piece, explains the economic consequences:
The effect of large and small depositors removing funds on that scale will be a brutal economic downturn as the money supply collapses. In particular, the dominant financial sector will suffer a severe contraction, putting thousands of jobs at risk and paralysing lending to Cypriot households and businesses. And that is IN ADDITION to the estimated 4.5% economic contraction that is already happening due to austerity measures imposed on Cyprus in 2012 to reduce its fiscal deficit, and the further measures required in this bailout.
Yes, exactly how will this help Cyprus emerge from their recesssion? If you guessed "it won't," you are correct. But expect European policymakerst to drone on about how their plan will restore confidence in the economy of Cyprus. Coppola also bemoans the culpability in the ECB:
The FT confirms the ECB's role in forcing through the deal. It says the ECB threatened to stop providing liquidity to Laiki, Cyprus's second-biggest bank, which would have caused an immediate disorderly collapse. I have written previously about the ECB's disgraceful behaviour. This is the worst example yet.
Just two weeks ago I implored the ECB not to do anything stupid. They didn't listen.
Like me, Karl Whelan is challenged to see that this was a good choice:
Even if we get through the next week without panic, my gut feeling is that this decision is a bad one and the Europeans should have chosen from the other two options on the table. Over the longer-term, I doubt if financial stability in the euro area (and the continued existence of the euro) is compatible with a policy framework that doesn’t protect the savings of ordinary depositors.
Nick Rowe points out that savers in Cyprus are suffering disproportionately because they lack the ability to print their own currency:
The difference is that inflation from printing too much money is a tax on currency too. Cyprus cannot tax currency; it can only tax bank deposits.
Joseph Cotterill (another must read piece), identifies the reason to spread the pain to small depositors:
The spin that this is about spanking money-launderers is rubbish. The 9.9 per cent levy will be the cost of doing business for the average CIS corporate shell, as Pawelmorski notes. More to the point, someone clearly balked at increasing the rate above 10 per cent for big-ticket depositors — because why else distribute pain to small holders to make up for it. Someone has an eye on Cyprus somehow maintaining a future as an offshore banking centre.
Too big a hit to large depositors would end any hope that Cyprus could hold onto its biggest industry. The anonymously penned Some of it Was True blog wonders if there are any rules in European finance:
Probably of more lasting importance is the latest bout of rule-changing by the authorities. Debt unwindings are generally well-defined in law. First equity, then sub debt, then deposits and senior bonds together, and all treated equally. Most of these principles have been tweaked over the last few years, but the tweaks are getting steadily more aggressive. The ECB, holders of Athens-law and foreign law Greek debt all got different treatment; the Dutch didn’t restructure SNS Reeal paper, they confiscated it; the Irish banned lawsuits against the ultimate wind-down of Anglo Irish. This is scratching the surface compared with the rule-changes of the past but it’s getting steadily more creative.The referee has gone from being quasi-neutral arbiter, to pulling off his black shirt to reveal a Manchester United one underneath and awarding himself a series of penalties. While there’s clearly no point in market participants playing the shocked blushing virgin in the face of a situation where the consequences of following the legally-logical steps are socially unacceptable, the uncertainty generated creates costs too.
Edward Harrison (yet another must read) takes a fatalistic view of the news:
It was inevitable that we would be in crisis again. The austerity world view of crisis resolution is completely at odds with the capacity of the euro zone’s institutional architecture to handle a crisis. And so, we keep doubling down on the same policy of austerity in exchange for reforms which has created the downward spiral to begin with. I wish I could be optimistic here. But I think it is going to get worse. I hope I’m wrong. And I certainly hope that periphery depositors still have enough faith in the euro to ride this one out. If the Cyprus panic metastasizes, it will get ugly.
Peter Siegel at the FT places the blame on the Germans:Unbeknown to the Cypriot delegation members as they entered the hulking Justus Lipsius summit building in Brussels on Friday night, their fate was already sealed: their German counterparts wanted about €7bn for the estimated €17bn bailout of their country to come from deposits in the country’s banks.
“They were hand in hand with Finns, who were much more dogmatic,” said one senior eurozone official involved in the 10-hour marathon talks that stretched until 3am on Saturday morning. “Had that not happened, full bail-in,” the official added, using the terminology for wiping out nearly all Cypriot bank accounts.
Felix Salmon see the German influence as bad for Euope and Germany itself:
The Cypriot parliament is probably not going to revolt this weekend, but any politician who votes for this bill is going to have a very, very hard time getting re-elected. This decision is important not only because of the precedent it sets with regard to bank depositors, but also because of the way in which it points up just how powerless all the Mediterranean countries (plus Ireland) have become. More than ever before, it’s Germany’s Europe. That’s bad for Cyprus — and it’s not even particularly good for Germany.
For their part, the Germans deny responsibilty for actions against small depositors:
"It was the position of the German government and the International Monetary Fund that we must get a considerable part of the funds that are necessary for restructuring the banks from the banks owners and creditors - that means the investors," German Finance Minister Wolfgang Schaeuble told public broadcaster ARD in an interview.
"But we would obviously have respected the deposit guarantee for accounts up to 100,000," he said. "But those who did not want a bail-in were the Cypriot government, also the European Commission and the ECB, they decided on this solution and they now must explain this to the Cypriot people."
Bottom Line: In the short-run, the implications for the European periphery might be limited. But, in the long-run, it is hard to see the assault on Cypriot depositors as anything but a step backwards for financial stability in Europe. This crisis remains far from over.
Next week could be fun for economists in search of natural experiments -- will there be a large bank run? -- but not so fun for Europeans:
The Cypriot Haircut, by Paul Krugman: ... With all the problems in Greece, Italy, Spain, and Portugal I wasn’t watching Cyprus. But that’s where the big euro news is this weekend; in return for a bailout, Cyprus is supposed to impose a large haircut — that is, loss — on all depositors in its banks.
You can sort of see why they’re doing this: Cyprus is a money haven, especially for the assets of Russian beeznessmen; this means that it has a hugely oversized banking sector (think Iceland) and that a haircut-free bailout would be seen as a bailout, not just of Cyprus, but of Russians of, let’s say, uncertain probity and moral character. ...
The big problem, however, is that it’s not just large foreign deposits that are taking a haircut; the haircut on small domestic deposits is a bit smaller, but still substantial. It’s as if the Europeans are holding up a neon sign, written in Greek and Italian, saying “time to stage a run on your banks!”
Tomorrow and the days immediately following should be very interesting.
ECB Should Pledge to Not Do Anything Stupid, by Tim Duy: Market participants were rattled today by the election news out of Italy, as it looks like the economically-challenged nation is now politically adrift. But what exactly might worry investors? I pulled this quote from Bloomberg:
“We don’t want to see more chaos out of Europe,” Bruce McCain, chief investment strategist at the private-banking unit of KeyCorp in Cleveland, said in a phone interview. His firm oversees more than $20 billion. “Any question about whether or not Italy would be committed to austerity measures after the elections gets investors concerned.”
Why should we be concerned that Italy backslides on its commitment to austerity? After all, evidence of the economic damage wrought by such policies continues to mount. If anything, a reversal of recent austerity should be welcome.
I suspect, however, that it is not the austerity that worries market participants. It is the fear that European Central Bank head Mario Draghi will threaten to pull his pledge to do whatever is takes to save the Euro in the face of Italian intransigence. The fear that European policymakers are about to partake in another grand game of chicken that once again will bring the sustainability of the single currency back into question. In short, I think that market participants fear tight monetary policy much more than loose fiscal policy.
I am very much hoping that the ECB will keep calm and not do anything that encourages market participants to once again doubt the central bank's commitment to the Euro. Otherwise, this spring and summer will look much like last year's. And the year before that. And the year before that.
..these conventional and unconventional actions work the same way: by lowering the real (inflation-adjusted) interest rate, they stimulate domestic demand and consumption...This pushes the exchange rate down in two ways. First, a lower interest rate reduces a currency’s relative expected return...Second, higher inflation reduces a currency’s real value and thus ought to lead to depreciation. But higher inflation also erodes the competitive benefit of the lower exchange rate, offsetting any positive impact on trade.
If this were the end of the story, the currency warriors would have a point. But it isn’t. The whole point of lowering real interest rates is to stimulate consumption and investment which ordinarily leads to higher, not lower, imports. If this is done in conjunction with looser fiscal policy (as is now the case in Japan), the boost to imports is even stronger. Thus, QE’s impact on its trading partners may be positive or negative..The point is that this is not a zero sum game; QE raises a country’s GDP by more than any improvement in the trade balance.
The Federal Reserve is generally considered the first offender in the currency wars, yet it is often forgotten that the vast majority of the Dollar's real depreciation occurred prior to the recession:
To be sure the Dollar took a hit after the first round of quantitative easing, but that was a positive policy outcome for all as the calming of financial markets eased the rush to the safety of the US currency. On average, since the beginning of 2008 there has been little change in the real value of the Dollar, despite the massive expansion of the Fed's balance sheet.
Also note that by stabilizing the US (and global economies), the Fed contributed to a stabilization of the US current account balance:
All of the improvement in the current account balance occurred prior to the Fed's expansion of the balance sheet, largely due to collapsing global trade. And the subsequent period was one of generally declining real government spending; a more stimulative policy would likely have supported more imports such that trade remained an even greater drag on the economy.
In short, the Federal Reserve did not pursue a "beggar-thy-neighbor" policy. The Federal Reserve actually stabilized the Dollar's value, calmed global financial markets, made a positive contribution to international trade, and stabilized the US current account balance. Sounds like a net win across the board.
Separately, I see that Japanese policymakers continue to make the same mistake of needlessly antagonizing their trading partners. From Bloomberg:
The yen fell after Kazumasa Iwata, a potential candidate to become the next central bank head, signaled the currency has scope to depreciate further and data showed Japan’s gross domestic unexpectedly shrank...Iwata, a former deputy governor at the BOJ, said in a statement the price goal can’t be reached without a correction in the yen’s strength. The yen at 90 to 100 per dollar marks a return to equilibrium, he said.
While there are voices in Japan arguing that the Yen's depreciation is simply a side-effect of domestic policies, it is tough for other nations to buy that story when prominent current, former and potentially future policymakers repeatedly put numbers on the appropriate value of the Yen. They would be better off with some noncommittal statement about currency values being driven by economic fundamentals, with only one spokesperson for the currency. Trying to convince Japanese policymakers to not talk about the value of the Yen, however, is generally about as productive as trying to convince the sky not to be blue.
Two from Tim Duy -- this is the first:
The finance minister's [Taro Aso] comments indicate some surprise within the government at how quickly those expectations among traders translated into declines in the yen.
"It seems that the government's policies have fueled expectations and the yen weakened more than we intended in the move to around 90 from 78," Aso told lawmakers in the lower house budget committee.
Surprise, when you tell market participants exactly what you intend to do, they react accordingly. Market participants received a strong signal that Japanese monetary and fiscal policy would be joined to deliver a significant boost to the economy. The early exit, some might say forced exit, of Bank of Japan Governor Misaaki Shirikawa, clearing away an impediment to such plans, only further entrenched expectations. And market participants delivered accordingly:
Apparently this was too far, too fast? Was it concerns about the price of imported energy goods? Or international pressure? Still from Reuters:
Recently, Aso has reacted strongly to criticism from German and other European officials that Japan is intentionally trying to weaken its currency with monetary easing, so his comments on Friday could cause some confusion about Japan's currency policy.
I continue to think that Japan made a significant tactical error when outlining their policy objectives. A substantial monetary easing that accomplished the objective of driving up inflation expectations in and of itself would be expected to depreciate the Yen. Japanese policymakers could have framed the policy as simply supporting the domestic economy similar to the approach initiated by the Federal Reserve. The impact on the Yen itself could have been implicit rather than explicit. Instead, by making the Yen a part of the discussion at the beginning, Japanese policymakers angered their international partners. I tend to think this was an unnecessary and ultimately counterproductive strategy.
Bottom Line: If Japanese policymakers really intend the depreciation of the Yen be limited to 90, then the supposed currency wars may already be near an end.
The Japan Story Continues to Evolve, by Tim Duy: Evolving economic policy in Japan is an excellent distraction from the fiscal cliff story. From my perspective, the most interesting idea Abe floated was forcing the Bank of Japan to buy government debt to support additional fiscal stimulus. Noah Smith countered that Abe is unlikely to experiment with monetary policy and will simply fall back on a mercantilist policy. While I think it is too early to ignore the fiscal policy aspect, it is increasingly clear that Abe thinks the future of Japan is in its past. From Ambrose Evans-Pritchard:
Premier Shenzo Abe is to spend up to one trillion yen (£7.1bn) buying plant in the electronics, equipment, and carbon fibre industries to force the pace of investment, according to Nikkei news.
This on the back of:
The disclosure came just a day after Mr Abe vowed to revive Japan's nuclear industry with a fresh generation of reactors, insisting that they would be "completely different" from the Fukishima Daiichi technology.
I imagine that should advanced civilizations ever travel to the Earth, they would be amazed that we allow fission reactors on the surface of the planet. I am amazed after by this after the lessons of Chernobal and Fukishima.
I have trouble with this characterization:
The industrial shake–up shows the ferment of fresh thinking in the third–largest economy after years of paralysis.
I am not sure this is fresh thinking at all. It sounds as if Japan is trying to go backwards in time to the 1980's. Especially when combined with an obvious intent to devalue the Yen for mercantilist reasons:
He has set an implicit exchange range target of 90 yen to the dollar, instructing the Bank of Japan to drive down the yen with mass purchases of foreign bonds along lines pioneered by the Swiss.
Finance minister Taro Aso brushed aside warnings that naked intervention would anger trade partners and damage Japan's strategic alliance with the US. "Foreign countries have no right to lecture us," he said, accusing the West of failing to abide by a G20 pledge in 2009 to forgo competitive devaluations.
As I have said in the past, I think that a yen/dollar target of 90 will yield only minor economic benefits at the price undermining Japan's international relationships. The US and Europe will reply that their quantitative easing programs are primarily aimed at boosting domestic demand, whereas if Japan appears to be pursuing an obvious beggar-thy-neighbor strategy. Of course, Abe isn't too worried about offending the international community. From Reuters:
Japanese Prime Minister Shinzo Abe wants to replace a landmark 1995 apology for suffering caused in Asia during World War Two with an unspecified "forward-looking statement", a newspaper reported on Monday...
..Any hint that Japan is back-tracking from the 1995 apology, issued by then Prime Minister Tomic Murayama, is likely to outrage neighbours, particularly China and North and South Korea, which endured years of brutal Japanese rule.
This is shaping up as a year in which Japan moves to center-stage in the international arena.
Bottom Line: Explicit cooperation between fiscal and monetary authorities to dramatically support domestic demand in Japan would be a step forward, but everything else that seems to be coming from Abe is a step backwards.
Tyler Cowen on Europe:
... Until a broad solution is enacted, the system remains within the danger zone for a broader crash. ... Unfortunately, the relevant governments — and their citizens — still don’t seem close to accepting the onerous financial burdens they need to face. And when those burdens are unjust to mostly innocent voters, no matter whose particular story you endorse, acceptance becomes that much tougher.
Still, we shouldn’t forget that a solution exists. In essence, the required debt write-down is a large check lying on the table waiting to be picked up. No one knows how costly it is, but estimates have ranged from the hundreds of billions to the trillions of dollars. It need only be decided how to divide the bill. The reality is this: The longer that the major players wait, the larger that bill will grow. That they’ve yet to split the check is the worst news of all.
Here's my contribution to the debate over China bashing:
We Should Stop Blaming China for our Economic Problems: The second presidential debate featured Mitt Romney and Barack Obama going nose to nose over who would be tougher on China and other countries over their unfair trade practices. But by adopting a narrative that places the blame for our problems on other countries, President Obama is playing into the hands of those who’d like to make significant cuts to social insurance programs that protect working class households. ...
Here's the bottom line:
Blaming our troubles on external causes and implying that all will be well once these causes are eliminated allows the wealthy winners from globalization to escape the taxes that are needed to provide the social protections workers need in the global economy, and to ensure that the gains from globalization are shared equitably. President Obama needs to make it clear that helping the working class will take a lot more than just forcing China to change its ways... [It] will require us to look inward at our own character as a nation instead of blaming others.
Pointing fingers at other countries and demanding change may be politically effective, but the real change begins at home.[Read more]
Ben Bernanke responds to foreigners complaining about US monetary policy (including saying that if some countries want to enjoy the benefits of an undervalued currency, then they must also pay the costs, "including reduced monetary independence and the consequent susceptibility to imported inflation":
U.S. Monetary Policy and International Implications, Speech by Ben Bernanke: Thank you. It is a pleasure to be here. This morning I will first briefly review the U.S. and global economic outlook. I will then discuss the basic rationale underlying the Federal Reserve's recent policy decisions and place these actions in an international context. ...
Federal Reserve's Recent Policy Actions
All of the Federal Reserve's monetary policy decisions are guided by our dual mandate to promote maximum employment and stable prices. With the disappointing progress in job markets and with inflation pressures remaining subdued, the FOMC has taken several important steps this year to provide additional policy accommodation. ...
As I have said many times, however, monetary policy is not a panacea. Although we expect our policies to provide meaningful help to the economy, the most effective approach would combine a range of economic policies and tackle longer-term fiscal and structural issues as well as the near-term shortfall in aggregate demand. Moreover, we recognize that unconventional monetary policies come with possible risks and costs; accordingly, the Federal Reserve has generally employed a high hurdle for using these tools and carefully weighs the costs and benefits of any proposed policy action.
International Aspects of Federal Reserve Asset Purchases
Although the monetary accommodation we are providing is playing a critical role in supporting the U.S. economy, concerns have been raised about the spillover effects of our policies on our trading partners. In particular, some critics have argued that the Fed's asset purchases, and accommodative monetary policy more generally, encourage capital flows to emerging market economies. These capital flows are said to cause undesirable currency appreciation, too much liquidity leading to asset bubbles or inflation, or economic disruptions as capital inflows quickly give way to outflows.
I am sympathetic to the challenges faced by many economies in a world of volatile international capital flows. And, to be sure, highly accommodative monetary policies in the United States, as well as in other advanced economies, shift interest rate differentials in favor of emerging markets and thus probably contribute to private capital flows to these markets. I would argue, though, that it is not at all clear that accommodative policies in advanced economies impose net costs on emerging market economies, for several reasons.
First, the linkage between advanced-economy monetary policies and international capital flows is looser than is sometimes asserted. Even in normal times, differences in growth prospects among countries--and the resulting differences in expected returns--are the most important determinant of capital flows. The rebound in emerging market economies from the global financial crisis, even as the advanced economies remained weak, provided still greater encouragement to these flows. Another important determinant of capital flows is the appetite for risk by global investors. Over the past few years, swings in investor sentiment between "risk-on" and "risk-off," often in response to developments in Europe, have led to corresponding swings in capital flows. All told, recent research, including studies by the International Monetary Fund, does not support the view that advanced-economy monetary policies are the dominant factor behind emerging market capital flows.1 Consistent with such findings, these flows have diminished in the past couple of years or so, even as monetary policies in advanced economies have continued to ease and longer-term interest rates in those economies have continued to decline.
Second, the effects of capital inflows, whatever their cause, on emerging market economies are not predetermined, but instead depend greatly on the choices made by policymakers in those economies. In some emerging markets, policymakers have chosen to systematically resist currency appreciation as a means of promoting exports and domestic growth. However, the perceived benefits of currency management inevitably come with costs, including reduced monetary independence and the consequent susceptibility to imported inflation. In other words, the perceived advantages of undervaluation and the problem of unwanted capital inflows must be understood as a package--you can't have one without the other.
Of course, an alternative strategy--one consistent with classical principles of international adjustment--is to refrain from intervening in foreign exchange markets, thereby allowing the currency to rise and helping insulate the financial system from external pressures. Under a flexible exchange-rate regime, a fully independent monetary policy, together with fiscal policy as needed, would be available to help counteract any adverse effects of currency appreciation on growth. The resultant rebalancing from external to domestic demand would not only preserve near-term growth in the emerging market economies while supporting recovery in the advanced economies, it would redound to everyone's benefit in the long run by putting the global economy on a more stable and sustainable path.
Finally, any costs for emerging market economies of monetary easing in advanced economies should be set against the very real benefits of those policies. The slowing of growth in the emerging market economies this year in large part reflects their decelerating exports to the United States, Europe, and other advanced economies. Therefore, monetary easing that supports the recovery in the advanced economies should stimulate trade and boost growth in emerging market economies as well. In principle, depreciation of the dollar and other advanced-economy currencies could reduce (although not eliminate) the positive effect on trade and growth in emerging markets. However, since mid-2008, in fact, before the intensification of the financial crisis triggered wide swings in the dollar, the real multilateral value of the dollar has changed little, and it has fallen just a bit against the currencies of the emerging market economies. ...
Paul Krugman tries, once again, to explain why there's no reason to fear that "terrible things will happen" if China stops purchasing our government bonds:
Wicksell Goes To China, by Paul Krugman: The idea that we are at the mercy of the Chinese — that terrible things would happen if they stopped buying our bonds — is very influential. Yet it’s just wrong.
Think of it this way: the argument that interest rates would soar if the Chinese bought fewer bonds is the same as the argument that interest rates would soar when the U.S. government sold more bonds — which, as you may recall, was the subject of fierce debate more than three years ago — and you know how that turned out.
Again, you can think of this in terms of Wicksell: we’re in a situation in which the incipient supply of savings — the amount that people would save at full employment — is greater than the incipient demand for investment. And this excess supply of savings leads to a depressed economy.
What China does by buying bonds is add to the excess savings — which makes our situation worse. (This is just another way of saying that the artificial trade surplus hurts our economy — just another way of stating the same thing). And we want them to do less of it; far from fearing that they will stop, we should welcome the prospect.
Yet this point isn’t even controversial — by and large, commentators aren’t even aware that fear-of-China syndrome might be in error.
Will the euro be saved? Should it be saved?:
Crash of the Bumblebee, by Paul Krugman, Commentary, NY Times: Last week Mario Draghi, the president of the European Central Bank, declared that his institution “is ready to do whatever it takes to preserve the euro” — and markets celebrated. ... But will the euro really be saved? That remains very much in doubt.
First of all, Europe’s single currency is a deeply flawed construction. And Mr. Draghi, to his credit, actually acknowledged that. “The euro is like a bumblebee,” he declared. “This is a mystery of nature because it shouldn’t fly but instead it does. So the euro was a bumblebee that flew very well for several years.” But now it has stopped flying. What can be done? The answer, he suggested, is “to graduate to a real bee.”
Never mind the dubious biology, we get the point. In the long run, the euro will be workable only if the European Union becomes much more like a unified country. ...
But ... a United States of Europe won’t happen soon, if ever, while the crisis of the euro is now. So what ... could turn this dangerous situation around? The answer is fairly clear: policy makers would have to (a) do something to bring southern Europe’s borrowing costs down and (b) give Europe’s debtors the same kind of opportunity to export their way out of trouble that Germany received during the good years — that is, create ... a temporary rise in German inflation... The trouble is that Europe’s policy makers seem reluctant to do (a) and completely unwilling to do (b).
In his remarks, Mr. Draghi ... basically floated the idea of having the central bank buy lots of southern European bonds to bring those borrowing costs down. But ... German officials appeared to throw cold water on that idea. In principle, Mr. Draghi could just overrule German objections, but would he really be willing to do that?
And bond purchases are the easy part. The euro can’t be saved unless Germany is also willing to accept substantially higher inflation... — and so far I have seen no sign that German officials are even willing to discuss this issue...
So could the euro be saved? Yes, probably. Should it be saved? Yes, even though its creation now looks like a huge mistake. For failure of the euro wouldn’t just cause economic disruption; it would be a giant blow to the wider European project, which has brought peace and democracy to a continent with a tragic history.
But will it actually be saved? Despite Mr. Draghi’s show of determination, that is, as I said, very much in doubt.
Travel day, so here's a quick one:
Internal Devaluation, Inflation, and the Euro (Wonkish), by Paul Krugman: I’ve been writing for a long time about how the euro area needs more inflation. But I suspect that many readers don’t quite see how this ties into the macro story. So here’s something that may or may not clear things up — a stylized little model linking euro inflation and the adjustment problem to overall monetary policy. It’s very stylized, making some obviously untrue but I think still useful assumptions, and I have been finding that it clarifies my own thinking ...[continue reading]...
Martin Feldstein calls for a fall in the value of the euro:
A rapid fall in the euro can save Spain, by Martin Feldstein, Commentary, FT: The possible breakup of the eurozone is now openly discussed... The declining value of the euro holds the key to the eurozone’s survival. ...
A lower value of the euro would reduce the prices of eurozone exports and raise the cost of imports, reducing or eliminating the current account deficits of the peripheral European countries... The weaker euro would also boost Germany’s net exports, raise German wages and prices and reduce the trade imbalance within the eurozone.
The increase in peripheral country net exports would also raise their gross domestic product and so reverse their recessions that were caused by higher taxes and cuts in government spending. That would make it politically easier to achieve the needed fiscal consolidations. And shifting from recession to growth would raise business incomes and employment, reducing the volume of bad loans and mortgage defaults now hurting the banks. ...
The continuing decline of the euro reflects the market’s perception that the euro must fall or the eurozone will collapse. ... The decline of the euro can therefore occur without specific action by the European Central Bank. But a further shift by the ECB toward a looser monetary policy would speed the euro’s decline. ...
I believe now, as I did 20 years ago, that imposing a single currency on a heterogeneous group of countries is a mistake. ... But while the creation of the eurozone was an economic mistake, allowing it to dissolve now would be very costly to governments, investors and citizens. ... A new start for the euro is still well worth trying.
One more from Tim Duy:
Is There Even a Panic Button in Europe?, by Tim Duy: I didn't think it was possible, but my confidence in the ability of European policymakers to pull the Continent out of crisis continues to fall. This is saying a lot because I had virtually no confidence to begin with.
Consider where we are at today. Greece once again is making the headlines, as it is increasingly evident that they have made virtually no progress on the last bailout package, and will therefore need another. This should have come as no surprise; it was increasingly politically impossible to engage in additional austerity with the Greek economy plummeting into the abyss. But bailout fatigue will finally hit this time, as there appears to be no more appetite to limp Greece along. Evan Ambrose-Pritchard argues that Germany is leading the drive to finally force Greece out of the Eurozone. Ambrose rightly places at least some, if not the lion's share, of the blame for this outcome at the feet of the Troika:
This was entirely predictable – and was predicted by many critics – since Greece faced an IMF-style austerity package without the usual IMF cure of devaluation. The Troika's ideology of "expansionary fiscal contraction" – which the IMF has to its credit since abjured, but the fanatics in charge still swear by – is breaking a whole society on the wheel.
The Greeks were never given a bailout plan that had any hope of success. And they deserved such a bailout, given the rest of Europe's culpability in this crisis for letting Greece into the Euro in the first place.
Whether or not Greece can be forced from the Euro with little impact elsewhere remains to be seen. I doubt we will need to wait much longer to learn the outcome of Grexit. But the devastating train that is the debt crisis keeps rolling right along, currently crashing through Spain's economy.
And make no mistake, European policymakers have learned nothing from the Greek experience. One gets the sense that policymakers think the prescription was correct, but that the patient was simply unwilling to take the medicine. Where Greece failed, Spain will succeed, or at least so it is hoped. Indeed, today Spanish Finance Minister Luis de Guindos met with his German counterpart, and the FT reports:
Germany on Tuesday threw its considerable weight behind the reform and austerity programme of the Spanish government, in the face of a continuing surge in the cost of borrowing for Madrid, and strong protests against its spending cuts.
Spain is doing the right thing, apparently. It's just the markets that have it all wrong:
A joint statement by Wolfgang Schäuble, German finance minister, and Luis de Guindos, Spanish economy minister, condemned the high interest rates demanded for the sale of Spanish bonds as failing to reflect “the fundamentals of the Spanish economy, its growth potential and the sustainability of its public debt”.
The truth is exactly the opposite - market participants have looked at Spain's fiscal and economic situation, including the issue of provincial bailouts, and concluded that another sovereign bailout is coming, complete with private sector involvement. The "voluntary" kind of involvement, of course. And in return for this bailout, Spain will be pushed further down the same path of never ending recession as Greece. Because if once you don't succeed, try, try again. European policymakers will pursue the same path because they know of no other:
But after talks in Berlin last night on the eurozone crisis, the two gave no hint of any new initiatives to try to calm the markets, or prevent contagion from Spain affecting any other members of the eurozone, such as Italy.
This comes as Spanish 10 year yields hit 7.62% and the Italian equivalent lurches up to 6.60%. And unbelievably, the ECB is apparently out of the game, no longer willing to buy sovereign debt either to avoid being a victim of "public sector bailout" or because they believe that restrictions against monetizing the debt of member states trump imminent financial collapse. Meanwhile, the crisis is increasingly bleeding through to the supposedly immune German economy, with the Markit PMI continuing to fall. The deeper Europe slides into recession, the harder it will be to find solutions.
And it is already almost near impossible to find solutions, a fact proved by the seemingly pointless European summits that always seem to come too late and offer too little.
Yet despite what is obviously clear and present danger to the Eurozone project, and, more importantly than the project, but to the economy on which millions depend for their livelihood, there doesn't seem to be any panic in official circles. No sense that policies need to be fundamentally reassessed. No sense that time is of the essence. No one is even bothering to leak unsubstantiated and false rumors of some "Grand Plan" in the works.
In my view, the lack of panic is downright scary. Is Europe completely devoid of new ideas? Or is everyone simply on vacation?
Bottom Line: Still a Euroskeptic, and an increasingly pessimistic one at that. I really, really want to believe that Europe will quickly coalesce around a solution to the crisis, and I hope to see a move in that direction soon. At a minimum, the ECB should throw in the towel and backstop sovereign debt. But all I see are the same failed policies again and again. Worse, no one is running for the panic button. Maybe there isn't a panic button; I guess it was another piece of the necessary institutional framework forgotten during the creation of the Euro.
Can Europe save itself?:
Europe’s Great Illusion, by Paul Krugman, Commentary, NY Times: Over the past few months I’ve read a number of optimistic assessments of the prospects for Europe. Oddly, however, none of these assessments argue that Europe’s German-dictated formula of redemption through suffering has any chance of working. Instead, the case for optimism is that ... a breakup of the euro ... would be a disaster for everyone, including the Germans, and that in the end this prospect will induce European leaders to do whatever it takes to save the situation.
I hope this argument is right. But every time I read an article along these lines, I find myself thinking ... disaster, no matter how obvious, is no guarantee that nations will do what it takes... And this is especially true when pride and prejudice make leaders unwilling to see what should be obvious.
Which brings me back to Europe’s still extremely dire economic situation. ... European leaders committed themselves to ... the notion that fiscal austerity and “internal devaluation” (basically, wage cuts) would solve the problems... Meanwhile the euro’s crisis has metastasized... Yet the policy prescriptions coming out of Berlin and Frankfurt have hardly changed at all.
But wait, you say — didn’t last week’s summit meeting produce some movement? Yes... Germany gave a little ground... But these concessions remain tiny compared with the scale of the problems.
What would it really take to save Europe’s single currency? The answer, almost surely, would ... involve both large purchases of government bonds by the central bank, and a declared willingness by that central bank to accept a somewhat higher rate of inflation. Even with these policies, much of Europe would face the prospect of years of very high unemployment. But at least there would be a visible route to recovery.
Yet it’s really, really hard to see how such a policy shift could come about.
Part of the problem is ... that German politicians have spent the past two years telling voters something that isn’t true —... that the crisis is all the fault of irresponsible governments in Southern Europe... — ... now the false narrative stands in the way of any workable solution.
Yet ... even elite European opinion has yet to face up to reality. ... So will Europe save itself? The stakes are very high, and Europe’s leaders are, by and large, neither evil nor stupid. But the same could be said ... about Europe’s leaders in 1914. We can only hope that this time is different.
A Bigger Bailout Awaits, by Tim Duy: The half-life of European bailouts is getting shorter and shorter, which should come as no surprise in these kinds of repeated games. The announced Spanish bank bailout triggered some early euphoria in financial markets which at the moment is quickly fading. Why? I suspect that market participants fear the bank bailout is simply a precursor to a much bigger bailout of Spanish government debt, a bailout that will involve some sizable private sector involvement.
One of the most telling stories is this from the FT:
Spain’s Treasury on Monday vowed to continue as normal with sovereign bond auctions, arguing that the eurozone’s weekend agreement on a €100bn bailout for Spanish banks would underpin the country’s debt market.
Spain desperately needs to be able to finance at lower bond yields - the fiscal situation simply is not sustainable at interest rates currently north of 6%. They can't close deficits fast enough at those yields. Moreover, the ECB for all intents and purposes is out of the game. Not only do they feel honor bound to avoid anything that looks like the direct financing of national deficits, but they have likely run out of patience. Recall ECB President Mario Draghi's comments in May:
In a damning indictment of Spain’s handling of the problems at Bankia, its third largest lender, ECB president Mario Draghi said national supervisors had repeatedly underestimated the amount a rescue would cost. He also cited the rescue of Dexia, the Franco-Belgian lender, as an example.
“There is a first assessment, then a second, a third, a fourth,” Mr Draghi said. “This is the worst possible way of doing things. Everyone ends up doing the right thing, but at the highest cost.”
One also wonders what kind of fiscal deterioration is being hidden from the general public. Or other EU officials for that matter.
Apparently, the hope was that by channeling the bailout funds to Spain's Fund for Orderly Reconstruction, it would appear as if Spain itself is not paying for the bailout. The lack of a "program" with IMF involvement was added to further create the illusion that this was not a sovereign bailout, and was instead some type of EuroTARP. Thus, a potential liability would be avoided and Spanish bond yields would fall accordingly. In essence, the bank bailout was a last-ditch gamble on the part of the Spanish government to avoid a general government bailout. (For further reading, FT Alphaville has a nice series of posts trying to understand the details of the bailout. See here, here, and here).
The trouble is that market participants started to poke holes in this ruse, realizing that the bailout is just sovereign debt by another name, and debt that most likely would be senior to existing bondholders. There was some initial confusion over this point, although it seems that Germany wants the funds to coming from the soon-to-be-launched ESM, in which case the debt will be senior. It really doesn't matter, though. FT Alphaville hits the nail on the head:
But we’ll close by noting even ‘pari passu’ EFSF debt (or ESM debt which might subsequently absorb EFSF pari passu status) has shown signs of de facto seniority in Greece. EFSF loans to Greece were rescheduled before bondholders, but when it came to the PSI, the EFSF did not take write-downs in common with bondholders.
I think that no matter how many smoke and mirrors the Europeans try to put into the place, they can't cover up the fact that the Spanish government owns this bailout. Market participants came to this conclusion as well and sent Spanish yield higher:
Which means that as of roughly 9am on the West Coast, Spain's gamble has failed. And that pushes Spain once step closer to a real bailout of sovereign debt, and the mess - private sector involvement, Troika monitoring, etc - that comes with it.
Another one from Tim Duy:
Push Comes to Shove, by Tim Duy: The Spanish banking crisis is forcing another showdown in Europe with the German-led Northern contingent increasingly under siege not just from the South but now from just about everyone else. Spain is under pressure to finance a bank recapitalization, but worries that that path will push them straight into a Troika bailout program. And we all know just how well that has worked for Greece and Ireland and Portugal. And Spain holds real leverage. No one is under the delusion (well, almost no one) that Spain can exit the Euro without significant economic damage throughout Europe. Hence we are seeing increasing pressure on Germany to step-up the timetable to real fiscal integration, starting with a Euro-wide banking rescue using ESM funds. From Bloomberg:
German Chancellor Angela Merkel was besieged by critics for letting the euro crisis smolder, with the leaders of Italy and the European Central Bank demanding bolder steps to stabilize the 17-nation economy.
Italian Prime Minister Mario Monti and ECB President Mario Draghi pushed Germany to give up its opposition to direct euro- area aid for struggling banks. Monti further antagonized Germany by urging a roadmap to common borrowing.
The idea is to let banks tap the funds directly without going through their respective national governments - thus avoiding another Troika bailout disaster. Germany, of course, continues to resist, as this would force them to give up one of their tools to enforce austerity throughout Europe. Perhaps, however, German Chancellor Angela Merkel is starting to break under the pressure:
Merkel put some nuance into the German position today. While promising “no taboos” in attacking the crisis, she floated a timeline of “five to 10 years” for fixing flaws in a currency shared by countries with divergent wealth and attitudes toward taxing and spending.
Of course, Europe doesn't have a 5 to 10 year horizon. I am thinking they have something closer to a 5 to 10 week horizon to get their act together. Something big is going to happen in Europe this summer, and I think the odds of a tail-end outcome are increasing, at both ends of the tail. Either Europe pulls together sooner than the German timeline, or finally blows apart. The middle-ground, muddle-through option looks less attractive each day.
Cash Exiting China, by Tim Duy: Something that I have thinking about for a few weeks - and was reminded of reading Ryan Avent this morning - is the series of pieces at FT alphaville regarding the outflow of cash from China. See here and here and here. The thinking had been that the renminbi was a one-way bet as China moved forward with capital account liberalization as investors rushed to be part of the Chinese story. The growing exodus of cash, however, is calling that story into question.
Moreover, I am interested in how much of the outflow is attributable to a generalized rush to safety as a result of the European crisis versus how much is attributable to capital flight due to a a deteriorating economic environment inside China itself. I am reminded of this story from the Wall Street Journal earlier this year:
With a fortune of at least $1.6 million, Mr. Shi is part of the wealthy elite that benefited most from the Communist Party's brand of capitalism. He is riding the crest of arguably the biggest economic expansion in history.
And yet, while the party touts the economic success of the "Chinese model," many of its poster children are heading for the exits. They are in search of things money can't buy in China: Cleaner air, safer food, better education for their children. Some also express concern about government corruption and the safety of their assets.
Domestic money in China will be the first to head for the exit - insiders will always know more than outsiders about the underlying economic conditions. So the exodus of cash could indicate that the Chinese story is coming to a close - and that will have significant consequences for the global economy. It is another signal that emerging markets will not be supporting global demand anytime soon. I think the team at alphaville is right - this story is slipping under the radar while we all have our eyes focused on the farce in Europe. But it could be the real game changer in the global economy.
European leaders put off any decisions on shoring up the region’s banks at a late-night summit on Wednesday despite rising concerns that instability in Greece was undermining confidence in the eurozone’s financial sector.
Instead, the heads of the EU’s main institutions were given the task of drawing up proposals for closer fiscal co-ordination in time for another summit next month, including plans that could include a path towards a Europe-wide deposit guarantee scheme and, in the longer term, commonly-backed eurozone bonds.
The trouble is that Europe doesn't have a month to wait for another summit. I am not confident they even have a week. But not to fear - the ECB is expected to step into the breech once again. At least that is the hope. But notice the irony. Germany doesn't want Eurobonds because of the moral hazard risk. They don't want to get stuck paying for Southern Europe's profligacy. At the same time, the ECB does want to act as lender of last resort for fear that will only encourage policymakers to put off hard decisions on fiscal union. Moral hazard to the right, moral hard to the left. The only path left is gridlock - and failure.
In the meantime, the Wall Street Journal reports on accelerating plans for a Greek exit.
European officials are stepping up contingency planning for a possible Greek exit from the euro zone, even as Europe's leaders struggled to overcome differences on how to resolve the currency bloc's crisis at a summit meeting here.
And, for good measure, St. Louis Federal Reserve President James Bullard let's us know that he sleeps easy at night. Via Reuters:
"I'm one that thinks that Greece could exit, and it could be handled in an appropriate way without causing too much damage, either in Europe or in the U.S.," St. Louis Federal Reserve Bank President James Bullard told Reuters.
I wish I could be so confident.
Cutting Off Your Nose...: ...to spite your face. This should be the new, official slogan of German policymakers. It is pretty clear that financial conditions in Europe are unravelling, now putting the Euro into free-fall. European policymakers simply became far too complacent over the winter, thinking that the ECB's two LTROs had fixed the problem. And, in a sense they did - for the moment. But as it became increasingly evident that the ECB was back out of the game, everything went sour. The economic realities came back into play. Moreover, there has been precious little action taken to resolve those problems - essentially, the lack of an federal fiscal institutional structure - that would make a common currency workable.
Moreover, Germany continues to block movement in that direction. From the FT:
Germany refused to share the debt burden of stressed eurozone peers on Tuesday, ignoring two of the most influential international economic bodies which offered support for proposals championed by Paris, Rome and Brussels ahead of a summit.
Angela Merkel, Germany’s chancellor, has argued that any co-mingling of eurozone debt would remove incentives for southern economies to adopt structural reforms. The calls from the International Monetary Fund and the Organisation for Economic Co-operation and Development came on the eve of Wednesday’s EU summit.
Merkel sees a large stick as the only way to end the crisis. She is unwilling to recognize that she needs to match that stick with a large carrot. At the end of the day, rather than concede on the necessity of internal fiscal transfers to make this work, she would rather doom the entire project to failure.
And speaking of the path to failure, notice another warning sign. Germany is now selling zero coupon bonds. Again from the FT:
Germany sold €4.5bn of two-year government bonds at a record low yield of 0.07 per cent, underscoring the strong demand for safer assets amid fears that Greece could be forced out of the eurozone.
The German Bundesbank said the two-year “Schatz”, which was sold with a zero-coupon for the first time, received bids for €7.7bn, compared to a maximum sales target of €5bn.
Germany is rushing headlong on the Japanese (and arguably) US path, dragging the rest of Europe along for the ride. Of course, German policymakers see it exactly the other way, and worry about the moral hazard implications of changing course. But Europe is beyond moral hazard, which at this point is just something to talk about over a few pints at the pub. Germany needs put moral hazard concerns in the back seat and find a cooperative path, and needs to find it soon.
Calm Before the Storm?, by Tim Duy: A relatively calm start to the week. Can it last? Almost certainly not. It will get worse before it gets better.
A few themes popped since last Friday that are worth considering. First is that some calmer voices have come to the forefront, arguing that a Greek exit is not really all that likely. See Brad Plummer at Ezra Klein's blog or Kate MacKenzie at FT Alphaville. The general point: Breaking up is hard to do. No argument here - a Greek exit would be ugly for Greece, and the rest of Europe as well. And, by all accounts, the Greek people don't want that outcome. The problem, however, is that the alternative, unending austerity to induce a substantial internal devaluation, is not really a solution either.
Indeed, it seems to me that on the current path, the cost of austerity will soon outweigh the cost of exit. And we are running out of time to change that trajectory. As I noted in my last post, it looks like the Greece fiscal situation is quickly deteriorating. And it looks like a collapsing tourism industry will only worsen the economy, thereby putting additional pressure on deficit to GDP targets. From FT Alphaville:
Greece received a boost last year as the unrest in the Middle East made countries such as Egypt unattractive destinations. But it looks like German tourists won’t be propping up the Greek economy so much this summer...
...When you think of the tax revenue that might be lost from this drop in activity, it’s possibly another sign that the bailout programme may be so far off course since the elections that it could have to be renegotiated anyway.
The last bailout is quickly being overtaken taken overtaken by events. What will be the demands of any new bailout? If history is any guide, more austerity - and with it a higher probability of exit.
This seems to be exactly the story that Syriza party leader Alexis Tsipras is trying to sell in Germany. To be sure, this is politically motivated, as he seeks to convince Greeks that voting for his party does not ensure an exit. Indeed, he is pushing the opposite story - that only by tearing up the bailout agreement can Greece stay in the Euro. From Bloomberg:
“Until when should German taxpayers pay into a bottomless pit?” Tsipras said to reporters in Berlin today after he held talks with leaders of Germany’s anti-capitalist Left Party. “It apparently flows to the Greek economy, but in reality only the banks and bankers are being financed.”...
...For Greeks, voting for Syriza “doesn’t mean that we’ll be kicked out of the euro,” he said. “It will mean a great opportunity for us to save the euro.”
A victory for Syriza would mean stability for Greece, whereas insisting on a continuation of the “catastrophic” austerity measures means a return to the drachma, Tsipras said.
I think he is right - except that to the Germans, tearing up the bailout is the same thing as exiting the Euro. Both sides have their hands on the buttons that ensure mutually assured financial destruction, and each austerity package forces Greece closer to pushing that button.
Another theme is one I find particularly intriguing - the idea that Greece will establish an internal currency that trades side-by-side with the Euro. FT Alphaville explains a version of this plan by Deutsche Bank’s Thomas Mayer. The basic idea is that the government will need to turn to issuing some kind of IUO's in the weeks ahead due to its deteriorating fiscal situation. The new currency would trade internally and need to be exchanged for Euros to pay for imports. The exchange rate would not be one to one, of course, and internal prices would be devalued against the Euro. To prevent the banking system from collapsing, it would need to be pulled into European supervision that guarantees Euro denominated accounts - thereby alleviating the fear of depositors that their Euro accounts would be replaced with a New Drachma, thus preventing a massive bank run. This is only a half exit, and the goal would be to stabilize the budget to the point where the government could cease printing the New Drachmas and eventually return to the Euro.
I am not confident this would work - and particularly not confident that the Greek government could wisely use its new-found power of the printing press. But it is a possible third way out, and this is a situation that desperately needs a third way.
Finally, Eurobonds are back on the table. Sort of. From the Wall Street Journal:
But next month's elections in Greece could dramatically change the euro zone's political calculus, analysts say. A victory by parties opposed to the bailout negotiated with the euro zone and the International Monetary Fund would sharply raise the risk of Greece leaving the currency area, and possibly prompt policy makers to adopt more far-reaching measures to contain the turmoil arising from such a threat.
These bolder policies include the creation of "euro bonds," or debt jointly guaranteed by the euro zone that would allow weaker countries such as Spain to borrow at interest rates partly subsidized by Germany. Berlin remains staunchly opposed, though new French President François Hollande is expected to raise the topic during informal discussions at the summit.
Edward Harrison argues that Germany is not entirely opposed to the idea and see a path - an austerity-laden path - to Eurobonds. (Other views on the role of Eurobonds can be found at the NYT's Room for Debate). The challenge, however, is that Europe doesn't have time to wait. Nor does it have time to wait for the other institutional plumbing, such a mechanism for Eurozone bank recapitalization under a full banking union.
Lacking a path to a real fiscal and economic union, the outcome of tomorrow's EU meeting is likely to disappoint. Back to the Wall Street Journal:
Without agreement on these major steps, the leaders will in the meantime back three relatively minor policy initiatives. The first is a proposal to increase the capital of the European Investment Bank, the bloc's long-term lending arm, by €10 billion. The second proposal would ease requirements for troubled governments to use funds due to them from the EU budget.
The third is a plan to borrow money against the EU budget that would be dedicated to infrastructure-investment projects. The plan would create a pilot project using €230 million in EU budget money that could leverage funds of up to €4.6 billion. After two years, the program will be reviewed and possibly increased.
Analysts say none of these ideas is enough to have a significant, near-term macroeconomic effect in the bloc's troubled economies.
"These ideas don't materially improve trend growth prospects in the euro zone," said Mujtaba Rahman, an analyst at the Eurasia Group, a political risk consulting firm. "It's a lot of rhetoric and not a lot substance."
Enough to look like policymakers are doing something, but a far cry from the steps needed to bring the crisis under control. In other words, more of the same.
Can the euro be saved?:
Apocalypse Fairly Soon, by Paul Krugman, Commentary, NY Times: Suddenly, it has become easy to see how the euro — that grand, flawed experiment in monetary union without political union — could come apart at the seams ... with stunning speed, in a matter of months... And the costs — both economic and, arguably even more important, political — could be huge. ...
Greece is, for the moment, the focal point. Voters who are understandably angry at policies that have produced 22 percent unemployment — more than 50 percent among the young — turned on the parties enforcing those policies. And ... the result ... has been rising power for extremists. ... Greece won’t, can’t pursue the policies that Germany and the European Central Bank are demanding.
So now what? Right now, Greece is experiencing ... a somewhat slow-motion bank run, as more and more depositors pull out their cash in anticipation of a possible Greek exit from the euro. Europe’s central bank is, in effect, financing this bank run by lending Greece the necessary euros; if and (probably) when the central bank decides it can lend no more, Greece will be forced to abandon the euro and issue its own currency again.
This demonstration that the euro is, in fact, reversible would lead, in turn, to runs on Spanish and Italian banks. Once again the European Central Bank would have to choose whether to provide open-ended financing; if it were to say no, the euro as a whole would blow up.
Yet financing isn’t enough. Italy and, in particular, Spain must be offered hope —... some reasonable prospect of emerging from austerity and depression. Realistically, the only way to provide such an environment would be for the central bank to ... accept and indeed encourage several years of 3 percent or 4 percent inflation...
Both the central bankers and the Germans hate this idea, but it’s the only plausible way the euro might be saved. ... So will Europe finally rise to the occasion? Let’s hope so... For the biggest costs of European policy failure would probably be political.
Think of it this way: Failure of the euro would amount to a huge defeat for the broader European project, the attempt to bring peace, prosperity and democracy to a continent with a terrible history. It would also have much the same effect that the failure of austerity is having in Greece, discrediting the political mainstream and empowering extremists.
All of us, then, have a big stake in European success... The whole world is waiting to see whether they’re up to the task.
Closer to Colliding, by Tim Duy: Each passing day brings the runaways trains closer to collision.
The European strategy to scare the Greek people into voting for pro-austerity parties was always risky. My tendency is to think it will drive voters in the other direction, this is especially the case if voters come to believe they hold the real leverage. And that is exactly the strategy that is emerging. From the Wall Street Journal:
The head of Greece's radical left party says there is little chance Europe will cut off funding to the country and if it does, Greece will repudiate its debts, throwing down a gauntlet that could increase tensions between Greece's recalcitrant politicians and frustrated European creditors...
..."Our first choice is to convince our European partners that, in their own interest, financing must not be stopped," Mr. Tsipras said in an interview with The Wall Street Journal. "If we can't convince them—because we don't have the intention to take unilateral action—but if they proceed with unilateral action on their side, in other words they cut off our funding, then we will be forced to stop paying our creditors, to go to a suspension in payments to our creditors."
Europe and the Greece are locked in a battle of mutually assured financial destruction. Nor can European leaders afford to take Tsipras' threats lightly:
According to recent opinion polls, Mr. Tsipras' party is poised to win the most votes in repeat elections next month, bettering its surprise second-place finish in an inconclusive May 6 vote that left no party or coalition with enough seats in Parliament to form a government. With Mr. Tsipras poised to win pole position in the coming vote, it raises the risk that Greece will soon face a showdown with its European creditors over the contentious austerity program that Athens must implement in order to receive fresh aid.
If Europe caves and gives in to Greek demands, however, a new set of challenges to the austerity agenda will arise. How long would it be before the people of Spain or Italy or Portugal or Ireland realize that they too have much more leverage than they ever imagined. Can the Troika cave to Greece while remaining credible with other troubled economies? I doubt it - which I think increases the risk that the core of Europe will believe it necessary to create a moral hazard example out of Greece.
Of course, this worked so well with Lehman Brothers. We will just foget about that little detail for the moment.
Senior European leaders are attempting to turn Greece’s repeat national election next month into a referendum on the country’s membership of the euro, a high-stakes political gamble that officials believe can win back voters disillusioned by the tough bailout conditions but eager to stay in the single currency.
José Manuel Barroso, president of the European Commission, made the choice clear on Wednesday, telling Greek voters the €174bn rescue programme would not be changed and that remaining in the eurozone was now in their hands...
...“The next election is going to be a sort of referendum election,” said one eurozone finance minister. “We are going to convey very clearly to the Greek people that if there is no stable government to implement the conditions of the programme then we are going to have difficulties and are going to have to adopt plan B.”
I thought the last election was supposed to be a referendum on Greece's commitment to the Euro. European policymakers fail to understand that they have provided the Greek people no way out - they are damned if they do, damned if they don't. Even if the Greeks overwhelming want to remain in the Euro, the austerity program guarantees ongoing recession, and the Greek people are being asked to commit to a program that is effectively already overtaken by events. The deteriorating fiscal situation seems to guarantee a new program will be necessary in the months if not weeks ahead. Would the rest of Europe agree to another bailout, regardless of whatever new conditions were required to get another deal done? If the rest of Europe really wants Greece to stay in the Euro, I think it can only work with a program of bilateral transfers to Greece in exchange for radical, rapid restructuring of the economy. Carrot, meet stick.
The rest of Europe might not think this is fair, but let's be honest - ultimately, it wasn't fair to bring Greece into the Euro in the first place.
On the issue of internal fiscal transfers, British Prime Minister David Cameron is joining the chorus of policymakers calling on Continental leaders to understand the extent of their problem:
“Either Europe has a committed, stable, successful eurozone with an effective firewall, well-capitalised and regulated banks, a system of fiscal burden sharing and supportive monetary policy across the eurozone or we are in uncharted territory which carries huge risks for everyone.”
That pretty much summarizes the situation. The institutional structure, the fiscal plumbing, simply isn't present in the Eurozone to adequately adjust for asymmetric shocks. End of story. Either get that structure in place or accept that the project is a failure. Can Europe make such a transition fast enough? Yes - with German leadership to offer a mix bilateral transfers, Eurobonds, and ECB commitment to stand as lender of last resort to all the region as a whole. Economically possible and politically possible, however, are two different things.
Finally, the ECB has reverted to its usual helpful self. From Bloomberg:
The European Central Bank is conducting a comprehensive review of all its policy tools and has no immediate plans to increase stimulus even as market tensions mount, two euro-area officials said.
The review, mandated by the central bank’s six-member Executive Board, intends to assess the effectiveness of its measures, including the bond-buying program and long-term refinancing operations, and is scheduled to be completed in June or July, said the officials, who spoke on condition of anonymity because the deliberations are private. A third official said the ECB may not consider taking any further policy action until July, and that the bank sees current market tensions as a way of focusing politicians’ minds on reform efforts.
Way to stay ahead of the central banking curve! Maybe if ECB members just close their eyes, tap their heels together, and softly whisper "there's no place like home," the crisis will come to a sudden end.
Hey, it works in the movies.
Here's the third part (German version) of an interview of Jamie Galbraith conducted a few weeks ago by Roger Strassburg and Jens Berger of the German blog NachDenkSeiten (first part, second part). This is on the Euro crisis:
NDS: You've pretty much followed what's been happening in Europe in the past years, haven't you?
Galbraith: I have been.
NDS: You've seen what's been going on in Germany? I've sent you some stuff that may or may not have enhanced what you know.
Galbraith: Thanks to you I have some familiarity.
NDS: I think if you look at the euro crisis, the financial crisis, and the reaction from German policy-- because Germany's power – became the European answer to the Euro crisis. Do you think that if we look at inequality, is inequality rising due to reactions like the austerity policy, like the constitutional debt brake, which now comes in future and … the Stability Pact...
Galbraith: Well, what you're seeing already is divergence across Europe, and that's the basic mechanism of rising inequality – and again, what played out in the United States in the form of credit booms to sectors, and in some cases in housing to various parts of the country – that boom followed by a bust played out in Europe as credit booms to countries, so you see the rise and the fall of Ireland and Spain and so forth, and it's that divergence which is truly the major, the largest single stress in the euro zone right now. Obviously what you describe going on inside Germany is also important, but the German national community is still bound together with a great many stabilizing institutions that still exist, although they are – as in the United States...
NDS: ...very much weakened...
Galbraith: …they're weakened, but they are still strong compared to what happens across national lines. So you expect things to fracture along the weakest links, and that's clearly the national boundaries in Europe. What will happen as a result of that is that you'll have a re-management of populations. It's clear that anybody with a professional qualification and the ability to do so will exit Greece to large expatriate communities already in the United States and in Australia. People will go – and Europe has a long history of people emigrating from Portugal and Spain – and if pressed, they will do that again. So you're going to see that the failure to stabilize national economies in Europe is simply going to lead, in the long run, to the redistribution of its populations.
NDS: I know you did compare inequality in Europe with the United States in your book. Do you think it's really legitimate to compare Europe, though, to the United States? In general you don't move from one country to another very often, because learning a language, of course, you're not going to learn a language and then move somewhere else two years later.
Galbraith: But I assure you, people do in fact, and they will. But it doesn't matter – in any event, for a valid measure of inequality, it is not necessary that people physically move. The important thing is that Europe is a unified economic whole from the standpoint of, let's say, an enterprise making investment decisions or an investor making portfolio decisions. The absence of barriers to capital mobility is just as decisive in creating a unified entity as fluidity of labor movement. But the other thing is one should not exaggerate the extent to which people inside the United States move permanently from one part of the country to another – it's very common for professionals, but a very large part of the population lives where it started from.
NDS: I don't know if you'd just call it a strategy, or if it's just more of an ideology of competitiveness between countries – Germany even goes so far as to want to have competition between the states for investment.
Galbraith: One consequence of European integration, which was clearly foreseen from the beginning and is characteristic of all industrial systems as they move to larger scale is that activity concentrates in the most competitive spot, and it's not just industrial, it's also agricultural. You've actually had concentration of certain agricultural activities in north Europe, which would hardly be thought to be ideal for that, but it happens. And it was foreseen that this would require compensating investments in the European periphery, but those investments haven't been close to being of an adequate scale. The same exact thing was true in the United States. You had, as the country developed on a continental level, industrial activity concentrated the North, Northeast and the Midwest. What ultimately happened to offset that was the New Deal. And the New Deal distributed economic activity – massive infrastructure projects in the South. We had, of course, the advantage of having a single country from the standpoint of distributing military expenditures, which is very important in the State of Texas, very important in other parts of the South. And we had a continental-level Social Security system that was established, which basically means that your base retirement is done at the national standard, not the local standard. So if you have a working life in Alabama, you're still getting at least the federal minimum Social Security payment. This has an enormous equalizing effect. People talk about the ways in which the United States is a very unequal country, but over the last 80 years, it has become radically less unequal geographically than it was before. It was a huge difference between the North and the South, which is no longer the case. Even forty years ago, when I was a kid, nobody, let's say, very few academics would consider making a move from New England to Texas. Because it was a oneway trip, you took a big cut in pay and you would never be able to come back. Now it's routine. The whole place has become substantially integrated, at least to a certain level. Now there are lots of inequalities and growing inequalities at the local level in the U.S., which is what people observe, but at the national level, it's much, much less than it used to be.
NDS: So do you think that a modern version of the Roosevelt New Deal would be the right answer for the euro crisis?
One more from Tim Duy:
Hopeful Signs From Europe?, by Tim Duy: While I suspect this is a case of too little, too late, it is increasingly evident that European policymakers on some level realize the errors of their ways. From the Wall Street Journal:
Euro-zone governments are expected to give Spain more leeway to meet its budget-deficit target next year, according to officials involved in the discussions, in a sign they intend to shift away from rigid enforcement of the currency bloc's budget rules.
Austerity will still be the guiding principle of European fiscal policies. But the likely Spanish move suggests the rules will be adjusted in some cases to account for the fact that when economies go into recession, their budget deficits usually rise.
Officials said the flexibility is unlikely to stop with Spain's politically sensitive deficit target. Among other countries that may take advantage of the rules in the future is France, which would have to pass large cuts to achieve its current deficit target for next year—a task likely to clash with the pledges of Socialist President-elect François Hollande to spur economic growth.
It is not clear that this shift gives struggling nations enough room, but it is a step in the right direction that policymakers now recognize that austerity programs have been self-defeating. Likewise, perhaps even the Bundesbank is coming around to the realities of European adjustment. From the FT:
The Bundesbank, the most hawkish of central banks, has signalled it would accept higher inflation in Germany as part of an economic rebalancing in the eurozone that would boost the international competitiveness of countries worst-hit by the region’s debt crisis.
A future German inflation rate above the eurozone average could be part of a natural adjustment process as crisis-hit countries pulled themselves out of recession, the Bundesbank argued in evidence to German parliamentarians submitted on Wednesday.
That said, I wouldn't get too eager that the Bundesbank is eager to rush into more easing:
“In this scenario, Germany could in the future have an inflation rate somewhat above the average within the European monetary union, although monetary policy will have to ensure that inflation overall in the Emu is consistent with the goal of price stability and that inflation expectations remain firmly anchored,” the bank said.
They are not talking about easing overall policy, just acknowledging that even in the context of a maintained inflation target, Germany will experience inflation in excess of that target.
All in all, though, positive developments, at least at the margin. My concern is that all the recent talk about "growth compacts" and such will yield more headlines than positive outcomes, and as a consequence policymakers will begin to believe that the original path of austerity was in fact the only path to follow.
Greece, Again, by Tim Duy: It is shaping up to be another long, hot summer, and not just because of global warning. As has been widely noted, the austerity backlash in Europe began in earnest this past weekend. And Greece is once again the epicenter, at least for now. The Greek political system appears rudderless, which is calling into question the nation's resolve to complete the conditions of the last bailout package. Moreover, there are open calls for Greece to renege on the deal:
Greece’s Syriza party leader Alexis Tsipras, charged with forming a government, told his pro-bailout counterparts they must renounce support for the European Union- led rescue if there is to be any chance of forging a coalition.
Tsipras said he expected Antonis Samaras of New Democracy and Evangelos Venizelos, the former finance minister who leads the Pasok party, to send a letter to the EU revoking their pledges to implement austerity measures by the time he meets with them tomorrow to discuss forming a coalition. Samaras said he would not do so, and would support a minority government if necessary.
The Troika can't be particularly optimistic about Greek resolve whatever government finally holds together. Also note that in the coming days, Greece is faced with some real debt management decisions. From Bloomberg:
The government taking office after this weekend’s election has 30 days to decide whether to make today’s interest payment on 20 billion yen ($250 million) of 4.5 percent notes maturing in 2016, or default. Then, by May 15, officials must decide if they’re going to repay the 436 million euros ($555 million) due on a floating-rate note issued a decade ago.
These are among about 7 billion euros of bonds whose holders took advantage of being governed by foreign rather than Greek law to sidestep losses suffered under the private-sector involvement rescheduling, or PSI. Paying the holdouts in full would arouse the ire of Greek taxpayers, as well as investors who cooperated with PSI. A failure to pay would signal Europe’s debt crisis is worsening.
A lot of moving pieces here, but any way you organize the pieces, the odds of a Greek exit from the Eurozone are heading up with each passing day, and market participants are increasingly leaning in that direction. From Bloomberg:
“This summer I think is very likely,” Taylor, founder and chief executive officer of FX Concepts in New York, said today in an interview on Bloomberg Television’s “Inside Track” with Erik Schatzker and Sara Eisen. “The Europeans aren’t going to give them the money, the International Monetary Fund’s not going to give them an OK. They will be out of money in June.”
June is coming up fast. And, for the moment, the rest of Europe is drawing a line in the sand. As expected, the Germans are at the forefront. From Reuters:
The European Central Bank will not renegotiate Greece's bailout package and there are no alternatives to sticking with it if Greece wants to stay in the euro zone, ECB Executive Board member Joerg Asmussen was quoted as saying on Tuesday.
"Greece needs to be aware that there are no alternatives to the agreed bailout program, if it wants to stay in the euro zone," Asmussen told German financial daily Handelsblatt.
See also Athens News. Of course, the sustainability of the last bailout might have been a moot point anyway, given that the Greek economy will likely deteriorate more than expected anyway. From Athens news:The economy will contract by a steeper-than-expected 5 percent this year, the central bank chief said in a speech to the bank's shareholders on Tuesday.Last month, the bank in March had forecast a 4.5 percent contraction in the economy this year.
I don't know if this includes expectations of a decline of the Greek tourism industry. From ekathimerini:
Online tourism bookings from abroad are pointing to a 12.5 percent decline for this year, according to the Airfasttickets travel agency.
Nikos Koklonis, head of the company that owns the agency, says that the biggest drop in bookings for Greek destinations this year is from the German market, which last year accounted for 15 percent of all bookings. Its share has now shrunk to just 3 percent.
In my opinion, what makes a Greek exit more likely is the apparently growing belief that the external costs will be minimal. Back to Bloomberg:
“I think that people are feeling the implications of a Greek exit aren’t so bad,” Taylor said. If Greece leaves the euro, Europeans will “turn around and huddle together and say, ‘how do I help Portugal and Spain?’”
And Athens News:Voters' rejection of pro-bailout political parties in Sunday's election has raised the chances of Greece leaving the euro, but this unprecedented step is seen as manageable rather than catastrophic for the currency bloc.Some banks have raised estimates of the likelihood of Greece quitting the euro. But after a year of investors shedding bonds issued by highly indebted euro zone countries and big injections of central bank cash, they said the damage could be contained.And from CNNMoney:
The results of the latest elections in Greece may make it more likely that the country will eventually leave the eurozone. But such an exit would probably be more orderly than Greece's default, experts said....
..."[Greece] is not going to get pushed, but they might walk out," Citi chief economist Willem Buiter said at last week's Milken Institute Global Conference...
...Economist Nouriel Roubini thinks Portugal and Ireland may also find themselves restructuring their debt and could even wind up following Greece out the door, but none of that should prove disruptive to world markets.
"If a small country -- like Greece or Portugal -- exit, you can have an orderly divorce, but if that restructuring and/or exit hits Italy or Spain, effectively you could get a breakup of the eurozone," Roubini said. But he added that's an unlikely scenario....
The proximate cause for such optimism, I believe, is that the much feared Greek debt default failed to trigger a financial collapse. Apparently, European policymakers kicked that can far enough down the road that financial market participants had time to adjust to that ultimate outcome. That, in addition to the two LTRO's and more firepower in other emergency funding facilities have perhaps created a sense of complacency about a Greek exist from the Eurozone. And that complacency suggests that there will be no third bailout for Greece, especially if that means reserving resources for other ailing Euro members. No bailout renegotiations will likely tip the balance such that staying in the Eurozone will be more costly than exit.
Whether or not Europe should become so sanguine about a Greek exit is another question entirely. But perhaps at this point such concerns are irrelevant anyway. Unless economic conditions dramatically shift in a positive fashion in Greece, it is increasingly difficult to see how this ends with anything but a Greek exit from the Eurozone.
Joe Stiglitz on Europe:
After Austerity, by Joseph Stiglitz, Commentary, Project Syndicate: This year’s annual meeting of the International Monetary Fund made clear that Europe and the international community remain rudderless when it comes to economic policy. Financial leaders, from finance ministers to leaders of private financial institutions, reiterated the current mantra: the crisis countries have to ... bring down their national debts, undertake structural reforms, and promote growth. Confidence, it was repeatedly said, needs to be restored.
It is a little precious to hear such pontifications from those who, at the helm of central banks, finance ministries, and private banks,... created the ongoing mess. Worse, seldom is it explained how to square the circle. How can confidence be restored ... when austerity will almost surely mean a further decrease in aggregate demand, sending output and employment even lower? ...
There are alternative strategies. Some countries, like Germany, have room for fiscal maneuver. Using it for investment would enhance long-term growth, with positive spillovers to the rest of Europe. ...
Europe as a whole is not in bad fiscal shape... If Europe – particularly the European Central Bank – were to borrow, and re-lend the proceeds, the costs of servicing Europe’s debt would fall, creating room for the kinds of expenditure that would promote growth and employment.
There are already institutions within Europe, such as the European Investment Bank, that could help finance needed investments in the cash-starved economies. ...
The consequences of Europe’s rush to austerity will be long-lasting and possibly severe. If the euro survives, it will come at the price of high unemployment and enormous suffering, especially in the crisis countries. And the crisis itself almost surely will spread. ...
The pain that Europe, especially its poor and young, is suffering is unnecessary. Fortunately, there is an alternative. But delay in grasping it will be very costly, and Europe is running out of time.
A quick one while waiting for Bill Clinton to take the stage at the conference I'm attending. This is Ken Rogoff:
Why a More Flexible Renminbi Still Matters, by Kenneth Rogoff, Commentary, Project Syndicate: One of the most notable macroeconomic developments in recent years has been the sharp drop in China’s current-account surplus. The International Monetary Fund is now forecasting a 2012 surplus of just 2.3% of GDP, down from a pre-crisis peak of 10.1% of GDP in 2007, owing largely to a decline in China’s trade surplus – that is, the excess of the value of Chinese exports over that of its imports.
The drop has been a surprise to the many pundits and policy analysts who view China’s sustained massive trade surpluses as prima facie evidence that government intervention has been keeping the renminbi far below its unfettered “equilibrium” value. Does the dramatic fall in China’s surplus call that conventional wisdom into question? Should the United States, the IMF, and other players stop pressing China to move to a more flexible currency regime?
The short answer is “no.” China’s economy is still plagued by massive imbalances, and moving to a more flexible exchange-rate regime would serve as a safety valve and shock absorber. ...[continue reading]...
The ECB’s Lethal Inhibition, by Barry Eichengreen, Commentary, Project Syndicate: Last December, with Europe’s financial system on the brink of disaster, the European Central Bank stunned the markets with an unprecedented intervention... The ECB’s surprise liquidity operation put the continent’s crisis on hold. But now, just fourth months later, matters are again coming to a head. The big southern European countries, Spain and Italy, battered by austerity, are spiraling into recession. ... So, will it be once more into the breach for the ECB?
The hurdles to further monetary-policy action are high, but they are largely self-imposed. At its most recent policy meeting, the ECB left its policy rate unchanged, citing inflation half a percentage point above the official 2% target. ...
A second argument against further monetary-policy action is that it should be considered only as a reward for budgetary austerity and structural reform, areas in which politicians continue to underperform. ...
With governments hesitating to do their part, the ECB is reluctant to support them. In its view, rewarding them with monetary stimulus ... only relieves the pressure on national officials to do what is necessary.
If this is the ECB’s thinking, then it is playing a dangerous game. Without spending and growth, there can be no solution to Europe’s problems. Absent private spending, budget cuts will only depress tax revenues, requiring additional budget cuts, without end. There will be no economic growth at the end of the tunnel, and political support for structural reforms will continue to dissipate.
The ECB is preoccupied by moral-hazard risk... But it should also worry about meltdown risk... The ECB will object, not without reason, that ... a ... cut in policy rates or “quantitative easing” by another name will do nothing to enhance the troubled southern European economies’ competitiveness.
True enough. But, without economic growth, the political will to take hard measures at the national level is unlikely to be forthcoming. ...
Paul Krugman writing from Lisbon:
What Ails Europe?, by Paul Krugman, Commentary, NY Times: Things are terrible here, as unemployment soars past 13 percent. Things are even worse in Greece, Ireland, and arguably in Spain, and Europe as a whole appears to be sliding back into recession.
Why has Europe become the sick man of the world economy? ... Read ... about Europe ... and you’ll probably encounter one of two stories, which I think of as the Republican narrative and the German narrative. Neither story fits the facts.
The Republican story — it’s one of the central themes of Mitt Romney’s campaign — is that Europe is in trouble because it has done too much to help the poor and unlucky, that we’re watching the death throes of the welfare state. ...
Did I mention that Sweden, which still has a very generous welfare state, is currently a star performer...? But let’s do this systematically. Look at the 15 European nations currently using the euro..., and rank them by the percentage of G.D.P. they spent on social programs before the crisis. Do the troubled Gipsi nations (Greece, Ireland, Portugal, Spain, Italy) stand out for having unusually large welfare states? No,... only Italy was in the top five, and even so its welfare state was smaller than Germany’s.
So excessively large welfare states didn’t cause the troubles.
Next up, the German story, which is that it’s all about fiscal irresponsibility. This story seems to fit Greece, but nobody else. ...
So what does ail Europe? The truth is that the story is mostly monetary. By introducing a single currency without the institutions needed to make that currency work, Europe effectively reinvented the defects of the gold standard — defects that played a major role in causing and perpetuating the Great Depression. ...
If the peripheral nations still had their own currencies, they could and would use devaluation to quickly restore competitiveness. But they don’t, which means that they are in for a long period of mass unemployment and slow, grinding deflation. Their debt crises are mainly a byproduct of this sad prospect, because depressed economies lead to budget deficits and deflation magnifies the burden of debt.
Now, understanding the nature of Europe’s troubles ... makes a huge difference, because false stories about Europe are being used to push policies that would be cruel, destructive, or both. The next time you hear people invoking the European example to demand that we destroy our social safety net or slash spending in the face of a deeply depressed economy, here’s what you need to know: they have no idea what they’re talking about.
Teaching day, so a quick one on Greece -- the reviews are in:
We must do something. This is something. Therefore we must do it.
What can I say? As Felix Salmon says, this really isn’t credible. The problem with all previous rounds here has been that austerity policies depress the economy to such an extent that it wipes out most of the topline fiscal gains: revenue fall, so does GDP, so the projected debt/GDP ratio gets, if anything, worse.
Now we have another round of austerity — which is assumed not to do too much damage to growth. The triumph of hope over experience.
OK, nobody here is an idiot (although see my next post). What’s happening is that nobody is prepared to take the plunge into either of the paths that might eventually lead out of this: sustained aid (not loans) to Greece, or departure from the euro, leading eventually to higher competitiveness and faster growth. Both options would be politically catastrophic, which means that they can’t be taken until there is literally no alternative.
So Greece will be strung along some more.
Eric Rauchway tries to clear up some misconceptions about the gold standard:
Bretton Woods: not the gold standard, by Eric Rauchway, Edge of the American West: In a WSJ op-ed called “Forty Years of Paper Money,” Detlev Schlichter, a supporter of the gold standard, begins thus:
Forty years ago today, U.S. President Richard Nixon closed the gold window and ushered in, for the first time in human history, a global system of unconstrained paper money under full control of the state.
Now, with that title, that lede, and Schlichter’s very stern opinions about paper money, you’d think that the paper money era began right then, forty years ago. But as Schlichter himself says in his very next sentence,
It is not that prior to August 15, 1971, there was a gold standard. Far from it. Most countries had severed any direct link between their currencies and gold many years earlier.
Right..., the monetary thing that was not, per Schlichter, a gold standard – the monetary thing that happened to go along with decades of global growth and prosperity, the monetary thing that goes wholly unmentioned in the op-ed, was the Bretton Woods system.
The whole point of Bretton Woods was to get away from the gold standard. Indeed, that was practically the whole point of the Roosevelt administration’s monetary policy. Which is unsurprising, because adherence to the gold standard exacerbated the Great Depression, as Federal Reserve officials viewed keeping gold in vaults a more important goal than adding jobs to the economy. ...
The best monetary arrangement, some of Roosevelt’s Treasury officials figured in 1934, was to fix exchange rates – that would give you one advantage of gold, which is to say that international contracts would always be predictable, so trade would be easy – but you would also reserve the right to move rates in case of need. Best of both worlds... Hence Bretton Woods and the adjustable peg – currencies convertible to one another at fixed, but (at need) adjustable, rates.
The dollar was off gold for domestic purposes – there were no circulating gold coins after 19331 nor was paper money redeemable in gold – but the dollar remained convertible at $35/oz for international claims. The IMF existed to stabilize exchange rates among member currencies.
Wait, you say, isn’t that a gold standard? No, in thunder, wrote Bretton Woods’s architects – read what Harry Dexter White said: under a gold standard you’re interested only in price stability – “the sole purpose of the Fund might be misunderstood to be stability of exchange rates.” That’s actually not how Bretton Woods worked. Take a look at the IMF charter – stability of prices is subordinate to “high levels of employment and real income” – stability of currency was “a means of achieving the objectives” of jobs and high wages.
The Roosevelt administration had to fight like tigers for the IMF against bankers who hated it for just this reason – the bankers wanted debts paid off first, without inflation, and they didn’t care much about jobs or wages. They wanted “the hard, patient labor of reestablishing the economic soundness of participating countries, balancing of budgets … checking inflationary influences” – what we now call “austerity”.
FDR’s Treasury said no, we need jobs, to make sure the Depression doesn’t come back, see; then we will worry about balanced budgets and stability.
It was those guys – the Roosevelt Treasury – who won, and their system – and not the gold standard – that prevailed until Tricky Dick’s time.
So why does Schlichter portray a choice between the current policy and the gold standard, when he knows there was an intermediate and evidently effective system? In fairness, op-eds are very difficult to do in any responsible way, and maybe he talks about Bretton Woods in his book. But he didn’t on Start the Week, either.
1I keep meaning to tell this story, and I will.
A quick post between appointments -- Joe Stiglitz is unhappy with the ECB. He says, "The ECB’s behavior should not be surprising: as we have seen elsewhere, institutions that are not democratically accountable tend to be captured by special interests":
Capturing the ECB, by Joseph Stiglitz, Commentary, Project Syndicate: Nothing illustrates better the political crosscurrents, special interests, and shortsighted economics now at play in Europe than the debate over the restructuring of Greece’s sovereign debt. Germany insists on a deep restructuring – at least a 50% “haircut” for bondholders – whereas the European Central Bank insists that any debt restructuring must be voluntary.
In the old days – think of the 1980’s Latin American debt crisis – one could get creditors, mostly large banks, in a small room, and hammer out a deal, aided by some cajoling, or even arm-twisting, by governments and regulators eager for things to go smoothly. But, with the advent of debt securitization, creditors have become far more numerous, and include hedge funds and other investors over whom regulators and governments have little sway.
Moreover, “innovation” in financial markets has made it possible for securities owners to be insured, meaning that they have a seat at the table, but no “skin in the game.” They do have interests: they want to collect on their insurance, and that means that the restructuring must be a “credit event” – tantamount to a default. The ECB’s insistence on “voluntary” restructuring – that is, avoidance of a credit event – has placed the two sides at loggerheads. The irony is that the regulators have allowed the creation of this dysfunctional system.
The ECB’s stance is peculiar. ... There are three explanations for the ECB’s position, none of which speaks well for the institution and its regulatory and supervisory conduct. ...[continue reading]...
Another Experiment?, by Tim Duy: In the fall of 2008, US authorities conducted a financial market experiment. They allowed a large and heavily interconnected firm, Lehman Brothers, to file for bankruptcy, apparently under the belief that the consequences should be limited as everyone knew this was coming. I think that, in retrospect, US policymakers wished they had pursued an alternative path. The experiment was not exactly successful.
Now it seems that European policymakers are willing to risk yet another such experiment. To be sure, they could still pull the rabbit out of the hat, but it is starting to look like the Troika and Greece have was they call in divorce court "irreconcilable differences." Via the Financial Times:
Lucas Papademos, the Greek premier, failed to make party leaders accept harsh terms in return for a second €130bn bail-out, pushing Athens closer to a disorderly default as early as next month...
...After five hours of discussions, the three leaders of Greece's national unity government had not accepted demands by international lenders for immediate deep spending cuts and labour market reforms as part of a new medium-term package.
The Troika does not look ready to back down either:
The talks with the three leaders of a national unity government came after the government failed to persuade the so-called “troika”– representatives of the European Commission, European Central Bank and International Monetary Fund – to ease conditions for the rescue deal.
Patience with Greek politicians has evaporated among its creditors. During a conference call on Saturday, eurozone finance ministers bluntly told Athens to deliver on its promises and agree to reforms or face default next month.
Apparently, the Troika is playing serious hardball:
Eurozone officials are deliberately refusing to allow Greece to sign off on a €200bn bond restructuring plan because the threat of default is the leverage they have to convince recalcitrant Greek ministers to implement necessary cuts.
Now, perhaps Greece's leaders are just putting up a fight to look good to their voters and thus this will all blow over tomorrow morning with another last minute deal cobbled together that no one really believes will work. Indeed, everyone already knows the numbers are too small:
A further complication is the uncertainty over supplementing the €130bn bail-out to take account of the deteriorating economic position in Greece.
Some officials believe around another €15bn is needed – funds that Germany and other countries have said they are unwilling to provide.
It doesn't really make sense for Greece to accept a deal they know is doomed to failure from the start. Especially as the terms of the deal - including a steep wage cut to improve competiveness - is virtually guaranteed to plunge the Greek economy deeper into recession.
Fundamentally, the problem is as it always was - any decent adjustment program has the stick and the carrot. The carrot usually comes partly in the form of a currency devaluation that accelerates the process of adjustment by providing stimulus via the external accounts. This short-run stimulus allows for structural changes to take root. The approach to Greece has always been just the stick - more austerity and structural change, no carrot.
And I have to admit that I find the enforced wage-cutting a draconian solution. Will this policy eventually be applied to Spain and Portugal and Ireland? Is this the future of Eurozone economic policy? There are two ways to reduce competitive imbalances. Inflate German wages up, or deflate everyone else down. I think the former would prove to be a lot more fun than the latter.
Truth be told, I honestly believe that Greece is beyond saving without a significant transfer, not loan, that buys real time for the Greek economy to adjust. That is the only way to compensate for the lack of currency adjustment and is the conclusion I wish the Troika would ultimately reach. But, I am also starting to think that the ECB has made the Troika overconfident. When the ECB finally decided that yes, serving as lender of last resort, at least to the financial system, is actually the job of a central bank, they dramatically eased financial market stress throughout Europe. That stress, however, was Greece's leverage. Absent that stress, the Troika appears to believe Greece is backed into a corner with no other way out but to submit to Troika demands.
This is a dangerous game. Sometimes the person backed into a corner makes a sucide run at their attackers. And maybe Greece has nothing else to lose at this point. To be sure, they will suffer a devastating blow if they exit the Euro, but at least it will be the process of self-determination, rather than the devastating blow of Troika imposed austerity.
And, while I am thinking about it, what exactly is the policy precedent the Troika is trying to set? That it is acceptable to force European citizens - a whole people - into poverty? When does this become a human rights issue?
In any event, I don't think financial market participants are really prepared for Greece to make a suicide run. Why should they be? This whole episode is like The Boy Who Cried Wolf. Everytime we come to the brink, and prognosticators call for the apocalypse, someone backs down. Why should this time be any different? Honestly, it is tough to argue with that logic. Expectations of imminent financial crisis have simply gone unmet, leaving markets relatively unphased by the most recent events in Greece. Perhaps the ECB haas done enough to let Greece slide out of the Euro without much noise.
It would be an interesting experiment to see unfold. I am curious to see if the ECB has indeed done enough. Not curious enough, however, to want to take such a risk. The Boy Who Cried Wolf ultimately had a poor ending.
How This Gets Even Uglier, by Tim Duy: At this risk of beating a dead horse, I reiterate that I don't see how the European situation comes to a happy conclusion. Conditions in Greece appear to be deteriorating rapidly. Via Athens News, retail sales are in freefall:
Retail sales by volume fell 8.9 percent year-on-year in November after a 10.8 percent drop in October, statistics service data showed on Tuesday.Households, burdened by austerity measures to plug deficits and rising unemployment, have cut back on spending.Consumer confidence has also been hurt by a climb in the jobless rate to 17.7 percent in the third quarter.
Officially, hope springs eternal:
"Increasing unemployment and austerity are likely to continue weighing on disposable incomes and consumer demand in the first months of 2012. However, a positive conclusion of the PSI deal and the approval of the second bailout package could provide a kind of positive shock to business and consumer sentiment," he added.
Right, good luck with that, as the next agreement is only about tightening the screws even more. How exactly will consumer confidence get a boost given an acceleration in wage cuts, a late holiday gift from the Troika. An interview with the IMF's Poul Thomsen, via Kathimerini:
Are you advocating wage cuts?
Let me begin by saying what I think we all agree on. Greece still has a large competitiveness gap. Closing this gap will require actions on many fronts, not only wages, but it is clear that wages for the economy as a whole are too large compared to Greece’s productivity. One could hope to magically raise productivity to levels that will justify the current wage level. We are trying, but there is a limit to this. Thus, part of the adjustment must come by more closely aligning productivity in individual enterprises with wages. Reforms to the wage setting mechanism, to the system for collective agreements could help in this regard. I think that most of us agree on what I have said so far. Where we need to be more convinced, is that such reforms can deliver results in the foreseeable future. If not, we believe that the government should consider more direct interventions for a temporary period, until reforms become effective. These could include limitations on the minimum wage and possibly the 13th and 14th salaries. We are still discussing this. It is too early to say. We need to better understand what kind of reforms the government has in mind.
Under conditions of never-ending austerity with no exchange rate release valve, what exactly is the half-life on any new plan to reduce Greece's debt to GDP ratio to 120% by 2020 (itself a questionable goal)? 3 months? 6 months? Back to deteriorating conditions, via Kathimerini:
Archbishop Ieronymos, the head of the Church of Greece, has taken the rare step of writing to Prime Minister Lucas Papademos to express serious concerns about the effectiveness of the government’s fiscal policy and the effect it is having on Greek people.
In his letter, Ieronymos also raises doubts about the role of the European Commission, European Central Bank and International Monetary Fund – or troika – in the country and whether Greece should agree to further austerity measures to receive its next bailout, suggesting that they are “larger doses of a medicine that is proving deadly.”
Ieronymos expresses concern about the impact of the crisis, describing a rise in suicides, homelessness and unemployment and the desperate state that an increasing number of Greeks find themselves. He warned that this was creating a dangerous social situation.
“Greeks’ unprecedented patience is running out, fear is giving way to rage and the danger of a social explosion cannot be ignored any more, neither by those who give orders nor by those who execute their deadly recipes,” he wrote.
Meanwhile, Germany appears to have underestimated the possibility of resurgent nationalism in the periphery. Via Athens News:
Twenty-eight MPs tabled a proposal in parliament on Thursday requesting a debate on the so-called occupation loan paid by the collaborationist government to Germany during the Second World War as well as the issues of reparations for victims of Nazi atrocities and looted treasures...
...The MPs stressed that the now united German state owes Greece, a Second World War victor, roughly 54bn euros before interest, underlining that Greece was the victim of unparalleled cruelty inflicted by the Nazi forces.
The signatories stressed that Greece has been the subject of an obvious injustice because it is the only country to which Germany has not paid reparations.
Reopening the wounds the Euro was meant to close.
Call me a pessimist, but I can't help but conclude that unless Greece gets real relief more quickly, the cost of being in the Euro will outweigh the costs of leaving. At this point, I am starting to wonder what was the bigger mistake - to allow Greece into the Euro in the first place, or to force them to stay?
Unemployment in the 17 euro countries climbed to 10.4 per cent in December, with the November rate revised upwards to the same rate, setting a fresh record since the introduction of the single currency in 1999. So-called “peripheral” members such as Spain and Greece recorded the highest rates, of 22.9 per cent and 19.2 per cent respectively.
By contrast, national data from Germany, the eurozone’s bulwark, showed joblessness declined in January to 6.7 per cent, the lowest level since reunification in 1991.
And a picture is worth a thousand words:
Perhaps France and Italy can hang on while relative wage deflation increases competitiveness with Germany, but conditions in the periphery look downright dire. And note that years of austerity have done little to help Greece and Ireland. I don't see the same medicine working in Spain or Portugal either. It is no wonder that Greece is looking for very substantial reductions in its debt, and it seems inevitable that Portugal will come to the same conclusion sooner or later. The great disparity in unemployment rates is another factor that leaves me pessimistic on the ultimate outcome of the Euro experiment. We need real fiscal transfers, and soon. More carrot with stick.
For now, however, market participants are focused on the salutary effects of the ECB's LRTO (not to mention expectations for another round of QE from the Fed). Have these efforts eased conditions enough to allow for a Portuguese restructuring or even Greece's exit from the Euro? Or have market participants and European policymakers been drawn into a dangerous path of complacency? Thinking aloud, do current market conditions embolden German politicians to think they can finally cut Greece loose with little or no consequences to the rest of Europe? Would this indeed be the case? I have trouble believing in the "orderly exit" story, but perhaps the can has been kicked far enough down the road that it can happen.
Joe Gagnon says the "best way to discourage currency manipulation is to tax it heavily":
Should The U.S. Take A Harder Stance On China's Currency?, by Joe Gagnon, Planet Money: ...Ben Bernanke recently said that Chinese currency manipulation "is blocking what might be a more normal recovery process." In fact, the problem goes beyond China to include many other emerging economies and even a few advanced economies. ... The evidence suggests that currency manipulators jointly have increased their trade balances by about $1 trillion relative to where they would have been in the absence of manipulation. Europe and the United States have suffered the corresponding decline in trade balances. ...
Based on estimates of the International Monetary Fund, the $1 trillion boost to European and US net exports from the ending of currency manipulation would return these economies to nearly full employment.
The best way to discourage currency manipulation is to tax it heavily. The taxes should apply to all purchases of European and US assets, including bank deposits, by governments that engage in currency manipulation. Unlike trade sanctions, such taxation is allowed under international law, and it also does not cause the economic distortions that trade sanctions cause. As I outlined recently with my colleague Gary Hufbauer, anti-money-laundering procedures now in place can prevent currency manipulators from hiding their investments through third parties.
One consequence of a reduction in currency manipulation would be a sharp drop in the values of the dollar and the euro in terms of the currencies of the manipulators. It is this exchange rate adjustment that would boost US and European exports, thereby generating jobs. ...
Martin Feldstein says The French Don’t Get It:
The French government just doesn’t seem to understand the real implications of the euro, the single currency that France shares with 16 other European Union countries.
French officials have now reacted to the prospect of a credit rating downgrade by lashing out at Britain. The head of the central bank, Christian Noyer, has argued that the rating agencies should begin by downgrading Britain. The finance minister, Francois Baroin, recently declared that, “You’d rather be French than British in economic terms.” And even the French Prime minister, Francois Fillar, noted that Britain had higher debt and larger deficits than France.
French officials apparently don’t recognize the importance of the fact that Britain ... has its own currency, which means that there is no risk that Britain will default on its debt. When interest and principal on British government debt come due, the British government can always create additional pounds to meet those obligations. By contrast,... the French central bank cannot create euros. ... That is why the market treats French bonds as riskier and demands a higher interest rate...
There is a second reason why the British situation is less risky than that of France. Britain can reduce its current-account deficit by causing the British pound to weaken relative to the dollar and the euro, which the French, again, cannot do without their own currency. Indeed, that is precisely what Britain has been doing with its monetary policy: bringing the sterling-euro and sterling-dollar exchange rates down to more competitive levels. ...
France should focus its attention on its domestic fiscal problems and the dire situation of its commercial banks, rather than lashing out at Britain...
2011 In Review: Four Hard Truths, by Olivier Blanchard: What a difference a year makes …
We started 2011 in recovery mode, admittedly weak and unbalanced, but nevertheless there was hope. ... Yet, as the year draws to a close, the recovery in many advanced economies is at a standstill, with some investors even exploring the implications of a potential breakup of the euro zone, and the real possibility that conditions may be worse than we saw in 2008.
I draw four main lessons from what has happened.
•First, post the 2008-09 crisis, the world economy is pregnant with multiple equilibria—self-fulfilling outcomes of pessimism or optimism, with major macroeconomic implications.
Multiple equilibria are not new. We have known for a long time about self-fulfilling bank runs; this is why deposit insurance was created. Self-fulfilling attacks against pegged exchange rates are the stuff of textbooks. And we learned early on in the crisis that wholesale funding could have the same effects, and that runs could affect banks and non-banks alike. This is what led central banks to provide liquidity to a much larger set of financial institutions.
What has become clearer this year is that liquidity problems, and associated runs, can also affect governments. Like banks, government liabilities are much more liquid than their assets—largely future tax receipts. If investors believe they are solvent, they can borrow at a riskless rate; if investors start having doubts, and require a higher rate, the high rate may well lead to default. The higher the level of debt, the smaller the distance between solvency and default... Without adequate liquidity provision to ensure that interest rates remain reasonable, the danger is there.
•Second, incomplete or partial policy measures can make things worse.
We saw how perceptions often got worse after high-level meetings promised a solution, but delivered only half of one. Or when plans announced with fanfare turned out to be insufficient or unfeasible.
The reason, I believe, is that these meetings and plans revealed the limits of policy, typically because of disagreements across countries. Before the fact, investors could not be certain, but put some probability on the ability of players to deliver. The high-profile attempts made it clear that delivery simply could not be fully achieved, at least not then. Clearly, the proverb, “Better to have tried and failed, than not to have tried at all,” does not always apply.
•Third, financial investors are schizophrenic about fiscal consolidation and growth.
They react positively to news of fiscal consolidation, but then react negatively later, when consolidation leads to lower growth—which it often does. Some preliminary estimates that the IMF is working on suggest that it does not take large multipliers for the joint effects of fiscal consolidation and the implied lower growth to lead in the end to an increase, not a decrease, in risk spreads on government bonds. To the extent that governments feel they have to respond to markets, they may be induced to consolidate too fast, even from the narrow point of view of debt sustainability.
I should be clear here. Substantial fiscal consolidation is needed, and debt levels must decrease. But it should be, in the words of Angela Merkel, a marathon rather than a sprint. It will take more than two decades to return to prudent levels of debt. There is a proverb that actually applies here too: “slow and steady wins the race.”
•Fourth, perception molds reality.
Right or wrong, conceptual frames change with events. And once they have changed, there is no going back. For example,... not much happened to change the economic situation in the Euro zone in the second half of the year. But once markets and commentators started to mention the possible breakup of Euro, the perception remained and it also will not easily go away. Many financial investors are busy constructing strategies in case it happens.
Put these four factors together, and you can explain why the year ends much worse than it started.
Is all hope lost? No, but putting the recovery back on track will be harder than it was a year ago. It will take credible but realistic fiscal consolidation plans. It will take liquidity provision to avoid multiple equilibria. It will take plans that are not only announced, but implemented. And it will take much more effective collaboration among all involved.
I am hopeful it will happen. The alternative is just too unattractive.
As Krugman notes here and here -- the former memorable for the line "there is a sanity clause" -- the IMF wasn't as crazy as the ECB and the OECD (and policy elites more generally) on the austerity issue:
...the [IMF] report takes on Alesina-type studies, which have been heavily promoted... The IMF basically finds them all wrong, largely for the reasons I have pointed out in the past: their methodology does a really terrible job at identifying actual changes in fiscal policy. ... And it turns out that identifying the episodes right reverses the results: contractions are contractionary, after all.
However, while sanity may have prevailed on fiscal policy, the lack of comments on monetary policy -- particularly as it relates to the euro and the ECB -- is notable. Blanchard has, in the past, called for higher inflation targets and more aggressive policy, and I doubt it's an accident that this is omitted from his comments. There are vague references to this, e.g. "Without adequate liquidity provision to ensure that interest rates remain reasonable, the danger is there," but nothing specific. I think there's a big lesson to be learned about what can happen if a central bank refuses to act as a lender of last resort, and would have liked to have seen something along these lines included among the bullet points.
The ECB's purchases of government bonds are "neither eternal, nor infinite," Mr. Draghi said in a speech in Berlin, stressing it would take "a lot" more than monetary-policy measures to restore market confidence in the euro zone.
Asked whether the ECB should copy the U.K. and U.S. in printing money to buy government bonds, a policy known as quantitative easing, Mr. Draghi said: "I don't see any evidence that quantitative easing leads to stellar economic performance" in those economies. EU treaties forbid monetary financing of government debt, he added.
This suggests Draghi believes quantitative easing should only be used if it delivers "stellar" economic performance. This is depressing, not to mention severely misguided. The appropriate metric should not be achieving a "stellar" economy, but what would have occurred in the absence of QE. Hopefully, he will recognize this distinction should (when) the situation deteriorate further.
The combination of fiscal consolidation and ECB intransigence promises to keep the European crisis in the headlines for a long, long time.
Europe Still Heading For Collapse, by Tim Duy: The half-life of the effectiveness of European summits is growing increasingly shorter. While I have been a long-term Europessimist, market participants are more willing to trade on whatever appears to be positive news, thus markets jump whenever it appears the Europeans are taking action. But eventually the game will wear thin as market participants increasingly realize European "solutions" are never more than half-measures intended to kick the can down the road another few months.
And the last summit was no exception. The reality is quickly sinking in that, relative to the dimensions of the challenge, very little was really accomplished two weeks ago. And very little will be accomplished until European leaders come to the realization that they continue to treat the symptoms of the disease, not the cause of the disease. They need to find a mechanism to address Europe's internal imbalances that does not rely exclusively on deflation as a cure. Alan Blinder provided the background in the Wall Street Journal:
All financial eyes are fixed on the euro. Europe's common currency actually has two gigantic problems. The debt and banking crisis hogs all the attention because of its immediacy, plus the high drama of all those summit meetings. But the other, slower-acting problem—lopsided competitiveness within the euro zone—is far more intractable.
Blinder sees three paths out of the resultant mess:
There are three ways for the other countries to close the gap with Germany—and remember, the gap is large. First, Germany can volunteer for higher inflation than its euro partners by, for example, implementing a large fiscal stimulus or ending its wage restraint. How do you say "ain't gonna happen" in German?
Second, the other countries can engineer German-like productivity miracles through structural reforms while Germany, relatively speaking, stands still. Good luck with that. And even if it somehow happens, the timing is all wrong. Reforms take years to bear fruit while financial markets count time in seconds.
Third, the other countries can experience deflation, meaning a prolonged decline in both wages and prices, which is incredibly difficult and painful—and generally happens only in protracted recessions. Sadly, this may be the most likely way out.
The reality of Blinder's view - that option two will not work and option three is excessively painful - is revealed by the most recent IMF update on Greece. From the report:
Meanwhile, since the fourth review, the economic situation in Greece has taken a turn for the worse, with the economy increasingly adjusting through recession and related wage-price channels, rather than through structural reform-driven increases in productivity.
Really, this is a surprise to IMF economists? Yet apparently, the IMF still believes that structural change is an immediate cure:
We recognize the need to reach a critical mass of reforms and reform synergies to jump-start growth.
I like this - the IMF does not believe in "confidence" fairies; they believe in "synergy" fairies. I keep kicking myself for missing the "synergy" fairy lecture in graduate school. Apparently all the IMF economists made it to that lecture.
Of course, it is not their fault. The IMF attempts to shift some of the blame onto the Greeks:
Structural reforms have not yet delivered expected results, in part due to a disconnect between legislation and implementation.
While likely true, this is something of a red herring. The long-term nature of reforms was no match for the pace of financial market developments, while the willingness of the population to accept externally-driven reforms is understandably lacking given the desire of the external agents to support ongoing recession. Without more direct transfers and debt relief, the IMF, ECB, and EU continue to use more stick than carrort.
Arguably, European policymakers might see the fundamental problem, but also recognize a real solution in years away. Via the Financial Times:
Member states of the eurozone have set themselves on an “irreversible course towards a fiscal union” to underpin their common currency, even if it may take years to reach that goal, Angela Merkel, the German chancellor, told her parliament on Wednesday.
Europe doesn't have years. The vice of austerity packages will eventually crush to hard, and the cost of staying within the Euro will exceed the costs of exit.
Meanwhile, the ECB is at best having mixed results. On one hand, recent actions appear to have stabilized government debt markets in Spain, Belgium, and France. On the other, Italian yields have retraced much of their collapse. Probably more importantly, however, stabilization of the banking crisis remains elusive. From the Financial Times:
But, despite the central bank facilities, the cost of obtaining dollar funding in the private market continues to soar, pointing to a dollar funding squeeze as Europe’s banks head into their all-important year-end reporting period.
The three-month euro-US dollar basis swap dropped to as low as -150 basis points on Wednesday, meaning banks would have to pay an extra 1.5 per cent premium to swap their euros into dollars for a three-month period. The premium has not been persistently below the -140bps region since late 2008, during the depths of the financial crisis.
Not good, not good at all. Also, the hopes that the ECB will provide an unlimited backstop for soveriegn debt now look to be premature at best. Via the Wall Street Journal:
With many in Europe still hoping against hope that the European Central Bank will step in more aggressively to buy bonds and bring down borrowing costs for struggling governments, Jens Weidmann, the president of Germany's Bundesbank and member of the ECB governing council, indicated his opposition to that hadn't softened.
The idea that the ECB should turn on the printing presses to help finance some debt-ridden euro-zone states should be put to rest for good, Mr. Weidmann said. Central bank "independence is lost when monetary policy is tied to the wagon of fiscal policy and then loses control over prices," he said.
Some argue the ECB is just jawboning to drive a hard bargain when it comes to fiscal and structural reforms. I am not so sure - these guys sound pretty serious to me.
And perhaps you thought the Fed would ride to the rescue. Think again. From Bloomberg:
Federal Reserve Chairman Ben S. Bernanke told Republican senators the Fed plans no additional aid to European banks amid the region’s sovereign debt crisis, according to two lawmakers who attended the meeting.
Senator Bob Corker, a Republican from Tennessee, said Bernanke made it “very clear” in closed-door comments today the central bank doesn’t intend to rescue European financial institutions. Lindsey Graham, a South Carolina Republican, said Bernanke told lawmakers that “he doesn’t have the intention or the authority” to bail out countries or banks. Both senators spoke to reporters after leaving the one-hour session at the Capitol in Washington.
Simply put, the Fed is politically limited in what it can do for Europe. I don't see the hopes that the Fed could step in for the ECB being realized. Moreover, US lawmakers will resist efforts to contribute more to the IMF to help Europe, especially if this is the general attitude:
The belief in fiscal austerity runs deep. We need to teach those Europeans a lesson even if it means shooting ourselves in the foot. Now, in all honesty, you really can't expect US taxpayers to offer much support to Europe when German taxpayers themselves are resistant. Because I think that fundamentally Blinder is right on the appropriate cure to save the Euro. Germany needs to issue a massive amount of debt to support demand in Europe, even at the cost of higher relative inflation. And, better yet, to support debt writedowns in the periphery. The response from Germany: Nein.
Bottom Line: I still don't see where this ends well. Play the news cycle if you are so inclined, but keep one eye on the key issue. Is Europe working to resolve their fundamental internal imbalances with anything other than deflation? As long as the answer continues to be "no," be afraid. Be very afraid.
Barry Eichengreen cannot endorse the disaster scenario for Europe, at least for 2012. But if the problems persist, 2013 could be a different story:
Disaster Can Wait, by Barry Eichengreen, Commentary, Project Syndicate: Nowadays there is no shortage of pundits, economic or otherwise, warning of impending disaster. ... My view is different: 2012 ... will be a year of muddling through.
Many people think that 2012 will be the make-or-break year for Europe – either a quantum leap in European integration,... or the eurozone’s disintegration, igniting the mother of all financial crises.
In fact, neither scenario is plausible. The collapse of the eurozone would, of course, be an economic and financial calamity. But that is precisely why the European Central Bank will overcome its reluctance and intervene in the Italian and Spanish bond markets, and why the Italian and Spanish governments will, in the end, use that breathing space to complete the reforms that the ECB requires as a quid pro quo. ...
While the eurozone is unlikely to collapse in 2012, there will be no definitive answer to the question of whether the euro will survive, because there will be no quantum leap in European integration. Treaty revisions take time to draft – and more time to ratify. ...
It is a sad state of affairs when a recession qualifies as muddling through. But such is the European condition. ... But muddling through cannot continue forever. Europe needs to draw a line under its crisis and figure out how to grow. The US needs to overcome its political polarization and policy gridlock. And China needs to rebalance its economy – shifting from construction and exports to household consumption as the main engine of growth – while it still has time.
Of course, if none of this happens – or if not enough of it does – 2013 could turn out to be the annus horribilis of the perma-bears’ dreams.
A Mixed Bag From Europe, by Tim Duy: I find it somewhat hard to judge the merits of this week's developments in Europe. Some positives, some negatives. On net, though, I remain a Europessimist. In my opinion, the issues of internal rebalancing remain completely ignored, and this will eventually doom the Euro if not addressed.
The European Central Bank moved forward with additional easing specifically intended to alleviate pressures in the banking system. The breakdown in the interbank lending market threatened to create a Lehman-type event sooner than later, and that threat was receded with the ECB's extension of liquidity facilities and cutting in half reserve requirements for commercial banks. The ECB also cut interest rates to 1%, with more cuts expected.
That said, the European financial system remains under pressure with continuing deleveraging and eventually more bank recapitalizations efforts needed. The result will be a worsening of the European recession, an event that is only in its infancy. And, as has been widely reported, ECB President Mario Draghi did not offer unlimited support for Eurozone sovereign debt, which was greeted with disappointment yesterday. I think it is premature to expect such a commitment; they will only play that card as a very last measure.
Overall, somewhat more aggressive than than I expected, and a clear indication that the ECB now realizes the depth of the Eurozone's financial problems. So far, so good. Yes, I would be happier with a clear statement that the ECB is the lender of last resort for European sovereign debt, but I just don't expect to hear this yet anyway.
In contrast, the Eurozone summit predictably failed to meet expectations. The UK bowed out of the agreement, guaranteeing a lack of EU wide commitment. At best you get the 17 Eurozone nations plus a few others to sign up. This opens up the possibility of more EU ruptures in the future. The seal has been broken. Second, as Felix Salmon points out, we have an agreement in principle, but ratification battles lie ahead:
It seems that German chancellor Angela Merkel is insisting on a fully-fledged treaty change — something there simply isn’t time for, and which the electorates of nearly all European countries would dismiss out of hand. Europe, whatever its other faults, is still a democracy, and it’s clear that any deal is going to be hugely unpopular among most of Europe’s population. There’s simply no chance that a new treaty will get the unanimous ratification it needs, and in the mean time the EU’s crisis-management tools are just not up to dealing with the magnitude of the current crisis.
Many opportunities for national politics to blow this agreement apart in the weeks ahead.
As far as Eurozone crisis-management tools are concerned, we are simply still where we have always been - the wealthier nations of the Eurozone - largely Germany - continue to resist putting in the necessary capital to create effective crisis funds. Moreover, the ECB appears to remain unwilling to lend the necessary money to rescue funds. In the absence of internal support, Europe continues to look toward international support. I still think this is ludicrous. How much help should Europe really expect knowing that Germany is not willing to go all-in financially to save the Euro, and now that we know the UK is making a calculated bet that the Euro is already a doomed experiment?
Let's put aside the above concerns for a minute. When all is said and done, I am still amazed that the outcome of this summit is being described as a move toward fiscal union. It is not that - it is commitment to unified fiscal austerity, nothing more. Consider just a strict enforcement of the 3% deficit ceiling in light of actual deficits in the EU. Via NPR:
Just on the surface, it is tough to see any commitment to fiscal austerity as credible. Germany itself exceeded the targets in 7 out of the past 11 years. Talk about the pot calling the kettle black. France missed 6 in the past 11 years. And Italy 8 times. Thus, in addition to the periphery nations, the biggest economies in the Eurozone will all need to increase government saving to meet these targets.
Such saving will be attempted in the context of a recession in which the private sector also will be increasing savings as well. In other words, the public sector will be engaging in massive pro-cyclical fiscal policy as the recession intensifies. You have to imagine the end result is a substantial deflationary environment.
In short, I think Europe is rushing full speed to a Japanese outcome, with slow growth coupled with an appreciating currency. And it is that promise of slow growth and a strong currency will be what eventually tears the Eurozone apart. And this is truly sad given that deficits are not really the problem to begin with.
Why will the Eurozone fail? Because we still see nothing that addresses the internal imbalances between the core (largely Germany), and the periphery. That is the result of failing to commit to a real fiscal union. Such a union would include automatic internal fiscal transfers that are essential to maintaining regional economic stability. For example, economic distress in a US state results in an automatic relative transfer of resources via decreased tax revenue from and increased transfer payments to that state. Lacking such a mechanism, a slow growth, hard money regime will increasingly ratchet up the levels of economic distress in the periphery. And eventually the costs of staying in the Euro will exceed the costs of exit.
If Europe was serious about saving the Euro, they would commit to issuing more safe assets (more sovereign debt), using the ECB backstop to create such assets, and engage in direct fiscal transfers to reduce economic pain in the periphery while encouraging continuing structural and budget reforms in recipient economies. I don't think we are anywhere near such a plan - and are arguably moving in the opposite direction.
Bottom Line: I remain a Europessimist. The ECB is moving aggressively to preventing an imminent financial collapse. That should be seen as good news. But there remain unresolved deeper issues. At the core of those issues is the inability to see Europe as one large, fiscal unified economy rather than a combination of separate, fiscally austere economies. And in that remains the long-term vulnerability of the Euro experiment.
The eurozone’s terrible mistake, by Felix Salmon: The FT is reporting today that the new fiscal rules for the EU “include a commitment not to force private sector bondholders to take losses on any future eurozone bail-outs”. If this principle really does get enshrined into some new treaty, it will be one of the most fiscally insane derelictions of statesmanship the world has seen — but it certainly helps explain the short-term rally that we saw today in Italian government debt.
Right now, the commitment is still vague...
To understand just how stupid this is, all you need to do is go back and read Michael Lewis’s Ireland article. The fateful decision in Ireland was to take the insolvent banks and give them a blanket bailout, with the banks’ creditors all getting 100 cents on the euro. That only served to put a positively evil debt burden onto the Irish people, forcing a massive austerity program and causing untold billions of euros in foregone growth, while bailing out lenders who deserved no such thing.
Are we really going to repeat — on a much larger scale — the very same mistake that Ireland made? ...
Stiglitz on Europe:
What Can Save the Euro?, by Joseph Stiglitz, Commentary, Project Syndicate: Just when it seemed that things couldn’t get worse, it appears that they have. Even some of the ostensibly “responsible” members of the eurozone are facing higher interest rates. Economists on both sides of the Atlantic are now discussing not just whether the euro will survive, but how to ensure that its demise causes the least turmoil possible.
It is increasingly evident that Europe’s political leaders, for all their commitment to the euro’s survival, do not have a good grasp of what is required to make the single currency work. ...[continue reading]...
Markets clearly believe that the Europeans have found a formula that will make it possible for the ECB to step in and buy lots of Italian bonds.
I hope they’re right
Will the euro survive? I've always thought that it would, but that is based upon political considerations, not economics, and I can't claim to be an expert on the politics of the eurozone. What do you think?