Possible Outcomes for the Euro

The Financial Times presents a very clear and pedagogical explanation of the consequences of a Greek default, leading to a possible euro exit and potential euro break up,  here , including an interactive map describing the mechanism and the succession of events.

The emphasis is put on the “nightmare” that this scenario would represent for

Greek and other European citizens. As such, however, the presentation is unbalanced, first because it neglects to point the responsibility of the euro in leading our economies into this dead end, and second because the high cost of the alternative before us, i.e. higher taxes everywhere in Europe, leading to a deep depression and reduced levels of living for many years to come, is not mentioned at all.

As noted by Paul Krugman today in his blog, “The Conscience of a Liberal” (September 17):

 “It’s astonishing how many European officials and unofficial wise men insist, with a great air of wisdom, that the euro crisis was caused by failure to enforce the stability pact — that is, limits on deficits and debt. How hard is it to look at the data and discover that Ireland and Spain appeared to be fiscal paragons on the eve of the crisis, with budget surpluses and low debt? Yet another triumph of the Very Serious narrative over easily checked facts.”

Indeed, the euro crisis is the result of a chronic overvaluation of the euro with respect to the inflation rates of several member countries, that destroyed their competitiveness and led to a negative cost of funds (the ECB borrowing rate minus the current inflation rate) in many countries, and, logically, to excess borrowing by the private sector and also by governments when the 2008-2009 crisis left them in need of a fiscal stabilization policy, absent any possibility of using the usual loosening of monetary and exchange rate policy to fight the downturn.

This is again the case today. The best policy would be one of substantial depreciation of the euro that appeared likely a few days ago, when its dollar value fell from 1,45 to 1,36, raising the hope that it would fall further to more reasonable values of about 1,1, or even better 0,9.  But this was not to be and it returned towards 1,4 or 1,5.

The second shortcoming of the Financial Times article and of the governments’ official position is in the neglect of the consequences that “saving Greece and the euro” will exert on the economy. The defense of an overvalued euro will continue to depress the European economies (with the possible exception of Germany) while increasing taxes to subsidize Greece and other southern countries (by further transfers to their governments and banks), and simultaneously limiting money creation by the ECB, will make a deep recession more likely.

The real choice then is between disruption now (default and possibly early euro exit) and a durable depression and disruption tomorrow. Politicians having, like the rest of us, a preference for present wealth over future one, and thus for future losses over present ones, it is not difficult to forecast what alternative is most likely.

Given the recent policy choices of the largest governments within the zone, my guess is that they will try to consolidate the euro now by all means, “whatever the cost”, as they repeatedly pledged, that is, by increasing taxes at home and transfers to bankrupt governments, and dampening an already fledging growth to avoid the immediate turmoil and political costs of Greece’s and others’ bankruptcy. They again further the “kick the can” process for a few weeks or months, and by reducing temporarily the risk of an euro exit or break up in the near future they maintaining a high price of the single currency in the markets, and, in the process, lead their countries towards a depression in order to avoid the complete destruction of their political capital and the loss of the coming elections. 

Trying to avoid economic turmoil and political losses they’ll get both economic depression and political turmoil.

Alesina and Giavazzi on How to Cut Deficits

A good advice for deficit ridden governments.

Excerpt:

“The experience of Italy in the 1990s is consistent with three lessons that we have learned from examining examples of large fiscal consolidation in OECD countries with a government sector that accounts for well over 40% of GDP:

1.    Only fiscal adjustments based on structural reductions in spending (as opposed to temporary cuts) can have a lasting effect on the debit-to-GDP ratio.

Tax-based  adjustments simply keep filling the holes in the budget opened by automatic increases in spending.

2.    Cuts to government spending have smaller recessionary effects than tax increases.

3.    To the extent that spending cuts have a negative effect of output, this can be offset by enacting structural, growth-enhancing measures.”

My comment:  I am not too sure about point 3, either about what they mean or if they are right in general.

Point 2 however is straightforward, but usually not understood by policymakers: since the welfare losses from taxes increase as the square of the marginal tax rate, reducing taxes in general exerts a powerful positive effect on production. The same for a tax cut that accompanies a spending cut, leaving the budget deficit unchanged. This is the expansionary effect of a balanced budget reduction (the inverse of the so-called “Haavelmo theorem” of the expansionary effect of a balanced budget increase, in an economy with much unemployed resources).

This effect should be especially strong in the European economies where overall tax rates are high (a discussion of which taxes should be reduced for maximum result is of course in order).

Accordingly, making one more step in the right direction, one should advise European governments not to try to reduce too hastily budget deficits (as Ms. Lagarde admonishes them) but to cut spending resolutely while cutting taxes even more, not less.

But maybe this is too complex for the limited economic understanding of politicians (and their advisers).

The Alesina and Giavazzi paper concerns Italy but the conclusions are also of value for other European economies. It is downloadable here .

Further reading: Alberto Alesina and Silivia Ardagna, “Large changes in fiscal policy: taxes versus spending”, revised October 2009, on Alesina’s Harvard website. 

The Eurozone Double Dip is Almost Here

That’s what Edouard Harrison* writes in Seeking Alpha.

Excerpt:

“The euro acts as a gold standard for individual euro zone members. As with the gold standard, euro zone members abdicated currency sovereignty in order to benefit from the price stability of the currency tie. Individual euro zone sovereign states are now currency users with limited policy space, meaning that a recession must be met with the deflationary response of pro-cyclical fiscal policy (budget cuts and tax increases).

Over the medium-term, this decreases demand and reduces economic growth. In a credit crisis, when private sector debt levels are high, debt deflationary forces of reduced output can lead to falling asset prices, debt distress, deflation and depression.

I see the procyclicality as one of the structural flaws of the euro zone; there is no federal agent to do counter procyclical budgeting during a recession. Thus, the euro zone business cycle will invariably be volatile, making current account imbalances a lightening rod for intra-European recrimination.

(…)

In the past few months, I have become negative on the euro zone’s chances of survival. I no longer believe the political imperatives for the euro zone will be enough to overcome the politics of this next downturn.”

* Edward Harrison is the founder of the blog Credit Writedowns (www.creditwritedowns.com) and is a finance specialist at Global Macro Advisors. Previously, Edward was a strategy and finance executive at Deutsche Bank, Bain, and Yahoo. He started his career as a diplomat and speaks German, Dutch, Swedish, Spanish and French. Edward holds an MBA from Columbia University and a BA in Economics from Dartmouth College.

My comment: Neat and concise summary.

A Simple Truth Beginning to Be Recognized

By David Cottle on the Wall Street Journal’s blog “The Source”: “Leaving Euro Zone Isn’t Impossible”, here.

The author still exaggerates the difficulties of getting out, compared to those of staying in the zone. But most commentators now tend to get away from the Eichengreen’s fallacy that the participation in the eurozone is forever.

The End of Empire by Stealth

A recent post by “Charlemagne” in The Economist (September 3^rd) describes “the end of Monnet”, the EU’s godfather.

“The French functionary believed in gradually unifying post-war Europe through discrete projects run by a caste of technocrats, with the end-point left deliberately ambiguous.” His method has gone far. Too far in fact.

By the time when the common market project – a classical free trade zone with obvious economic benefits for the protectionist and fragmented post-war European economies – was achieved, in the late 1980s, the caste of eurocrats led by the prototypical Jacques Delors launched a very different enterprise, that of a supranational public good, a single currency, meant to force a later political integration of several nation-states members of the European economic association. Instead of decentralization through market unification, the process became one of statist centralization without the explicit consent of voters. It was a process of technocratic empire-building by stealth.

The whole enterprise is now in shambles because you cannot manage a public good without a centralized political authority, a state in fact. And precisely at the moment when this statist project was launched, in the 1980s, the underlying prerequisites for its eventual success vanished. On the political ground, the integration of several independent states, quite difficult in itself, requires a common external enemy against which the fundamental public good of a common defense could provide the benefits of economies of scale and increased efficiency. But by 1991 the Cold War was over and the USSR had disappeared. Symmetrically, the US lost interest in the political unification of Europe. On economic grounds, the information and communication revolution of the 1980s (computers plus the internet) reversed the previous trend towards centralization and the advantage of large size, into a trend of general decentralization of large hierarchies, whether private or governmental, into smaller and more efficient units. In organizational matters small became beautiful, or at least efficient. Whereas in the 1970s the use of computers (and thus of efficient information gathering, storing and processing) was restricted by its high cost and limited availability to big organizations (large firms, state bureaucracies) it became available to every individual in the 1980s and 1990s, and instant communication worldwide became the rule. Hence the trend towards democracy, the counter example being found in information repression by Communist China and Middle East dictatorships. The organizational consequences of that revolution were devastating for the largest hierarchies (see my book “The Second Twentieth Century: the Decline of Hierarchies and the Future of Nations”, Grasset, 2000 and Hoover, 2006). Large and heterogeneous states – usually called “empires” – were the first victims, coming just after large and heterogeneous corporations – usually called “conglomerates”. Smaller and ethnically or economically fragmented states followed, such as Czechoslovakia and Yugoslavia, while separatist movements prospered everywhere. Small entrepreneurial firms multiplied. It was no time for large bureaucratic structures and empire building.

That mutation made the European process of multi-state integration obsolete overnight. It thus happened that the technocratic "empire-building by stealth" enterprise was doomed at the very moment it was launched, with the currency centralization as its first stage. It follows that the failure of the euro is not specific: it is just one example of the new trend towards general decentralization that characterizes the second twentieth century and the ICT revolution. It is in my opinion a durable trend.

In Europe, governments and banks tried to resist the trend by cartelization, and succeeded temporarily to avoid the downsizing necessity. Instead of reducing their excess capacity they could in that way temporarily increase it. But as a consequence they are now confronted with bankruptcy. The call for a “European governance” (read: a major step in political integration) is just plain wishful thinking and is no real option. The only solution now is to downsize these overblown technocratic structures and increase by this means the overall social efficiency (and level of living for the European populations) by returning to smaller and autonomous and competitive bureaucratic organizations, public as well as corporate. This is also the condition for a return to effective democracy, breaking away with the rule of technocracy.

Yes, this is the second death of Mr. Monnet.

Plus ça change …

An interesting paper by Michael Sauga on the different designs and management styles of “transfer unions” (aka “federal states”): “Designing a Transfer Union to Save the Euro” (Spiegel Online). The author reviews several variants of such unions, and one historical episode stands out as a forerunner of current events.

Excerpt:

"In the mid-19th century, for example, France, Belgium, Italy, Greece and Switzerland established the Latin Monetary Union, a precursor of the European Monetary Union. The exchange rates among the members were set, and all members were required to accept the currencies of their partner countries. But Italy and Greece, in particular, took advantage of the rules of this union to take out high government loans, which they paid for in part by printing money. The other countries resisted the southern countries' inflationary policy, but then the monetary union fell apart in the mid-1920s.”

Read the whole article here.

When Will Euro Rioting Start?

The question is raised by Bob Pisani  (CNBC’s “Trader Talk Blog”). He summarizes an interview in the German newsmagazine Spiegel with economic historian Hans-Joachim Voth who studied the history of 28 European countries over the last 90 years and has come to the following conclusion:

1)    “Austerity and anarchy are closely linked”

2)    “Savings (budget cuts) amounting to just one percentage point of GDP are accompanied by social unrest. And when they reach two or three percentage points, it massively increases.”

Voth also gives the euro another five years before disappearing but says it is Germany that should quit the euro, not Greece. This is precisely what the former head of the Federation of German Industries, Hans-Olaf Henkel, has suggested in a Financial Times opinion, “A sceptic’s solution – a breakaway currency” on Tuesday August 30.

Read the whole CNBC post here .

Read also the complete Voth interview in the SpiegelOnline.

Excerpts:

“Spiegel: Wouldn’t abandoning the common currency sound the death knell for the EU entire project?

Voth: I believe that the consequences of ending the euro have been overstated. Not every dumb economic idea needs to be defended to the bitter end. Europe is infinitely more than the European Union, and the European Union is infinitely more than the euro.”

My comment:

1)    Rioting has already begun in Greece.

2)    Both Germany and Greece could benefit from quitting the euro … but also Portugal, Spain, etc.

3)    Five years seems quite a long time given the deteriorating conditions of Greece, Portugal and Spain and the growing criticism of the euro in Germany. My guess would be that a radical move could be taken after the coming French and German elections.

4)    In the meanwhile the only realistic policy would be to substantially devaluate the euro vis-à-vis the dollar, but with Germany staying in the eurozone to take its share of responsibility for the debasement of the external debts in euros, after benefiting from years of undervaluation of its “implicit DM” vis-à-vis other member countries within the zone.

5)    Lastly, Voth sees a “southern euro” surviving with France, Italy and Spain, and maybe others, but he fails to recognize that the divergences between these economies would perpetuate the present euro problem. It would not constitute an optimal currency area either, and thus it will break down sooner or later.  Sooner would be best.