Monday, June 28, 2010

Excess Austerity and the Third Depression

Paul Krugman has an interesting Op-Ed in the New York Times, about the perspective of a double dip following the present austerity policies and transforming the 2007-2009 Great Recession in the Third Great Depression.

The current episode could prove to be the early stage of the third depression, probably looking more like the Long Depression, the years of instability and deflation that followed the Panic of 1873, than the much more severe Great Depression that followed the financial crisis of 1929-1931. Both included periods when the economy grew, but these episodes of improvement were followed by relapses.

Why it could happen today is because, after correctly allowing deficits to rise in a first phase, the governments are now obsessing about inflation when the real threat is deflation, preaching the need for belt-tightening when the real problem is inadequate spending. Unemployment shows no sign of coming down rapidly anywhere, and both the United States and Europe are well on their way toward Japan-style deflationary traps.

The punch line: “In the face of this grim picture, you might have expected policy makers to realize that they haven’t yet done enough to promote recovery. But no: over the last few months there has been a stunning resurgence of hard-money and balanced-budget orthodoxy.”

Thursday, June 24, 2010

Germany Is Not Guilty

But nevertheless it has a critical responsibility as a key actor in the European economic drama.

George Soros, not one of my favorite economic commentators, writes in the Financial Times today (June 24):

“The policies currently being imposed on the eurozone directly contradict the lessons learnt from the Great Depression of the 1930s, and risk pushing Europe into a period of prolonged stagnation or worse. That, in turn, would generate discontent and social unrest. In a worst case scenario, the EU could be paralysed or destroyed by the rise of xenophobic and nationalist extremism.

If that were to happen, Germany would bear a major share of the responsibility. Germany cannot be blamed for wanting a strong currency and a balanced budget, but as the strongest and most creditworthy country, it is unwittingly imposing its deflationary policies on the rest of the eurozone. The German public is unlikely to recognise the harm German policies are doing to the rest of Europe because, the way the euro works, deflation will serve to make Germany more competitive on world markets, while pushing the weaker countries further into depression and increasing the burden of their debt.

Germans should consider the following thought experiment: withdrawal from the euro. The restored Deutschemark would soar, the euro would plummet. The rest of Europe would become competitive and could grow its way out of its difficulties but Germany would find out how painful it can be to have an overvalued currency. Its trade balance would turn negative, and there would be widespread unemployment. Banks would suffer severe losses on exchange rates and require large injections of public funds. But the government would find it politically more acceptable to rescue German banks than Greece or Spain. And there would be other compensations; German pensioners could retire to Spain and live like kings, helping Spanish real estate to recover.

Of course, this is purely hypothetical because, if Germany were to leave the euro, the political consequences would be unthinkable. But the thought experiment may be useful in preventing the unthinkable from actually happening.”

The paper’s title is: “Germany must reflect on the unthinkable”. Let’s try to do think about it.

I tend to agree with the first two paragraphs, and disagree with the last two.

First the political consequences of a German exit from the euro would not be apocalyptic, because such an exit would leave in place the European Union as it is now, with all its common institutions and non macroeconomic policies. Indeed, not all members of the Union participate in the euro zone, Britain being a prominent example, and Poland another.

Second, and contrary to what many euro advocates claim, the economic consequences of a German exit would not be dramatic, either for the other members of the euro zone, or for Germany.
A plummeting “residual euro” – excluding Germany – would boost activity in most countries of the present euro zone. The external debt of these countries would not be increased since still labeled in euros. On the other hand GDP growth would resume in these countries, stimulated by the depreciation of the “plummeting” euro in international currency markets. As a second, positive effect of this return to growth, the increase of GDPs would contribute to a decrease of the Debt/GDP ratio, a measure of the real burden of the external debts on their economies.

Germany on the other hand would suffer from the reevaluation of the DM, but the Mark probably would not “soar” since market operators could anticipate the partial loss of the competitive advantage that German exporters presently enjoy with respect to their partners in the euro zone. Thus the depressive influence of exiting the euro would not be dramatic for Germany, especially since its wage moderation and recent fiscal cuts would still make its economy strongly competitive in international markets, although a bit less than before leaving the zone.

The overall effect on the European economies would thus be positive and moreover would contribute to the overall recovery of the world economy. And that’s precisely what the U.S. government requires the German government to do now, but through increased deficits and the "German" (i.e. euro)currency depreciation, which are in direct contradiction to what Germans want.

The “unthinkable” I guess does not look too bad.

Wednesday, June 23, 2010

Germany and the European Predicament

Dany Rodrik, not my preferred economist usually, has a very good paper on “Who Lost Europe?” in Project Syndicate.


“The traditional remedy for countries caught in the kind of crisis that Spain, Greece, Portugal, and Ireland find themselves in is to combine fiscal retrenchment with currency depreciation. The latter gives the economy a quick shot of competitiveness, improves the external balance, and reduces the output loss and unemployment that accompany fiscal cutbacks. But eurozone membership deprives these countries of this powerful tool, and depreciation of the euro itself is of limited benefit since so much of their trade (around 50%) is with Germany and other eurozone members.

Short of dropping out of the eurozone, the only real option available to Greece, Spain, and the others to boost competitiveness is to engineer a one-time across-the-board reduction in nominal wages and prices for utilities and services. This is a difficult task under the most favorable circumstances. The European Central Bank’s low inflation target (2%) renders it virtually impossible, as it implies requisite downward adjustment in wages and prices of 10% or more.”

Conclusion: Since Germany refuses to boost domestic demand and reduce its external surplus, and insists on conservative inflation targets for the ECB, it severely undercuts prospects for European prosperity and unity.

My comment:

Rodrik sees no other solution than Germany changing its policy choices. But since they permanently differ from those of other eurozone members, I think it more realistic to suggest, and more likely to expect, a breakup of the euro. Each country would then be free again to follow its preferred policy and apply the traditional macroeconomic remedies to the common present predicament, due in large part (although not exclusively) to the euro itself.

Tuesday, June 22, 2010

Income and Economic Freedom

Scott Sumner (The Money Illusion) has an interesting post about the relationship between income and economic freedom. Here is his graph.

Read the whole post here.

Monday, June 21, 2010

Germany and Spain

Paul Krugman posts an interesting graph on his blog, The Conscience of a Liberal.

The blue line is for Germany and the red one for Spain.

No fiscal rule would have constrained the Spanish housing bubble and its consequences, writes Krugman. Agreed.

The graph raises other questions: Is Germany still a model of orthodox macroeconomic management? And could Spain simply have reacted to the crisis with the only policy instrument that it still could control? Apparently the change in budget policy was intended to dampen the impact of the crisis, absent any possibility to use a national monetary policy. It is not a question of government profligacy but the result of the euro.

Thursday, June 17, 2010

Euro Error

Richer countries benefit more from flexible exchange rates concluded Aasim Husain, Ashoka Mody, and Kenneth S. Rogoff in their NBER Working Paper Exchange Rate Regime Durability and Performance in Developing Versus Advanced Economies (No. 10673, August 2004), later published in the Journal of Monetary Economics (January 2005).

« For advanced economies, floats are distinctly more durable and also appear to be associated with higher growth », they write.

Here is the abstract:

“Drawing on new data and advances in exchange rate regimes’ classification, we find that countries appear to benefit by having increasingly flexible exchange rate systems as they become richer and more financially developed. For developing countries with little exposure to international capital markets, pegs are notable for their durability and relatively low inflation. In contrast, for advanced economies, floats are distinctly more durable and also appear to be associated with higher growth. For emerging markets, our results parallel the Baxter and Stockman classic exchange regime neutrality result, though pegs are the least durable and expose countries to higher risk of crisis.”

This may have something to do with emerging economies being often smaller in size, thus more open, and trading more with a dominant partner in exchange, thus fullfilling some of the basic conditions for being included in a common currency zone.

Monday, June 14, 2010

Leaving a Currency Union: They Did It

Is the departure from a currency union a most unusual move? Not really. Does it have to be a traumatic event, jeopardizing the economy? Not at all. That is what one can learn from a recent Andrew K. Rose paper « Checking out : Exits from Currency Unions » (Draft, December 15, 2006, published in the Journal of Financial Transformation, 2007).

Here is the abstract:

”This paper studies the characteristics of departure from monetary unions. During the post-war period, almost seventy distinct countries or territories have left a currency union, while over sixty have remained continuously in currency unions. I compare countries leaving a currency union to those remaining within them, and find that leavers tend to be larger, richer, and more democratic; they also tend to have higher inflation. However, there are no typically sharp macroeconomic movements before, during, or after exits.”

In fact his sample, the largest to date, includes 69 leavers, and 61 stayers. And, unsurprisingly, the countries that have been continuously members of a currency union during that period tend to be small, dependent ones, as confirmed by another study by Alesina and Barro (Alesina, Alberto and Robert J. Barro (2002) “Currency Unions”, Quarterly Journal of Economics, CXVII, 409-436).

I say “unsurprisingly” because one of the theoretical conditions for being a potential member of an optimal currency area (OCA) is to be a small country trading mainly with a large partner.

As Rose puts it:

“it is true that 24 currency union members are dependencies, such as Aruba, the Channel Islands, and Greenland. However, 37 independent countries have remained continuously in currency unions, including Cameroon, Luxembourg and Panama.” These are, I would say, also small countries dependent on large ones for their trade, one of the main conditions for entering an OCA.

A quick look at Rose’s list of continuous currency union members is quite revealing of the typical small size (and most likely concentrated trade) of these staying countries:

American Samoa; Antigua & Barbuda; Enin; Brunei Darussalam; Central African Republic; Cook Islands; Faeroe Islands; French Polynesia; Greenland; Guam; Kribati; Lichtenstein; Marshall Islands; Monaco; Nauru; Niue; San Marino; St. Kitts; Swaziland; Tuvalu; Wallis & Futuna.
Andorra; Aruba; Bermuda; Burkina Faso; Chad; Cote d’Ivoire; Falklands; Gabon; Grenada; Guernesey; Lesotho; Luxembourg; Martinique; Montserrat; New Caledonia; Palau; Senegal; St. Lucia; Togo; Virgin Islands.
Anguilla; Bahamas ; Bhutan; Cameroon; Congo; Dominica; French Guiana; Gibraltar; Guadeloupe; Jersey; Liberia; Isle of Man; Micronesia; Namibia; Niger; Panama; St.Helena; St.Vincent & Grens; Turks and Caicos Islands; Wake Islands.

Nothing indeed like France, Italy or Spain.

Regarding our second question, the possibly traumatic effect of leaving a union, an answer is also to be found in Rose’s study. He compares various macroeconomic variables of leavers three years before leaving and three years after leaving: GDP growth, inflation, government budgets, and so on.

His conclusion:

“perhaps the most striking feature of the data is the absence of volatility. In general, there are remarkably few signs of dramatic macroeconomic events either preceding or following currency union dissolutions.”(p. 7).

My conclusion: an exit of the southern members of the eurozone, including France, especially at the right exchange rate parity of the euro relative to the dollar as I explained in my Thursday post “Apocalypse No: Euro Exit Without Tears” , would most probably be painless.

Thursday, June 10, 2010

Apocalypse No: Euro Exit Without Tears

The main medium term problems with the euro have been, first, its overvaluation against the dollar and other currencies linked to the dollar such as the renminbi, reaching a maximum of 1.60 dollars for a euro in 2008. And second, the twin disequilibrium of “intra zone real exchange rates” overvaluation of some member countries (the “Club Med” ones) relative to Germany, due to diverging wage costs between them.

These growing handicaps have penalized exports from Italy or Spain and encouraged their imports from Germany and from out of the zone economies. With exports and imports representing a third or more of their GDP, these exchange rate trends have constituted a significant brake on growth.

On this background, the 2007-2009 recession has led these relatively more inflationary countries to borrow heavily on the cheap (because their higher inflation rate and low nominal and uniform ECB borrowing rate resulted in minimal real interest rates) in order to dampen the recessionary shock, since monetary and exchange rate policies were not available at the national level anymore. Hence the large budget deficits, even in countries such as Spain that had previously adhered to quite conservative fiscal policies.

Today, since deflationary policies and massive budget cuts further depress activity and will possibly deteriorate the budget balance even more, these southern countries are caught in a macroeconomic trap.

It is only logical that they contemplate leaving the eurozone to regain some degrees of freedom by a return to national currencies and flexible exchanges rates. Major devaluations against the dollar and against either a “new Mark” or a smaller eurozone currency would help restore these countries’ competitive advantage.

A lot of objections have been raised against such a breakup of the euro, but according to a frequently quoted paper by Barry Eichengreen, while these arguments do not hold water, it is simply impossible to leave the eurozone without plunging the outgoing economy in an awesome crisis. Indeed, entering the euro would be an “irreversible” move because the procedural delays necessary for exiting would unleash speculation that would bankrupt banks and governments.

Here is the “impossibility” scenario:

« The very motivation for leaving would be to change the parity. And pressure from other member states would be ineffective by definition.

Market participants would be aware of this fact. Households and firms anticipating that domestic deposits would be redenominated into the lira, which would then lose value against the euro, would shift their deposits to other euro-area banks. A system-wide bank run would follow. Investors anticipating that their claims on the Italian government would be redenominated into lira would shift into claims on other euro-area governments, leading to a bond-market crisis. If the precipitating factor was parliamentary debate over abandoning the lira, it would be unlikely that the ECB would provide extensive lender-of-last-resort support. And if the government was already in a weak fiscal position, it would not be able to borrow to bail out the banks and buy back its debt. This would be the mother of all financial crises. »

The perspective is scary all right, but wrong. There is a better way out and European countries are already following that trail.

What is the recipe for exiting without tears? Well, just devalue the euro prior to leaving it.

Let’s take the example of the Lira. There exists an exchange rate between the euro and the dollar at which the Italian economy is competitive with the US (and other dollar related countries) or with Germany, despite the faster growing Italian wages. Let’s assume that Italian wage growth has exceeded that of US wages by 25 % during the last ten years and that of German wages by 35 %. Then a fall of the euro relative to the dollar from its recent value of 1.45 dollars down to 0.85 dollars (its 2000 level) would constitute a (1.45 – 0.85)/1.45 = 42 % devaluation.

At that price of the euro a newly created Lira would make the Italian economy super competitive relative to both economies and no further devaluation necessary. We should even expect the new Lira to be revalued in order to return to a PPP equilibrium.

Accordingly, no anticipation of further devaluation in the medium term would form, and thus there would be no reason for a capital flight from the new currency, and no bank run either. At that price the “mother of all crisis” is just a myth.

Eichengreen concludes in his paper that:

« The implication is that as soon as discussions of leaving the euro area become serious, it is those discussions, and not the area itself, that will end. »

On the contrary I claim that when discussions of leaving the euro area become serious, the value of the euro plunges on foreign exchange markets, and thus makes way for a parity at which euro exit for the Lira is possible without any further devaluation, making it both easy and efficient.

Sorry, no apocalypse is in view.

Friday, June 4, 2010

Eugene Fama, Simon Johnson, and Too Big To Fail Banks

Gene Fama, a staunch defender of markets and of the competitive market economy, and widely known as “the father of modern finance”, is interviewed by CNBC in a clip here .

He answers questions by Ed Lazear from Stanford university and the Hoover Institution.Excerpt :

“(Too Big To Fail) is not capitalism. Capitalism says – you perform poorly, you fail.”

And that one:

TBTF gives big financial firms “ a license to increase risk; where the taxpayers will bear the downside and firms will bear the upside.”

A must see.

Simon Johnson comments favorably here .

My comment: An interesting case of converging diagnoses at a time when regulators consider imposing much higher capital requirements on banks, as an alternative to shrinking them. And a welcome clarification on the nature of our current economic system, wrongly accused of being excessively "capitalist", but which is more a system rigged in favor of large institutions: firms, not markets.