The Draghi Dilemma

Mr. Draghi “solved” the euro problem – the doubts the international investors harbored about the single currency’s future due to the perspective of several southern governments defaulting on their debts – by promising that he would do “whatever it takes to save the euro”, i.e. buy unlimited amounts of these debts in order to guarantee their market value. In other terms, do whatever it takes to save the value of the capital that international investors put in European government bonds.

Indeed such a policy so reassured the international capital investors that, lacking an equally central-bank-guaranteed investment opportunity elsewhere in the world (the “Draghi put”), they flocked to the Eurozone, determining a rise in the euro/dollar exchange rate in the process.

Mr. Draghi thus added a supplementary deflationary influence to the budgetary austerity policies that northern governments are currently forcing on the southern European governments, as a condition for continued northern lending that the “south” badly needs to avoid government default and Euro exit. This is an unfortunate timing for monetary and exchange rate policy at the beginning of a recession, the present condition of the EU economies. What was needed, on the contrary, was a progressive but major depreciation of the euro in order first to stimulate the economy and second to allow the governments that absolutely need a competitive currency to revive their economies to exit the euro system altogether. 

Hence the Draghi dilemma: guarantee the investors’ stake in bankrupt government bonds and boost the euro in the exchange markets, and thus further depress the economy and deteriorate even more the public finance equilibrium while trying to improve it (by decreasing the risk premium in interest rates), or create more money in order to let the euro depreciate and alleviate the external debts of European governments but violate the ECB charter and enter in a conflict with the German government that just enters an electoral campaign, and risk determining a capital flight and government bankruptcies in the south.

Did they say that the euro problem was “solved”?  

More on Regulatory Capture

James Kwak (The Baseline Scenario) has written about “cultural capture”, an extension of the well known concept of “regulatory capture” that I used in my recent book “Euro Exit” to explain why big governments and big banks in Europe so strongly favor the single currency, the effects of which are so detrimental to growth. It also explains, I suggested in my speech at the Bruges Group (see my homepage), the replacement of the “common market” objective by the “single market” as the immediate purpose of the EU political integration policy.

Kwak now signals (January 25) that his analysis is being included in a collection of papers on the topic, that will be published by Cambridge University Press this year, but that you can download now,  here.

Authors include Richard Posner, Luigi Zingales (who has written very interesting things on the capture of economists), Tino Cuéllar and others. I haven’t read it yet but the chapters’ titles are quite appealing. And "preventing capture" should rank high among policy priorities in Europe.

My Analysis of the Single Market and European Organizational Sclerosis

On November 10, last year, I was invited by the Bruges Group in London to deliver a speech on the “Single Market”, to which the organizers of the conference wanted Great Britain to “say no”.

I used to be quite in favor of a single market that I saw as the continuation and deepening of the “common market”, thus leading to increasingly competitive markets in the EU.

But in the process of thinking the topic over I came to realize that the Single Market, a notion invented in1986 by Jacques Delors and the eurocrats in Brussels, was quite different from the Common Market created by the Treaty of Rome in 1957. Apparently, thirty years had not been enough to open the national markets in the European Community, in spite of the suppression of tariff and non-tariff barriers to trade, and more action was needed.

What Delors wanted actually was a suppression of political and regulatory competition within the EU. This, I realized when writing “Euro Exit”, amounted to a big boost for European wide cartels, intended to replace defunct national cartels that had been stripped of their market power by the opening of the national economies, both within Europe and by globalization. Indeed, when regulations are centralized, business firms have a strong incentive to collude in order to negotiate from a common position with the regulatory authority. And the distance is short from collusion to cartelization.

 

Thus it appeared to me that the suppression of regulatory competition, the political centralization and the cartelization of the European industries were just one and the same transformation.

The result, as I see it, is a growing sclerosis of the organizational structure of state and firms in the EU as large and centralized units are reinforced while the underlying trend of the information society is towards fragmentation of large hierarchical organizations and general decentralization.

This is what I call the “European organizational sclerosis”. While the official diagnosis and current conventional wisdom is that labor market rigidities constitute the main obstacle to growth, I now think that excessively large public and private organizations – and thus taxes and rents - are the real barrier to growth in Europe. At the same time as I explained elsewhere, the devastating effect of high taxes on growth is not so much that of taxes on capital, but of taxes on labor, the various forms of payroll taxes that have been growing massively during the last three or four decades.

A policy to stimulate growth should thus focus first on the overall organizational structure of European countries and on realistic plans to reduce the labor tax.

Meanwhile the process of continuously expanding centralized regulation should be halted and a return to diversity would favor economic and political competition within the EU.

The text of my London speech is now available on my homepage here.

A Balanced Balance-of-Payments Diagnosis of the Euro Crisis

It is developed by Galina Hale, a senior economist in the Economic Research Department of the Federal Reserve Bank of San Francisco in a FRBSF Economic Letter January 14, 2013 article, “Balance of Payments in the European Periphery.”

Excerpts:

“Greece, Italy, Ireland, Portugal, and Spain (GIIPS) are going through balance of payments crises stemming from persistent current account deficits and net private capital outflows. These crises are like the sudden stops in capital flows that have previously taken place in some emerging market economies. Traditionally, such crises triggered currency collapses, which restored external accounts to sustainable paths. For GIIPS, that can’t happen as long as they stay in the euro area.

(….)

The 2007–08 global financial crisis hit cross-border capital flows hard, but GIIPS were not initially affected more than other countries. However, in 2009–10, a sudden stop in private capital flows took place as it became apparent that the sovereign debt of some periphery countries might not be sustainable. The credit ratings of Greece, Portugal, and Ireland were marked down, and spreads on their government debt relative to German debt began to rise. If these countries had not been euro-area members, their current accounts would have adjusted, most likely through a currency crisis and rapid depreciation. Instead, these countries remained in the euro area and continued to run current account deficits, despite rapidly falling private capital inflows, and, in some cases, capital flight.

How was that possible? In essence, public capital replaced private capital. As private capital flows to GIIPS fell, they were replaced by growing liabilities of the central banks of GIIPS to the European Central Bank and the central banks of individual euro-area countries, a network known as the Eurosystem.

(…)

The ability to continue running current account deficits without private capital inflows has allowed GIIPS to avoid balance of payments crises, giving them opportunities to gradually adjust their external accounts.

Of course, gradual current account adjustment is generally preferable to abrupt rebalancing. This is especially true for GIIPS because exchange rate adjustment is not an option as long as these countries remain in the euro area. Nevertheless, to greater or lesser extents, the European peripheral countries have to go through painful adjustments similar to those experienced by other countries in the throes of balance of payments crises. For current accounts to return to surplus, the competitiveness of GIIPS within the euro area must be restored, which means wages have to fall relative to those in Germany.

Some of these adjustments have already taken place over the past two years. As Figure 2 shows, current account deficits of GIIPS have shrunk. Except in Italy, real wages have fallen about 5% since 2010, and a lot more in Greece. However, for GIIPS to return to sustainable growth paths, further adjustments may be necessary. In previous emerging-market balance-of-payments crises, current account reversals were as much as three times larger than the adjustment registered so far by GIIPS. In some cases, real wages plunged 20–25%. In addition, the sovereign debt and banking problems of GIIPS must still be resolved.”

Read more here.

My comment:  Can it be done while the current deflationary policies contribute to shrinking the economies of the GIIPS, and thus deteriorate the Debt/GDP ratios as well as destroy social and political cohesion?

It must also be understood that the initial disequilibrium inflow of capital in the south was largely a result of a same nominal ECB interest rate applied to countries with quite different inflation rates. Negative real interest rates in GIIPS made heavy borrowing attractive for investment and speculation purposes in these countries and determined the excessive capital inflows that pushed balance sheets (public and private) into highly risky zones.

Even if these balance sheets are returned to equilibrium through the current painful  (and relatively slow) deflationary adjustment, what will happen in the future when inflation rates diverge again, as they did in the past after the austerity adjustment period required for the entry into the Eurozone? Very open economies cannot easily accommodate shocks and divergences without a flexible exchange rate.

Euro: A Success Story

Tyler Cowen (Marginal Revolution) turns more radical about the euro and Mario Draghi as its “savior”. It is now a "diffuse disaster" as I wrote in my 1998 book, and as I explained again, together with the best way out of it in Euro Exit.

Read more here.