What ails Eurozone?

This from Ezra Klein is instructive, 

After it joined the euro area in 2001, Greece went from paying about 7 percent interest on a 10-year bond to a bit more than 3 percent because investors assumed that its debt was backed by Germany and the European Central Bank. This encouraged profligacy in Athens.

When the European economic and monetary union (EMU) became operational from 1 January 1999, all the peripheral eurozone economies experienced windfall gains from the sharp reduction in bond yields and resultant cost of borrowing. Over a four year-period, beginning 1995, the bond yields more than halved and converged around 4% across most of the eurozone economies (see graphics on France, Spain, Portugal, Greece, Italy, Ireland, Belgium).

Governments and, especially, corporates piled up debt, especially by way of borrowings from banks in the core area economies, as they splurged on this sudden access to cheaper capital, triggering off resource mis-allocation and asset bubbles. The boom also led to rise in wages and input prices, with the resultant decline in relative economic competitiveness. Therefore, deleveraging and restoration of external competitiveness is critical to a sustainable resolution of Eurozone's problems.

Update 1 (7/5/2012)

Paul  Krugman has this excellent analysis of how Germany managed its successful reforms last decade. As he writes, Germany benefited hugely from an export boom, driven by a combination of inflation in its periphery and rise in trade competitiveness vis-a-vis its Eruozone partners. 

Update 2 (10/5/2012)

Spain is a classic example of a country brought to its knees by reckless private external borrowing.

Even today, the government debt as a percentage of the total economic output for Spain is a relatively low ratio of 70 percent, compared with 165 percent for Greece and 120 percent for Italy. But, according to a recent report by McKinsey on global debt, Spain’s nonfinancial private sector debt is 134 percent of gross domestic product, higher than any major economy in the world with the exception of Ireland, where the figures are skewed by the outsize presence of foreign multinationals. Factoring in bank, household and government obligations, the total figure rises to 363 percent of GDP, trailing only Japan at 512 percent and Britain at 507 percent. 

Corporates borrowed heavily to invest and to diversify by buying large equity stakes in companies in Spain and elsewhere. Massive public investments in infrastructure helped boost the demand for private supply. The Times writes about a "relentless private sector downsizing in Spain — by individuals weighed down by mortgages and corporations tethered to their boom-time loans — that threatens to make the Spanish economic collapse semipermanent as opposed to cyclical".

Useless European austerity

By Sergio Cesaratto*

The European financial crisis is not over, it has just begun. In the long run, the Greek tragedy will appear just as one minor episode. It is not difficult for the Argentineans to understand the origin of this crisis, as I shall shortly explain, although they will still be surprised as to why one of the richest regions in the world and a world reference for growth with social fairness is committing suicide by adopting austerity measures that aggravate, rather than solve, the crisis.

The European Monetary Union (EMU) was born out of a French political design of linking for good the post-unification German destiny to Western Europe. The greater Germany would have otherwise looked East - as the facto it has anyway later done by becoming the manufacturing hub of Central and Eastern Europe where it has decentralized her low-value added productions. By participating in the EMU, Italy and the other Southern countries aimed to import the German fiscal, monetary and labor discipline.

The American economists alerted the Europeans that the EMU was not an “optimal currency area”, too heterogeneous, economically, culturally and linguistically. The European elites cried about an U.S. plot to avoid the birth of a new international currency along the dollar. Be as it may, what happened during the EMU from 1999 and 2008 is a story that the Argentinean public, mutatis mutandis, can well understand. Financial liberalization and exchange rates fixed for good led to huge financial flows from the European “core” (Germany, The Netherlands, Austria, Finland) to the “periphery” (mainly to Spain, Greece, Ireland). France and Italy do not strictly belong to either group - the Italian manufacturing sector is second only to Germany and this marks the main difference between Italy and Spain. The capital flows generated a construction boom in Spain and Ireland and encouraged government profligacy in Greece. This led to an ephemeral growth in these countries accompanied by a relatively high inflation and consequent lose of competitiveness. Their foreign accounts became negative and they accumulated a huge foreign debt mainly with Germany.

Asymmetrically, from the late 19990s under the social-democrat Chancellor Schroeder, Germany adopted a mercantilist policy of wage and fiscal moderation and of labour flexibility. So Germany was, on the one hand, compressing domestic demand and inflation and, on the other hand, financing aggregate demand in the periphery. This became the débouché for the German export-led model. The only problem is that the periphery accumulated a huge foreign debt without being able to get eventually out from the imbalances by devaluating the national currency, as Argentina did in 2001 or Italy did in a similar situation in 1992, after the imbalances created by the European Monetary System in the 1980s.

In late 2009, after the explosion of the American financial crisis and the discovery that the Greek centre-right government (a good friend and client of Angela Merkel) had concealed the true level of the public debt, the financial market begun to have doubts about the solvency of the peripheral economies. The crisis affected Greece, Ireland, the Portugal in 2010, and the fourth and third largest EMU economies, Spain and Italy (and marginally Belgium and even France), in 2011. As a consequence of the fall in the fiscal revenues and of the public bail out of the banking sector in countries like Ireland and Spain, the private debt problem became also a public debt problem. (The huge Italian public debt was much older and sustainable, but for a country used to defend her manufacturing competitiveness by devaluing the lira, the EMU was a clear disaster, so markets begun to doubt also about the Italian solvency).

The European reaction has always been characterized by being systematically “too little, too late”. European emergency funds have been created to avoid the default of the peripheral governments. There is a problem, however: a conspicuous part of the cash comes from the same countries that need support, a vicious circle. Against the German will, the European Central Bank (ECB) has timidly intervened to sustain the periphery sovereign debts, but just in order to avoid a sudden collapse of the EMU and not to keep at sustainable levels the interest rates on those debts (both the two German members of the top board of the ECB resigned in protest during 2011). The Germans oppose that the ECB acts as the lender of last resort for States and banks, the main reason why central banks have been created. The idea of a central bank that democratically cooperates with fiscal policy has, for instance, informed the recent Argentinean reform of the central bank.

Indeed German’s leaders, both the ruling Christian Democrats and the opposition Social-democrats, consciously or not, share a wrong diagnosis of the European crisis. In the name of a non-existing inflation fear they oppose a firm action of the ECB to calm down the markets acting as the ultimate guarantor/warrantor of the peripheral sovereign debts. Moreover Germany has imposed fiscal austerity measures on the periphery with the wrong argument that fiscal profligacy was responsible of the crisis. The result is that the economic situation is getting worse, while the social situation is deteriorating.

Germany likely hopes to outlive in spite of the fall of the European periphery markets, by looking at the emerging economies’ markets. The only effective action has been taken in December 2011 by the President of the ECB Mario Draghi, again with the German opposition, by lending European banks 1 trillion Euros at an interest rate of 1% for three years expecting that part of this money to be used to sustain government bonds. The operation brought some short-term relief, but now peripheral banks are even more plenty of domestic treasury bonds, a not very reassuring situation given that the underlying imbalances that generated the crisis are still there and the confidence on sovereign solvency is, as the result of the austerity measures, getting worse, as shown by Greece, Portugal and Spain.

European countries are in Kafkian situation: damned if they stay, damned if they leave. On the one hand, a Euro-break would likely leave the global financial system devastated, given that any indebted country will in practice default at the same time, Italy included. On the other hand Germany opposes the most reasonable solution: let the ECB to sustain the European sovereign debt; support domestic demand in Germany by letting wages and fiscal spending to grow; implement a great European Marshall plan for the periphery financed by issuing Eurobonds.

As I said at the beginning, this is the sad final of a beautiful European story of building a reasonably fair and efficient society. Perhaps once things get worse, including in Germany, the failure of the austerity policies might lead to more progressive actions. This would not compensate, however, the useless suffering that the present policies are imposing on millions of Europeans. Pressure by the U.S. and by the emerging countries on Germany to assume regional and global leadership and not to behave like small Switzerland would clearly be helpful.

*Published originally in Spanish in Página12 (Thanks to Sergio Cesaratto for providing the English version).

Post-Autistic Economics Review

I know, it's been renamed Real World Economics Review, but I like the old name better. New issue is here. A version of "The euro imbalances and financial deregulation" is in there.

Cesaratto on 'Monetary Mercantilism'

Sergio Cesaratto on what one might term national views on the European crisis, in particular on orthodox German views. Very instructive. He says:

It obviously makes little sense to blame Germany or any other country for the European crisis. Each dominant class joined the European Monetary Union (EMU) in its own interest or pretending to do so for its respective country. If the collective design of the EMU has failed, the responsibility is not of one single country: each national elite has made its own calculations and they should all have known that Europe was not an optimal currency area. We cannot know, of course, what would have happened to Europe or to single members of the Eurozone (EZ) without the EMU. Less excusable is, especially for major countries, not to appreciate and change national policies that are particularly inconsistent with the EMU. Unfortunately this is far from happening.

Read the rest here.

Barro, the euro and credibility

Robert Barro, the cheerleader of dollarization and common currencies, has finally come out of the closet. No, not in that way; he just came out against the euro in his Wall Street Journal column (subscription required). He says:

"The euro was a noble experiment, but it has failed. Instead of wasting more money on expanding the system's scope and developing ever larger rescue funds, it would be better for the EU and others to think about how best to revert to a system of individual currencies."

The interesting thing is that he wants to discard the euro for all the wrong reasons. In his view, the problem is fiscal, and what the new national currencies would allow is for 'credible' fiscal adjustments. Again, in his own words:

"Worries about values of government bonds are rational because it is unclear whether—even with assistance from the center—Italy and other weak members will be able and willing to meet their long-term euro obligations. A new (or restored) system of national currencies would be more credible, because Italy should be able and willing to meet its obligations denominated in new liras."

Forget that the ECB can actually buy bonds (Italian and others), and reduce the burden of interest payments, allowing for more expansionary fiscal policy, which is what you need in a recession.

The Euro Imbalances and Financial Deregulation

New paper at the Levy Economics Institute. From the abstract:

Conventional wisdom suggests that the European debt crisis, which has thus far led to severe adjustment programs crafted by the European Union and the International Monetary Fund in both Greece and Ireland, was caused by fiscal profligacy on the part of peripheral, or noncore, countries in combination with a welfare state model, and that the role of the common currency—the euro—was at best minimal.This paper aims to show that, contrary to conventional wisdom, the crisis in Europe is the result of an imbalance between core and noncore countries that is inherent in the euro economic model. Underpinned by a process of monetary unification and financial deregulation, core eurozone countries pursued export-led growth policies—or, more specifically, “beggar thy neighbor” policies—at the expense of mounting disequilibria and debt accumulation in the periphery. This imbalance became unsustainable, and this unsustainability was a causal factor in the global financial crisis of 2007–08. The paper also maintains that the eurozone could avoid cumulative imbalances by adopting John Maynard Keynes’s notion of the generalized banking principle (a fundamental principle of his clearing union proposal) as a central element of its monetary integration arrangement.

Read the rest here.

Why devaluation is the most effective route to regain competitiveness?

As many Eurozone economies face their winter of discontent, there is an intense debate about the best possible route to recovery. Since, the underlying problem is one of eroded competitiveness, its recovery can be achieved either through internal (austerity and wage freezes) or external (currency depreciation) devaluation.

Paul Krugman points to this brilliant description of why external devaluation is a far superior alternative from Milton Friedman's 1953 essay, "The case for flexible exchange rates".



How I wish I could have written that!

However, as Krugman and Matt Yglesias write, some like John Cochrane prefer the ciomplicated solutions.

Update 1 (26/12/2011)

Paul Krugman has this graphic which shows how Iceland could let its currency devalue and achieve a quick 30 percent fall in wages relative to the euro zone.

Arestis and Sawyer on the EU fiscal compact

Philip Arestis and Malcolm Sawyer are guest blogging at TripleCrisis on the so-called fiscal compact. They say:

The European Leaders agreed in principle at their meeting in Brussels on the 8th/9th of December 2011 to adopt tougher sanctions on the euro area countries that break the ‘new’ rules of what used to be the Stability and Growth Pact (SGP), what is now called the ‘fiscal compact’ (FC). The FC requires that tax and spending plans be checked by European officials before national governments intervene. There will be automatic actions against those countries that are deemed to have budget deficits that are too large. In effect the new agreement tightens the rules of the old SGP, but with no apparent improvement, as the FC retains the principles of the previous SGP but with the one addition that breaking the deficit rules may actually be punished in some way.

Read the rest here. Also read Tom Palley's take on the role of the ECB in the crisis here.

Not very old talk on the Euro crisis

My talk at the University of Texas, Austin, on the Crisis in the Eurozone Conference. I disagree with everything I said!

The Italian mess in a graph

The Eurozone authorities, both governments and the European Central Bank (ECB), have to bear a great deal of the responsibility for worsening the impact of the American sub-prime crisis and the Great Recession and taking the region to the brink of a potential collapse of the Euro project.

The graphic below captures the magnitude of ECB's failure. Even as the Italian economy lurched into crisis, ECB's tight monetary policy squeezed the Italian credit markets. All the three major credit growth indicators plunged steeply.



Update 1 (26/11/2011)

The Times likens the ECB to "a fire department that is letting the house burn down to teach the children not to play with matches". It writes that though the ECB "has a fire hose — its ability to print money... the bank is refusing to train it on the euro zone’s debt crisis". Influential ECB members and Germany believe that ECB cannot be a lender of last resort to backstop falling bond prices and its charter forbids them from using bank resources to finance governments.

Reverse Bond Vigilantism -- How is that austerity thing working out for you?

Let me see if I get this correctly: Monetary and fiscal austerity reigns over Europe like Napoleon. And beyond to the UK. So what is happening to sovereign bond yields? They are down, right?

In rough numbers, and for 10 years unless noted:

Spain 3 month over 5%
German auction fails by 40%, yields rising
Austria 4%
France 4%
Belgium 5%
Italy 7%
Spain 7%
Portugal 12% if I am reading Bloomberg correctly
Greece 30% ibid

While the risk premium is rising surely just because the Euro zone is currently so dysfunctional, clearly the bond vigilantes are not driving up rates because they think the economies will boom, not even the core economies.

Thus, can this be the last time we have to hear about how austerity must be invoked to please the bond vigilantes? Please? And focus on what they care about, which is growth (since they are after all Keynesians). And then we can fight the correct fight, which is over the meme of austerity-led growth. That one is easy to win. Nope, not even Canada. Sorry.

Update: From Tim Duy at Fed Watch, looks like Eurozone industrial production is tanking, leading growth forecasts down. The blue line headed almost straight down is the result of austerity, and doesn't look like growth to me. This chart also indicates US decoupling from the coming Eurozone depression may be difficult.

The European System: Dream or Nightmare?

This was the title of the first session of the University of Texas at Austin conference on the Euro Crisis organized by Jamie Galbraith. The whole panel is available here. My talk starts at around the minute 33. Before Bruno Amoroso, Terri Givens and Alain Parguez. Links to all the sessions (I liked all, but highly recommend session 5) here.

The political economy of the Euro crisis

The solution for the euro crisis seems increasingly out of reach. The victory of the conservative Popular Party in Spain, and the promise of more austerity, following the same in Italy and Greece, bodes badly for a more rational solution. Further, the German officials, and the ECB, in particular, its new head, Mario Draghi were very clear that they would not support anything but austerity.

A question that was raised in my talk last Friday was why would anybody favor such a suicidal policy. Think of the US for a second. Why would the Republicans play with the possibility of a self-imposed default (by not raising the debt-ceiling limit last summer)? The point is that the idea that there is a fiscal crisis (yep there isn't), would allow them (and some pro-business Dems too) to cut spending on welfare programs like Social Security and Medicare. And by the way, high unemployment helps to keep workers in line and wages low. The same is true in Europe.

A severe fiscal crisis, that forces adjustment in the periphery, helps to keep workers in line, not just in the periphery, but also in the core countries. And helps if they want to roll back their Welfare State too. Jerry Epstein says essentially the same thing here.

Talk tomorrow

If you are around Salt Lake and have nothing better to do, you can come to my talk. Tomorrow at 1 I'll present a paper on the Euro Crisis. Flyer below has the info.

The full Monti, and Papademos too

Mario Monti in Italy and Lucas Papademos have substituted the fragile and questioned prime ministers in their respective countries. Monti was an European Commissioner with great experience with the EU institutions, while Papademos was the president of the Bank of Greece and vice president of the ECB. Both are economists. The notion is that now with serious and responsible technical men in charge the chances for a solution, which is still in the view of European authorities more austerity, have increased.

The only possible logical diagnosis in which that would be true is if this would have been a crisis of "confidence." As that is not the case the crisis will continue, and become more intractable. Today, after the Eurozone bonds of almost all countries, including France, were forced to pay a higher risk premium the chief economist of JPMorgan Asset Management said that "Germany [is] the only functioning bond market left in the eurozone." A zone of one.

Original Sin And The Euro Crisis

Krugman has now twice argued that Europe faces an original sin problem (here and here). Let me be absolutely clear. Europe does NOT have an original sin problem. The original sin, a term invented by Ricardo Hausmann (see here), is a situation in which the domestic currency cannot be used to borrow in international markets or to borrow long-term in domestic markets. By the way, a new name for an old problem that was well known by Raúl Prebisch and other Latin American structuralists at ECLAC back in the 1950s, who recommended avoiding excessive borrowing in  foreign currency.

It is true that there are no European bonds, and that Greece, as the other countries of the euro, do borrow in a currency they do not control. However, the ECB can buy Greek bonds, and does print euros. That is not the case in a developing country that borrows in foreign currency, and does have an original sin problem. In that sense, the problem in the Eurozone is the unwillingness of the ECB to monetize even small amounts of debt. Misplaced monetarism, not the original sin, is the problem in Europe.

More old debates on the euro

Someone pointed this link on the The Economist site, about British economists (on the left and right of the political spectrum) that were against the euro. Vicky Chick, a very good post-Keynesian monetary economist, appears here.

"Just as the political opposition to a single currency spans both socialists and the free-market right, says Victoria Chick of University College, London (a self-described “left-wing anti”), so the economic Noes contain both old-style Keynesians and Marxists on the one hand, and monetarists on the other. However, says Ms Chick, left and right have different reasons for opposing a single currency. For instance, she and economists like her think that the ECB has an in-built bias towards being too tough on inflation—which is unlikely to concern the right.
That said, the two wings have some objections in common. The left-wingers say that the ECB lacks democratic accountability. So, from the other flank, does Patrick Minford, a monetarist at Cardiff Business School. “The idea that credibility requires unaccountable central bankers is wrong,” he says. “Central bank independence has been oversold.” Far from making the ECB an exact copy of the German Bundesbank as is often supposed, he says, the new bank’s designers forgot how much the Bundesbank relied on its political legitimacy.
Besides this, the anti camp—left, right and centre—have two main objections to joining the single currency. First, they say, monetary union has imposed a “one-size-fits-all” monetary policy on the euro-zone: in booming Ireland and slumping Germany alike, interest rates are 2.5%. To complicate matters, thanks to variations in the structure of economies, a given change in interest rates may have quite different effects in two different countries. Britain’s housing market, says Andrew Hughes Hallett of Strathclyde University, is dominated by variable-rate debt, making British consumption and housing expenditure far more sensitive to changes in interest rates than elsewhere in Europe. Meanwhile, German corporations’ reliance on debt rather than equity finance makes the supply of capital more sensitive to interest rates than, say, in Britain.
On top of this, there is little scope for fiscal policy to cushion the effects of economic shocks affecting different countries in different ways. The stability and growth pact limits national budget deficits to 3%. And the EU budget is not big enough for international transfers to take the strain instead.
This leads to the second objection: that Europe’s labour and product markets are too inflexible to deal with the strains that EMU will put on them. If interest rates, exchange rates and fiscal transfers cannot be called on to deal with economic shocks, then wages and prices will have to do the job. “The consequence of one-size-fits-all”, says John Flemming, warden of Wadham College, Oxford (and a former chief economist at the Bank of England) “is that the strain is likely to be taken by unemployment.”"

The whole thing is worth reading to remember the 1999 mood, and those that actually saw it coming.

Reuters on Greece's tiny debt load

Pedro da Costa, from Reuters, in their Macroscope blog, says that:

"No, that is not a typo in the headline. Greece has long been the focal point of Europe’s crisis. It was the first country to reveal some cracks in a monetary union that lacks a fiscal authority to back it. Indeed, Greek politics were dominating the headlines on Friday, with news that the prime minister had survived a confidence vote in parliament restoring a momentary sense of calm to a still very dramatic situation.

However, Greece’s actual debt load is only large relative to its own small and struggling economy. In the larger context of the euro zone, the actual amount of debt being haggled over is rather puny."

The rest of the post here. I can't but agree with him, in particular taking in consideration the expert he cites.

John Cassidy on Wynne Godley

On my way to the euro conference in Austin. Just read this nice piece on Wynne Godley (for whom I worked back in the 1990s) in the last issue of the New Yorker. Indeed Wynne was for the European Union, but skeptical about the way the common currency was being pushed. Must read. I have also a post here.

The Crisis in the Eurozone

A conference on the euro crisis at the University of Texas, Austin, organized by Jamie Galbraith, will be held this Thursday and Friday, and a live webcast will be available here. The program is here. The event will focus on “A Modest Proposal for Overcoming the Euro Crisis” by Yanis Varoufakis and Stuart Holland, a plan which would combine the innovation of the Eurobond with a “New Deal” approach to European development.