Sunday, August 12, 2012

The Main Reason for the Euro Crisis

Most or all politicians and most or all « euro-economists » are currently misleading the public and distracting the opinion from the actual issue. I call “euro-economists” those that have a vested interest in promoting the euro, because they have already been promoting it in all their publications during the last two or three decades, and keep denying the basic impossibility of “saving it” by bureaucratic-technical-financial tricks, complex schemes to reorganize and centralize (cartelize) the financial sector and the fiscal institutions in Europe, against the fundamental current trend towards decentralization.

That’s why a recent post on the INET blog (August 8) by Heiner Flassbeck (a former deputy to the German Finance Minister) is so important and his analysis outstanding. Commenting on a recent INET Report, “Breaking the Deadlock: A Path Out of the Crisis”, that purports to remedy the “fundamental structural flaws in the currency union”, he doesn’t mince his words either.


 “A currency union at its core is about harmonization of inflation rates as all countries give up national monetary policies and explicitly agree on a common inflation target (close to under two percent in the EMU). From here the argument is absolutely straightforward.
First, we have very strong evidence that inflation rates are highly correlated with unit labour costs (ULC, for the overall economy, of course, not for industry). Second, we know in general that the development of ULC is much more the result of exogenous factors than the development of price changes, which leads to the conclusion that ULC growth determines inflation to a very large extent. Third, we know specifically (or should know) that the biggest country in Europe, Germany, even before the official start of EMU, had decided to dramatically change the course of its wage policy.
In a tripartite agreement in 1999 government and negotiating partners on the labour market agreed not to allow growth of nominal wages along the lines of productivity growth and the inflation target of two percent (hitherto the traditional German approach) for the future but to remain clearly below that line. This has being applied and has been enforced by the “flexibilization of the labour market” in the first years of the Red-Green government. This implied that German ULC growth and its inflation rate would systematically remain below the commonly agreed inflation target in EMU.
As no other country had a similar arrangement it implied also that over time huge discrepancies in inflation rates and huge real appreciations of other countries (against those like Southern Europe that would slightly overshoot the inflation target but even against those like France that would strictly stick to the target) and huge unsustainable imbalances would be the result. One big country permanently gaining international market shares and increasing its surpluses and the others permanently losing and going deeper into deficit is a scenario for collapse if corrective forces do not come into play sooner or later.” 


“It is the result of a political campaign trying to make Germany fit for an alleged challenge of the “competition of nations” and it was sold exactly under that banner to the German population. Even without any of the booms you mention in the deficit countries, the euro was bound to fail.
I could stop just here because for any reasonable person it is obvious that a monetary union under these conditions will be in big trouble over time. That it was the biggest of all financial crises that would trigger the outbreak of the crisis is only of interest for historians. As has been the case in so many financial crises in Asia and Latin America before, the crisis was unavoidable due to unsustainable competitive positions.
What makes it much worse than former crises is the simple fact that exchange-rate changes are not available to close the gap in competitiveness. Europe has produced the biggest imbalances in history exactly at the time when it has given up the main instrument to correct such imbalances.

While it is currently fashionable among “euro-economists” to attribute the responsibility for the crisis to politicians, who allegedly did not follow their excellent advice, Flassbeck thinks otherwise:

“You see, reasonable people are one thing, economists are something else.  (…)
Orthodox economists cannot even take note of the undeniable correlation between ULC and inflation without being in danger of losing their strongest belief.” 

My comment:

As I wrote several times before, the key player is Germany. Different national preferences regarding the inflation rate make the Euro unsustainable because no amount of political pressure or “structural reform” is likely to erase rapidly these differences, and especially the differences cumulated over more than a decade , amounting in some cases to a price wedge of 30% to 50% between North and South. It follows that the German preference for “competitive disinflation” plays havoc with the other economies in the Eurozone. Of course a true federal state could manage permanent transfers from the growing economies towards the depressed ones (conditional also on a high geographical mobility of labour, as is the case in the US) as far as it would rely on a politically legitimate redistributive authority, contrary to the present situation where such a transfer raises political conflicts between sovereign nation-states. But no federal super-state can be build in Europe within a reasonably short time framework, and moreover our age of information revolution is also characterized by a revolution of organization leading to decentralization and fragmentation of large hierarchical structures, the opposite of the construction of bigger, more centralized ones that prevailed under the conditions of the late XIXth century, when major empires were developed or built (cf Hobsbawm, The Age of Empires).

So Germany is confronted to a dilemma: either sustain the euro as it is (probably without Greece) but that implies a permanent transfer economy and thus increased taxes that the German electorate rejects, or let the euro disintegrate (and the best solution would be , in a first phase, for Germany to exit the euro) with as a consequence a sharp appreciation of a new Deutsche Mark and a marked depreciation of the residual euro that would jeopardize the competitiveness of German exports, both within the ex-eurozone and in the world at large. At the same time German creditors would suffer a large loss on their euro assets, but would gain through a reduced volume of transfers from their taxpayers to the southern economies.

The choice is a question of relative costs, but the costs of maintaining the euro are rapidly rising as the southern economies sink and many German opinion leaders now openly advocate an exit, even though often trying to argue from a moral high ground and thus for the wrong reasons (the alleged “unethical” behavior of southern members, when in fact the real culprit is the  “competitive disinflation” bias of the German anti-inflation policy and mercantilist export model).

Let me be completely clear: a German exit would not mean that the “residual” euro would be any more sustainable than the current one. Divergences of political-economic equilibrium inflation preferences between southern members themselves make a single currency most probably non viable. But as I explained in “Euro Exit”, a depreciated euro would much reduce the burden of foreign debt in euros, and also reduce the need for further depreciation of the newly re-created national currencies, making exit much more appealing.

And a last word regarding the alleged devastating “mother of all crises” argument that a disintegration of the euro would bring about:  First, I have no idea of what a “mother crisis” could mean, if anything, except as an expression meant to scare the uninformed public and deter politicians to adopt such a strategy. Second, if we clearly understand that the fundamental problem of the euro is a misalignment of exchange rates, as Heiner Flassbeck rightly claims, then a return to national currencies and to equilibrium exchange rates should positively and strongly affect growth, beyond the current crisis. The crisis is a crisis of the euro, and not a result of the future exit from the euro, as “euro-economists” would have us believe.  

These biased economists nevertheless are losing ground as the growing debate in Germany shows, and as the key player, Germany will soon have to face a “révision déchirante”. 

Monday, August 6, 2012

From Kremlinology to Frankfurtology

 During the Cold War, lack of reliable information about the Soviet Union forced Western analysts to "read between the lines" and to use the tiniest tidbits, such as the removal of portraits, the rearranging of chairs, positions at the reviewing stand for parades in  Red Square, the choice of capital or small initial letters in phrases such as "First Secretary", the arrangement of articles on the pages of the party newspaper "Pravda" and other indirect signs, to try to understand what was happening in internal Soviet politics.

Kremlinology then was the name for the study and analysis of Soviet politics and policies, based on efforts to understand the inner workings of an opaque central government, while “Kremlinologist” referred to academic, media, and commentary experts who specialize in the study of Kremlinology (Wikipedia).
In the current “Cold War of the Euro” between southern and northern member states, and given the especially opaque decision-making in economic and monetary policy at the Union level, a new discipline of Frankfurtology is obviously a necessity.
Ambrose Evans-Pritchard is an outstanding practitioner of the approach and he provides an especially lucid analysis of Mr. Draghi’s skilled tactics (The Telegraph, August 6). According to him the ECB president has pulled off a master stroke. “He has secured a mandate for “unlimited open-market operations”, a far cry from the half-hearted and self-defeating bond purchases of the last two years”, he writes, and a licence to act like the US Federal Reserve does. He has done so with the help of Mario Monti in order to convince the conservative leaders in Nordic capitals to trigger an EFSF bail-out, with supplicant states (Spain and Italy) signing a "Memorandum" in which they  would pledge to enforce stricter austerity policies. Then, with the EFSF as the enforcer, the ECB would play the cash cow. According to the plan, Spain will go first, hat in hand, to request a bail-out that investors are already pricing in. Hence the 6% surge on Madrid’s bourse on Friday.

The key to this victory is the Italian (Draghi-Monti) mobilization of the Latins that realize they can inflict a deflationary shock and banking crisis on Germany at any time by walking out of EMU and imposing capital controls -- as a chorus of leading economists now advocate -- if provoked.

“But do they understand this in the Bundestag or the Tweede Kamer, or even want to understand? Or will they demand Carthaginian terms to placate their own electors before agreeing to any EFSF loan package? Will they push the great imperial capitals of Rome and Madrid one step too far?” asks Evans-Pritchard.

“The Draghi plan can still go badly wrong. Much of North Europe’s political class clings to a warped narrative of what has gone wrong in EMU, attributing the crisis to fiscal debauchery and Latin failings. They misdirect their wrath. The enemy is the currency itself. It is a structural crisis, a misalignment of cycles and real interest rates, a sorry saga of unbridled capital flows.

Without rehearsing the tedious details of this debate, let us remember that Spain ran a budget surplus of 2% of GDP during the Trichet bubble. Italy scores top of the IMF's fiscal sustainability index, far above Germany, France, Holland, Britain, the US, and Japan.

It is the euro that is suffocating Italy and Spain. They have the wrong intra-EMU exchange rate, and no sovereign control over anti-cyclical policy levers. The debt crisis -- a misnomer -- is a sympton. The sooner they break free, the better, for them.”

My comment:

Nevertheless, the prospect of an ECB flood of credit clearly implies a depreciation of the euro in foreign exchange markets and thus an improvement of the Eurozone economies competitive position relative to other countries of the world. It would also improve their short run growth perspectives as I explained in “Euro Exit”. That would make a survival of the euro more probable, on the one hand, but at the same time it would not solve the more serious problem of intra-EMU mispriced real exchange rates, while it would make it much easier for individual countries to get out of the euro (also explained in “Euro Exit”) on the cheap because the burden of their external debt in euros would have been reduced. 

Here lies the main virtue of Mr. Draghi strategy. By offering the best short term growth perspective for “saving the euro” in its present form, it also leads to the best opportunity for exiting the euro by reducing the burden of euro labeled debts without disrupting the international capital markets, and by minimizing the need for devaluation of the newly recreated national currencies.

If he succeeds, the sophisticated analyses of Frankfurtologists will loose much relevance just as those of Kremlinologists did when glasnost and perestroika disappeared overnight in their Soviet form as the Soviet Union imploded.