Thursday, June 16, 2011

The Case Against the Euro

 Fernanda Nechio, an economist at the Federal Reserve Bank of San Francisco, presents a set of charts indicating that, according to one well-respected monetary policy rule of thumb (the “Taylor’s Rule” named for Stanford economist John Taylor) Europe’s central bankers have the wrong policy for the peripheral countries (the “PIGS”).

The rule says monetary policy makers should adopt a “tight” monetary policy when inflation is above its target or when the economy is above its full employment level, and a relatively easy monetary policy when inflation is lower than targets or unemployment higher.

According to Nechio’s calculations, the ECB is adopting the policy Taylor Rule says is optimal for the core states (the northern ones), but for the peripheral countries (that some call in a derogatory and unjustified way the “Club Med countries” implying –wrongly – that people there do not work) the current target rates are far above where the Taylor Rule would recommend. For these countries (Greece, Ireland, Portugal and Spain) the policy target interest rate remains deeply negative, which corresponds also to a much lower equilibrium exchange rate vis-à-vis the dollar and the yuan I would like to add.

As Nechio writes:

“From the inception of the euro to the 2008 financial crisis, the actual ECB policy rate was below the rate predicted by the Taylor Rule for the peripheral countries and more in line with Taylor Rule recommendations for the core euro-area countries. During the financial crisis in 2008, the peripheral countries fell into deep recession, which was followed by a debt crisis from which they have yet to recover. … These events reversed the historic pattern and positioned the ECB policy rate above the Taylor Rule recommendation for the peripheral countries.”

Let’s add that the depth of the 2008 recession in these countries has been magnified by the previous excess activity and speculation that the much too low (for them) interest rates fostered before the crisis. This is quite compatible with an Austrian view of the business cycle and the fault is that of the eurozone unitary monetary policy.

To summarize, the ECB’s actual rate has been either much too low for the economic health of the periphery (thus explaining the real estate booms in Ireland and in Spain before the crisis) or much too high after the crisis (thus accentuating the recession already severe in the periphery, and especially in Ireland, Greece and Portugal).

“In other words, if you are a country in the peripherals, the ECB’s monetary policy has been consistently wrong” writes John Carney in CNBC’s “NetNet” here.

The problem is that there can be only one monetary policy in a monetary union, and that one policy cannot fit simultaneously all member economies. At the limit “one size fits none” but here the monetary policy is aiming at the current conditions of the sole core (northern) members.

No wonder that Greek and Spanish citizens are in the streets in protest against their government budgetary policy which further restricts the economic activity (under pressure from the ECB, IMF and northern governments) and push their economies into a deeper recession at a time when ECB’s monetary policy is already much too tight for them.

The ECB’s inadequate interest rate policy exacerbated the bubbles in the periphery before 2008 and now it exacerbates the severity of the recession. It is a recipe for instability. Moreover the governments of the “core” resist any “haircut” for the creditors of the peripheral governments (mostly French and German banks, as well as the ECB) and insist on aggravating the amount of the debts of peripheral governments through more loans, ostensibly to “save them”, precisely when the capacity for repayment of these countries’ debt (the level of their GDP) is plummeting. Can you seriously call that “helping Greece”?

There is no way out of this mess other than a partial default on debts, and devaluation, that is an exit from the euro. This is what Argentina did in 2001, exiting the dollar zone and defaulting on a large fraction of its debts, with the result of a rather quick return to growth (within months) and a return also to international capital markets. 

The current irresponsible policy of the “core” countries of the European Union, which consists in making Greek citizens pay for the euro disaster (and for their own banks), will only make matters worse. It will hasten secession from the eurozone, but fortunately for a better future.

The Nechio paper is well worth reading here .

No comments: