Tag Archives: Euro

Is the Euro worth saving?

Anglo-Saxon economists were always sceptical. And so was much of the British establishment, though less so in the early days. But sponsors of the European dream were determined. And at first European Monetary Union defied the sceptics. But now the dreams are vanished and the only people defending the union seem to be those that have face to lose. Is it all over for the Euro?

It is Greece that seems to prove the scheme’s futility. The Greek government cannot repay its debts; its banking system depends on a bankrupt government for solvency and the European Central Bank (ECB) for liquidity. Greece cannot print its own money to inflate its way out of the hole. Instead European institutions and the IMF have to bail it out, and they are demanding conditions that add up to a loss of the Greek government’s sovereignty over its economic policy. Both sides blame the other, and the more the blame game goes on, the more trust and solidarity break down. The Euro is tearing the union apart, when it was supposed to bring Europe’s peoples together.

It doesn’t take hindsight to see what went wrong. Mostly the scheme’s weaknesses were pointed out at the start. Its supporters (who included me) just thought that this time it would be different.

Monetary policy is set at continental level, and yet there isn’t a great deal of economic integration. In order to adjust to local business cycles and local economic shocks, national governments have only a very limited set of tools. And the most important, fiscal policy, is constrained by the Stability & Growth Pact. This was instituted to try and prevent member governments becoming insolvent, a contingency that the zone had no process to deal with. This made it quite unlike a federal system, like the US, the only comparable monetary system that most knew. In the US there is a strong federal level of government, which draws substantial taxes from all parts of the union, and can make big fiscal transfers between the union’s members to compensate for the lack of monetary flexibility.

Funnily enough the problems with this set up did not play out in the way that most critics foresaw.  They thought that different business cycles or local shocks in different parts of the union would be the big problem. This happened – especially when the central economies of Germany and France endured recession, while peripheral economies, such as Spain and Ireland fizzed. But these were not the main cause of the crisis that emerged following the global financial meltdown in 2008.

The first problem was that investors assumed that member governments could not go bust, and that if they got into difficulties somebody would bail them out. As a result, it became much easier for the peripheral governments to borrow, and this allowed them to run their economies with a looser hand than they should. This was most egregious in the case of Greece, who produced misleading economic statistics, which put their government into a completely unsustainable position. And when it was clear Greece could not repay its debts, the system had no set of processes with which to manage the crisis.

Perhaps Portugal and Italy were guilty of something similar without the fraud, though Italy has not needed a bailout. But the other bailout cases (Spain, Ireland, and Cyprus, though I am less confident that Cyprus follows quite the same narrative) the main problem was not government finances, but a reckless private sector that fuelled property bubbles. What added fuel to these bubbles was cross-border flows from elsewhere in the Euro area, and especially German banks. The Euro system had greatly facilitated such flows. When the bubble burst, it brought down the countries’ respective banks, and this in turn draw their governments down with them. Governments couldn’t let the banks go bust, since they controlled local payments systems and economic chaos would have resulted. Like Greece these countries then needed external support and bail-out.

The important point to make about this series of crises was that they were to great extent “endogenous” as economists like to say – they have to do with the way the system itself operated – and not exogenous – the external shocks and uncontrollable factors which most economists thought was the system’s weakness. That suggests that bad systems design was a large part of the problem – and that, in theory, could be fixed. Most suggest that it implies a fully federalised system, with a federal government, supported by federal taxes and federal debt. An alternative route would have two main elements: a national insolvency regime (a bit like US states, but not Puerto Rico, which is on the path to creating a US version of the Greek crisis); and banking reform to produce a more federalised banking system firewalled from member governments.

But either route would leave member governments facing a grim reality. The Euro offers a straitjacket for government finances, and not a liberation. In the fully federalised case, the scope of government responsibilities would be curtailed and handed over to a federal government. In the alternative governments would be heavily restricted by their ability to borrow in financial markets (which would do away with the need for the Stability & Growth Pact). This latter is, in fact, what many supporters of the Euro (including me) envisaged all along (though in my case I completely failed to grasp the difficulties of managing the banking system). It was rather a Thatcherite project. But others thought EMU would be a step along the path towards a federalised Europe. It was the unresolved conflict between these two visions of the Euro that got the system into its current mess.

And this conflict is still unresolved. But the federal vision is losing ground; there simply isn’t the political support for it. That doesn’t stop people in the European Commission from quietly pushing for it though. But those who aren’t convinced by the federal idea, aren’t convinced by the multi-state currency area alternative either. Why opt for a straitjacket? Wouldn’t it be more democratic and easier to say goodbye to monetary union altogether and let each country go its own way with its own currency?

And I don’t have the answer to that. One thing I will say is that the quality of economic commentary in the media is pretty dire. From this you would think that the advantages of having a floating currency make doing anything else foolish. But all Economics students are asked to do an essay on the pros and cons of floating currencies, and frankly it is not that obvious that either route is a winner. As a rule, the smaller and more open the economy, the more there is to be said for a fixed currency regime – which is why the Euro is popular with so many smaller EU members. Floating currencies reduce the effectiveness of fiscal policy, especially in such small and open economies. The rather loose fiscal policy of the Britain’s government in the 2000s caused the exchange rate to be too high, leading to a trade deficit and a hollowing out of British industry the country still have not recovered from. By contrast Germany has been able to maintain its industrial base within the Euro, albeit with some painful restructuring.

And a floating rate does not prevent banking bubbles. Iceland had one in parallel with Ireland, with its own currency. Recovering from the bust best no less painful for Iceland than for Ireland, though arguably not really any worse either.

But setting up a more secure banking system across the Euro area is no small thing, and its feasibility is an unknown. Against this, taking the Euro apart would be a huge undertaking, so there is there is much to say for trying to make it work on a rather less ambitious scope. Inertia is on the side of the Euro. But the starry-eyed enthusiam is gone

 

 

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Greek crisis: the problem is loss of trust

The leaders of Greece’s Syriza government are clever people. They include university academics, well versed in modern economics, including game theory and the theory of negotiations. After yesterday’s decisive No vote in the referendum on settlement terms, these negotiators now feel they have a strong hand. I don’t share their optimism.

Unless you believe the conspiracy theories that Syriza’s real aim is to create a Venezuela in the Mediterranean, they appear to think that their EU counterparts and the IMF will be forced to negotiate because the consequences of not doing so are dire. What they seek are two things. First is that the level of government debt be reduced through forgiveness. The second is that the Greek government has a free, or freer, hand to follow an economic policy of its choosing, supported by fresh funding, primarily in the form of support for the Greek banking system by the European central Bank (ECB).

On the face of it neither of these requests is all that unreasonable. The moral case for debt forgiveness is a sound one. In the modern age more responsibility needs to be pinned on creditors to lend responsibly, and to suffer losses otherwise. The lending made to Greece before the crisis was not responsible, although misinformation from the Greek government contributed. This moral case is softened but still stands after two things. The Greek debt has already been substantially restructured so that the country’s interest rate burden is proportionately less than even Germany’s; the net present value of Greece’s debt is not nearly as high as you might assume for its nominal size. And now the debt has been taken over mostly by government agencies; the private sector banks that originally lent the money have mostly been paid off, after significant losses were forced on them.

And as for economic policy, the nominal Greek aim is to set up a virtuous circle of increasing demand that will help the economy to recover, so that its banks can repay the ECB, and that other lending becomes more sustainable. There is a familiar, Keynesian demand management logic to this. I think this is why so many respectable economists (especially based far away in the US)  support the Greek government’s standpoint. There is also a powerful argument about democracy – surely a democratic Greek government should choose its own path to a sustainable economy? The sight of so many unelected functionaries dictating terms to the Greek government has angered not just Greek citizens. I have seen many comments this morning about how the Greek referendum vote was a blow for democracy. The People have spoken!

So what’s the problem? International leaders are masters of fudge and pragmatism. Surely some kind of face-saving formula can be found that will be better than the consequences of a collapse of the Greek banking system? This is now a clear and present danger. Greeks having been withdrawing deposits from their banks, making the system insolvent. Since this looks like a temporary problem, the ECB has been prepared to prop the system up with emergency funding, awaiting the return of those deposits once a new deal has been struck. But last week this support was cut off, as the confidence of European governments was shaken about the ability to do any deal, when the Greek government called the referendum. With the referendum done the outgoing Greek Finance Minister, Yanis Varoufakis, suggested that this funding would return while a new and more reasonable deal was in prospect. Mr Varoufakis, who had taken to lecturing his European colleagues on basic economics, even resigned to make such a deal easier to negotiate.

But all negotiations are built on trust. You have to believe that your counterpart will stick to their side of the deal. And this has always been the problem with Greece and its creditors. What these creditors fear is that the Greek government do not put their economy on the path to true sustainability, and that it and the country’s banks will continue to need injections of foreign money without any real prospect of these being repaid. And this further support will have to supplied or underwritten by fellow European governments. There is little feeling of solidarity with the Greeks from other European electorates. Better off countries, like Germany, Finland and the Netherlands are outraged about the prospect of more taxpayers’ money being sent to countries that they see as feckless. Many east European governments, like Slovakia or Lithuania, are poorer than the Greeks overall, and see no reason to let the Greeks off; in some cases they have been forced to endure harsher austerity regimes than the Greeks were. Governments in other countries that have been subject to bailouts, Spain and Portugal in particular, do not want to give an easy victory to Syriza, lest it encourage similar movements in their own countries.

And why isn’t the Greek economy sustainable? This is a familiar combination of corruption, clientalism and ineffective government. Tax collection is inefficient; many benefits are too generous; there are too many meaningless publicly funded jobs. Many Greeks are entrepreneurial and hard working, but overall the economy does not pay its way – consumption is sustained by net imports. To create something more sustainable would require a programme of reforms, most of which would be politically unpopular. They would also suck demand out of the economy in the short term, i.e. they involve what has become known as “austerity”. Some theoretical economists, like Joe Stiglitz and Paul Krugman, seem to think that economic reform programmes can be designed without austerity. But this requires a favourable context and an efficient government – which does not apply here. The commonest way for such reforms to be imposed is through the government following a programme designed by outsiders, such as the IMF. Or else it is the threat of such an intervention that forces governments to act. These outsiders become convenient scapegoats, but in the longer term the reforms may be popular, as they deliver a healthier economy.

But the hidden background to the current crisis is that the Syriza government has not offered any convincing programme of reforms, while reversing reforms enacted by its predecessor. You wouldn’t guess this from listening to their smooth-talking spokespeople on the international media. But the Syriza movement contains many with more extreme, anti-foreigner views, limiting the government’s ability to act. The IMF in particular have found their plans utterly unconvincing. Politically they seem happy to go after rich people to tax them more. But rich people’s money is a notoriously elusive quarry; and the government is unwilling to take on any other reform with a political cost.

So what are the European governments to do? They are the critical parties on whom a deal depends. They have been humiliated by the referendum. Their electorates are telling them to not throw good money after bad. Their expert advisers suggest the Greek offers of reform are unconvincing, which means that the crisis will simply repeat itself. Over the years they have increasingly embraced an idea that had been unthinkable: that countries may be able to drop out of the Eurozone. The political costs of a negotiating failure have never been lower.

So what might happen? This depends in some measure on how well-prepared the Greek government is for this moment. If they have in their back pocket a credible compromise deal that saves some face for the European governments, we might pull back from the brink. Mr Varoufakis’s resignation is a good start, it has to be said.

What are the ingredients of such a deal? The Greek banking system must be at its heart. The banks must be recapitalised using external capital. They need to be insulated from the Greek government – in other words the money supplied by outsiders shouldn’t be simply channelled into government debt. Something needs to be offered to reduce the principal of older debts – though perhaps the interest bill can be kept intact. The Greek government can then be left to work its own way out of its short-term economic problems.

Such a deal would point towards the sort of reforms that might make the Euro more sustainable. Separating the banking system from government, with a more centralised regulatory and ultimately deposit insurance scheme. A resolution system for insolvent governments that means debts can get written down quickly. More nominal freedom for government fiscal policy – with discipline forced by bond markets, not EU agencies.

Such a deal would be a way forward. But it still needs trust. Alternatively the Greeks will have to create a quasi-currency of their own to keep their banks afloat – a first step towards the Euro exit. I am not optimistic.

 

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The European dream slowly unravels

I am one of nature’s political optimists. But 2015 is one of those years where it is all going wrong. The Lib Dem near wipe out in this year’s UK General Election, for one thing. The rise of Islamic State is another – along with the spread of vicious Islamophobia promoted by such outfits as Britain First. Meanwhile state after state in the Middle East and Africa is failing, with vicious dictatorships taking hold in other countries. This gives Israeli hardliners the cover they need advance their own brand of apartheid, and the ghettoisation of Gaza. Any attempt at finding a humane middle way is undermined by extremists of one sort or another, in country after country.

And now, as Gideon Rachman points out in yesterday’s FT, the European dream is dying before our eyes. The idea of ever closer European union was one of the formative ones in my own politics. In 1975 I was a 17-year old that was definitely ready to vote in that year’s British referendum on Europe. I’m not sure why it should have caught my imagination so – I grew up in postwar prosperity, where the World War was just an interesting piece of history. I suppose I found British society so staid and constricting that I wished for its institutions to be subsumed into something much more modern and exciting. I meet many people of my age that feel the same way though.

But apart from opening out British society and commerce, the EU represented a path towards civilised governance and prosperity for the undemocratic countries on its fringes. Greece was the first country to take the path of throwing off dictatorship and coming in to the mothership of Europe. 35 years on and the achievements look hollow. Greece took on the trappings of a well-managed European democracy but did not take it to heart. It remained run by a rich elite which did as it pleased, while bribing the rest of society with generous pensions and meaningless public sector jobs. They became artful in keeping that show on the road by extracting grants and loans from the rest of the union at the same time as disregarding rules they did not like. They even managed to join the Euro, reducing borrowing costs, and allowing the fiction of a properly functioning European state to continue. But sooner or later the music had to stop. And when it did the foundations of the European project looked shallow. There is an absence of trust and solidarity.

The Greeks themselves, or at least those that govern them, seem in denial about the sort of reforms that will be needed to get them on the path to prosperity. They claim to be victims, condemned as to doom-spiral of “austerity”, with many Anglo-Saxon economic commentators (Noble Laureates Paul Krugman and Joseph Stiglitz among them) cheering them on. But dig a bit deeper and we find that words such as “austerity” and “reform” have been abused so that a lot of the dialogue is at cross purposes. The Syriza government wants to reform some aspects of the Greek state, but sees no problem with those aspects that I have referred to as “bribery”: maintaining ineffective public sector jobs and unaffordable state benefits, such as pensions.This leads to the suspicion, especially amongst Germans, that all the Greek government want to do is to keep the old, failed way of running the state on the road, lurching from bailout to bailout, using moral blackmail each time.

The Germans, of course, are hardly blameless. Their banks kept the Greek show on the road, in the apparent anticipation that their government would bail them out if things went wrong. That expectation proved sound enough – most of the bailout money went to them, and practically nothing towards providing the investment the Greeks so badly need. The Greek government’s moral case is not entirely hollow – but their combative approach to negotiation is destroying trust. No wonder that British Eurosceptics urge the UK government to emulate such tactics in their dealings with the EU! Even now the Greek Prime Minister, Alexis Tsipras, suggests that a No vote in the forthcoming referendum is just a step in the negotiation, not a real moment of decision. Those European leaders who have been trying to fudge things to get a deal, like Claude Juncker, the President of the EU Commission, feel betrayed.

The prospect of Greece dropping out of the Euro and then the EU is steadily growing. This would be a calamity for Greeks, and raises the prospect of yet another failed state. As more than one commentator has suggested, if the Greek ruling elites had what ti takes to run an independent monetary policy, they would not have got into this mess in the first place. It would mark a big moment for the EU too. Its first major defeat. But it has limited powers; it cannot make an unwilling partner reform itself.

And old Europhiles like me must wake up and acknowledge the truth behind that. Our dream cannot be fulfilled. The EU is a confederation, not a federal state. It cannot bind its members by force of arms, as the United Stares did when some of its members tried to secede over 150 years ago.

The question now is whether the EU can survive a Greek exit, or will it be the start of a general process of disintegration. Greece is not the only country to be a cause for concern. The other bailout cases -Spain, Portugal and Ireland – were always more serious about reform and integration, and I do not see these as being of immediate concern. Cyprus, with its cultural ties to Greece, may be different. But the future integration of Hungary, Romania and Bulgaria are far from secure.  At least they are not members of the Euro.

Greece seems to be the lesson that the EU learns by. After its entry to the Euro, the EU became much stricter about allowing further new members. After its flawed bailout, which let many private sector investors off the hook, it was much stricter with Cyprus.

But what is emerging is a different Europe. One where much less solidarity is expected. And one with an Exit door. It is a system of rules and standards that facilitate free trade, environmental cooperation and good governance – but one where it if you fail you are out. Integration is not necessarily in one direction. The union will no longer be ever closer.

Into this sad situation the British Prime Minister David Cameron enters with his attempt at British renegotiation, leading to a referendum. This may seem to be the last thing that Europe needs. But Mr Cameron’s negotiating skills are far more advanced than Mr Tsipras’s, and he is showing much more application than hitherto. This cloud offers a silver lining. It may define a looser union, but if the British public votes to stay in it will offer a counter-narrative to the slow disintegration that is happening elsewhere. Such is what is left of my European dream.

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Should I apologise for supporting the Euro?

The this week’s FT Janan Ganesh suggests that those who supported Britain’s entry to the Euro back in the late 1990s and early 2000s should own up to to their error and apologise for it. He feels that the arrogance of that generation of Europhiles is undermining the pro EU case as we face a referendum on membership. Well he won’t have me in mind. I am not a prominent politician; I wasn’t even blogging in those days. But I did have an opinion – and that was that that the country should be part of the Euro – though not at the exchange rate then on offer (about 65p per Euro). Should I hang my head in shame?

In fact this also seems to be a rather desperate line of attack by the Eurosceptics, who are at last realising to their horror that they are being out-manoeuvred. They want to discredit the whole pro-Europe cause. In today’s FT , one its other writers, Martin Sandbu, comes out with a robust defence of British entry to the Euro. He suggests that if the UK had been part of the Euro economic disaster would have been averted, because the European approach to fiscal and monetary policy would have been more pragmatically British. I have also heard a that idea suggested by a commentator from within the Euro zone, though I can’t remember who.

I’m not entirely convinced. But it at least raises the big question. It is treated as entirely self evident that the Euro is a disaster, and that British membership would have made things worse for the country. But both these are counterfactuals. We don’t know what would have happened if the Euro had never got off the ground, or if Britain had been a member.

Let’s consider the first of these. When the Euro was being formed the economies of Italy, Greece and Portugal were in real trouble. Their governments were losing the confidence of the markets; stagflation followed by hyperinflation beckoned. The Euro lifted these economies – before joining the governments were forced to bring fiscal policy under control; after joining interest rates fell dramatically. But these countries failed to deal with deeper seated problems, and eventually the chickens had to come home to roost. Membership of the Euro delayed the denouement rather than caused it. Indeed it gave these countries an opportunity to head off disaster which they failed to take. Contrast this, for example, to Belgium, also considered a bit of a basket case before the Euro, whose economy now prospers, relatively speaking at least. And for each of the other members of the  Euro that ran into trouble something similar can be said. Ireland suffered the consequences of a reckless expansion of its financial system not unlike that of Iceland, outside the zone. Iceland’s crash was at least as painful as Ireland’s. Their problems reflect underlying economic weaknesses that governments failed to tackle. The signs were there. Indeed no members inside the zone seem to want to return to life outside it, with the possible exception of Germany (and Finland perhaps).

The ambiguity of Germans is understandable. The interesting thing about that country though is that they were the only, or at least the first, country in the zone to understand the implications of membership for economic management. In the early days they realised they were uncompetitive, and embarked on a programme of “real” devaluation. This was a combination of holding pay rates down and economic reforms to improve productivity. The reluctance of other countries to embrace this style of economic management is the main failure of the Euro project.

And what of the second counterfactual? What if the UK had joined? Well the first thing to be said is that the country did not do so well out of the zone. The financial crash of 2008 was deeper, and the recovery slower, than the major Eurozone economies. Britain suffered a persistent current account deficit, supported by an unsustainable exchange rate. We were in a not dissimilar space to countries like Spain and Ireland, going through a financial boom offering the illusion of wealth while not enough was being done to fix the fundamentals. It is not so self-evident that things would have been worse inside the zone.

Or perhaps not. I would like to think inside the Euro the UK would have been locked into an exchange rate that suited exporting industries (like Germany after its reform/adjustment programme) and not so subject to financial shenanigans. That would have left the economy in a stronger position after the bust. But such an exchange rate wasSterling Euro X ratesnot on offer. The chart above shows the average exchange rate between the Euro and Sterling for each year of the currency (source: stastica.com). My view is (and was at the time) that the rate of 65p was high (or too low in terms of the graph). It was distorted by excessive government spending and a booming financial sector – there was a substantial current account deficit to show that it was unsustainable. It did not drop to a more realistic level until 2007-2008. That was too late. There was no chance that the government would have followed Germany’s example in conducting reforms to improve the real exchange rate – not while everything was rosy on the surface.

So If Britain had joined the Euro at its start or early in its existence, then the exchange rate would have been too high. Which would have made the adjustment period after the crash even more difficult. I’m not going to apologise for this because I understood that at the time (or that’s how I remember it!).

But there is a bigger issue that I will have to own up to. The design and operation of the Euro zone was flawed. There are two sustainable ways of running such a common currency area. One is part of an explicitly federal system of government, which allows substantial fiscal transfers between its members and a robust system of federal political control to match.  In this system members bail each other out if they get into trouble.To judge from most commentary, you would think that this is the only way to run the zone – and that because the European polity is not ready for such a federal system, then it will never work. But there is an alternative, where each member is not so tied to the others. Each country is left to run its affairs as it sees fit, and if it can’t pay its debts, it goes bust. It requires a sovereign insolvency regime. Nobody bails failing states out.

This latter arrangement is what the Germans wanted, and it is what most Britons that supported membership wanted too. But Euro-federalists in Brussels and the southern states saw the currency as a step towards federalism. The Germans didn’t help matters by insisting on  system of fiscal rules for members – the “Stability & Growth Pact” – which is only necessary if you are heading for a federal arrangement. The idea that the system was in fact of the federal type was implied by the fact that government bond rates for the different members were almost identical for much of the Euro’s life before the crisis. This was a bad sign – and yet most European leaders though it was a good one. When crisis approached European leaders were complacent. And when things went wrong, there was muddle and confusion. This problem is still not resolved.

And here I have to own up. While I saw some of the signs, I did not appreciate the full implications of this ambiguity. I thought it was a problem that could be solved by evolution from within.

I still believe that. But the politics of EU membership in Britain are toxic enough as it is. It is better that the country is not part of the tortuous politics of the Eurozone. That is why I accept the consensus that Britain probably never will be be part of  the Euro zone. Or not until firstly the zone finds a new and sustainable equilibrium, and secondly that Britain sinks into an economic mire that destroys its self-confidence as an independent nation. Both are possibilities.

Meanwhile I am not a fan of an independent Sterling. It has a way of distracting the political elite from dealing with deep-seated economic issues, like our current account deficit, our inefficient underlying economy and our over-dependence on volatile financial flows. But, it has to be admitted, that, with the exception of Germany, the Eurozone members were equally blind to the self-same issues. I apologise for not appreciating that enough.

 

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Greece: can you have reform without austerity?

The standoff between the Greek government and most other EU governments continues. The other governments are happy to extend loan facilities, but only if Greece stands by the conditions it had previously agreed. For the Greeks that is anathema, because it means holding to austerity. Many observers here in Britain seem to sympathise with the Greek side. And they offer a middle way: reform without austerity.

Three columns in the FT make the case. I have provided links, but beware – the FT operates a paywall with a very limited number of free goes. First was the weighty (intellectually) Martin Wolf. He condemns the EU programme for focusing too much on austerity and not enough on reform. Austerity sucks demand out of the economy, causing mass hardship; reform would make Greece’s economy more efficient. Next came the intellectually much lighter Tony Blair: Two false paths for Europe – and a new third way. This puts the idea into more overt political terms, though conjuring up memories of his own British “third way” that was politically successful for a while, but whose reputation is now somewhat tarnished. As an aside this is interesting because it shows that Mr Blair accepts uncritically the basic left wing economic narrative – looser fiscal and monetary policy will lead to growth. On Monday was regular FT columnist Wolfgang Munchau: Athens must stand firm on failed policies. This is positively vitriolic about the EU conventional wisdom on austerity, which he regards as economically illiterate and a complete failure. This article contributes to the picture by exploring Greece’s options in the event of breakdown, including the intriguing one of the country printing its own money.

So what to think? Austerity refers to the reduction of public spending and the increase of taxation. It is considered economically counterproductive because it sucks demand out of the economy, which in turn knocks tax receipts – which makes things worse by creating a downward spiral. In Greece’s case the object of vitriol is the target that the government should run a primary budget surplus of 3% , to pay for debt interest, which comes to about 3%, after the recent restructurings (and a remarkably low figure for debt of 175% of GDP). Surely even prudent governments should be allowed a deficit in a recession? So what about reform? It is here that each of these commentators is awkwardly silent. Just what on earth do they mean?

Economic reforms to promote efficiency usually mean changes to product and labour market regulation to make them more open to free market forces. These are undoubtedly required in Greece.  But they promote short-term insecurity to jobs and businesses. They are not politically popular, and I doubt very much that there that the Greek public distinguishes between these reforms and austerity. They all part of the same hateful phenomenon.

And the problem goes deeper. Regulation tends to create public service jobs., which deregulation threatens. Besides it is the scale of the public sector, both in terms of jobs and transfer payments, that is a large part of the problem. In several ways this undermines a dynamic private sector. They tie up resources; they undermine labour markets, and so on. For too many people the way to wealth involves politicking rather than delivering things that people actually need and want. And so reform often means cuts – which is back to austerity.

In fact to find ways of stimulating demand without blocking reform is quite hard. There is the economists’ old favourite: investment. But efficient public investment requires an efficient state to direct it. Otherwise the money simply lines the pockets of well-connected people. Surely Greece is vulnerable to this? More bank lending? Another can of worms. Frankly I will not be convinced that reform without austerity is a possibility until somebody can spell out a programme which delivers it. The Greek government is proposing a reversal of both austerity and reform. Once again British (and American) economists are guilty of using macroeconomic analysis to skate over practical problems that turn out to be the very heart of the issue.

There may be some hope a middle way though. Perhaps some fudge around economic cycles can be used to cut the target for primary surplus. And there must be some opportunity to reshape the austerity/reform programme to put more weight on collecting tax from wealthiest – which the new Greek government seems much better placed to do that the last.  Alas I am too far away from it all to have any feel for how likely such a deal might be. All I will say is that British commentators are generous with the taxpayers’ money of other nations, but their credibility would rise if they suggested that British taxpayers should join in. All the talk of respecting Greek democracy would then be put into a clearer perspective.

Meanwhile it seems quite likely that there will be some kind of Greek default. Following Mr Munchau it looks quite likely that the Greek government would issue some form of electronic currency of its own, in the from of IOUs, to keep things going. This may well be against the letter of the rules for the Euro area, but it could buy enough time for a compromise to be reached. And perhaps the development of a safety mechanism for the Euro currency area. The Eurozone needs to find some sort of middle way between the inflexibility of a gold standard, and the creation of a federal state without democratic consent. Might what amounts to local currencies be part of this?

Meanwhile, as the saying goes, if something looks too good to be true, it probably is. That is surely the case for reform without austerity. Sorry Mr Blair.

 

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The Euro does not need a federal superstate to prosper

The Euro crisis is in one of its quiet phases. But few are foolish enough to think that its future is now secure. It is often said that the currency is destined to fail because of a fundamental economic law which means that you cannot operate a successful currency without the full authority and resources of a state behind it. The Euro needs to the apparatus of a federal superstate to survive, it is said. One Tory MP even suggested that the Euro’s promoters were committing fraud to suggest otherwise. But, for all that many in Brussels want it, establishing such a superstate is not politically feasible. And yet it is possible to see emerging the institutional architecture that will allow the Euro to survive and prosper without it. It’s a hard road, but there are enough benefits for the currency’s members to persist with it.

There are four key elements to the architecture. The first is an obvious one: a powerful European Central Bank (ECB), able to do what it takes to ride out the various crises that financial markets will throw at the system. The current ECB has proved up to the task, albeit by pushing at the boundaries of its formal powers, for example by buying the debt of member governments on the secondary market. Confidence that it can handle future crises is growing, adding to the overall stability of the system. And yet this power has its limits; it cannot transfer taxpayer funds from one country to another (referred to as “fiscal transfers” by economists), in the way a federal government could. The Euro has to find a way of existing without the sort of massive fiscal transfers that you see in the United States, for example.

In its place is the second element: provisions for states to default on their debts. This has been resisted tooth and nail by Euro federalists, but at long last it has been implemented for Greece. Alongside this, a crisis infrastructure is emerging, including crisis funds to support governments that are in the process of restructuring their obligations. This whole process needs to go further: publicly held government debt, e.g. that bought by the ECB, needs to be included, for example. Greece will surely need another restructure. But we are seeing the different nations’ bond prices reflecting the risk of default, and this imposes a discipline on government finances. And no government will want to follow the humiliating path of Greece into default, if they can help it.

There remains the problem of managing the banking system, which is very much run along national lines. While Greece got into trouble because of a profligate government, Ireland, Spain and Cyprus were brought down by banking crises. At first the response to a banking crisis was for governments to underwrite all banks’ creditors in order to restore confidence. Many applauded the Irish government when they did this early in the crisis; but it is a terrible idea, transferring liabilities from various people who should have known better to taxpayers who could ill afford it. Therefore the third element of the new architecture is to force bank creditors to pay, or at least contribute to, bailing out bust banks, referred to as “bailing in”. This solution was put in place for Cyprus, and hopefully will be the pattern in future. Of course it remains possible for financially strong governments, like Germany’s, to stand behind their own banks – but this should be discouraged. It is essential for discipline to be brought back into banking, and the system whereby bankers keep the profits and pass losses on to taxpayers has to be terminated.

But this approach is undeniably destabilising; it adds to the risk of bank runs. The obvious solution to this is to establish a Europe wide deposit insurance scheme, just as America has its federal scheme. Initially European governments seemed to favour this, but as they grew to understand its full implications, possible taxpayer transfers between states and increased central regulation, they have backed off. This has left us with the fourth and final element of the new architecture: emergency capital controls. This has been implemented for Cyprus, where depositors at Cyprus banks are suffering severe limits to their ability to move money out. It is an ugly process, and represents a big step bank from the integrated ideal of the Euro. The third and fourth elements in particular mean that a Euro held in a German bank is worth more than one held in a Portuguese one, say. But this is better than the alternatives, which attempt to wish financial risks away into an anonymous federal centre.

I believe that these four elements can evolve into a system that will give the Euro long lasting stability, and a better distribution of risk than a federal system would. We must remember that systems of human relations are only in a small part dependent of formal laws and powers, and much more based on expectations of how people should and will behave. This is how the management of the Euro is evolving. In the early days those expectations were wholly unrealistic, and ultimately required some kind of federal system to underwrite them. Now that we know this cannot be, new expectations are evolving. This is a bit like the way the British constitution and Common Law develops.

But is it worth it? Is it a loveless marriage between southern economies locked into permanent austerity, and more dynamic northern ones which are constantly being dragged down by their neighbours? (And France which manages to be on both sides of this equation at once!) If so the enterprise will lose political support and die anyway.

This question deserves a post all to itself, but I believe that all this pain has benefits to both sides. For the southern economies, joining the Euro was all about converging with their rich northern neighbours and their higher standard of living. Unfortunately they at first thought this would be easy. Lower interest rates and hot money from the north created a short term boom, but could not do the trick. Endless tax transfers (like between north and south Italy), are not on offer, and probably wouldn’t work either. In order to raise living standards the southern economies will have to undertake a painful series of reforms, rather in the way Britain did in the 1980s, Sweden in the 1990s, and, to a lesser extent, Germany in the 2000s. The process is starting, and the new disciplines of the Euro zone help this.

And for the northern economies of Germany, the Netherlands and Finland? Being in the Euro gives them a more stable economic environment, at a time when the global economy has been destabilised by the rising of China and other emerging markets. With a lower exchange rate than otherwise they have been able to preserves their exporting industries and maintain a degree of social stability. You only have to look at Britain to see what might have happened otherwise. There a short-term boom and appreciating exchange rate led to a flooding in of cheap imports and a hollowing out of export industries. Living standards grew for a while, but it could not last. The country is still struggling to escape the bust of 2008/09, with exports remaining weak.

The first decade and a half of the Euro has not been a happy experience, taken as a whole. But these are difficult times for developed world economies. In these circumstances the Euro remains a good idea, and indeed eastern European countries are still queuing to join. In the rough, interconnected world that is the modern economy, living with a freely floating currency is much harder than many would have you believe.

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Europe and the US: the tortoise and the hare

Comparing the European economy to that of the US reminds me of Aesop’s fable of the race between the tortoise and the hare.  The US’s flexible labour and product markets, and decisive interventions in time of crisis, give it the ease of the hare.  To US politicians you only have to mention Europe to conjure up a picture of stagnant, over taxed and socialist economies.

But the tortoise wins the race in the fable.  And indeed, if you look beyond crude GDP growth statistics the race looks close, depending on the precise time frames and so on.  GDP per head tells a different picture to aggregate GDP (this is regularly quoted by The Economist, though I haven’t found a recent example to link to).  Other statistics on the incidence of poverty, life expectancy and so on, show Europe in a better light – though the US still does well in self-reported wellbeing, but not as well as Scandinavian countries.

All of which demonstrates how commentators, especially in the US and here in the UK (whom I shall collectively call the Anglo Saxons, following French practice – though this is a dangerous shorthand) don’t understand the dynamics of European economic policy.  As the EU lurches into another round of crises, this is worth taking on board.   Once again the US hare looks better placed than the European tortoise.  But look closer, and it isn’t so clear.

This is not to underestimate the scale of the crisis facing the Eurozone in particular.  Massive problems confront the economies of Greece, Spain, Italy and Portugal; the French economy is not in a place of safety either.  But Anglo Saxon commentators tend to relentlessly focus on the short term problems, to the exclusion of longer term issues, which they assume best dealt dealt with at a later time.  Europeans (from which I exclude the British, for now, though for most purposes the British are very much European) tend to look at the problem differently.  A crisis is one of the few opportunities to tackle longer term problems, and fixing the crisis while neglecting the long term is criminal.

The southern European economies are inefficient by developed country standards, and uncompetitive within the current Euro structure, and can’t sustain the level of social benefits that their electorates have come to expect.  This lack of competitiveness was not invented by joining the Euro – it predates it, and is based on decades of poor economic leadership.  Joining the Euro gave these economies a boost by reducing government borrowing costs – but this boost was used to put solving the bigger problems off until later.  Their northern European partners are to blame for going along with this, until a crisis threatened to engulf them all.  When the Euro project was launched, its supporters advocated it on the basis it would force governments to confront the inefficiencies of their economies, rather than rely on devaluation to put the problem off – a strategy that ultimately leads to stagflation, and even hyperinflation.  But somehow these supporters seemed think that the omelette could be made without breaking eggs.  But Europe’s leaders are keenly aware of their mistakes now.

The position of the southern European economies is not unlike that of Britain in the 1970s.  A massively inefficient and uncompetitive economy had been kept alive by a benign international economic climate, until the 1973 oil shock knocked it over.  There was no quick fix, no macroeconomic palliative to ease the pain.  A floating currency hindered rather than helped.  The turning point came in 1976, when the Labour government had to call in the IMF.  Then started a painful process of government cuts and market reforms.  This wasn’t what the party had promised when elected in 1974, and the government was grudging in the reform process.  They lost the election in 1979, with Margaret Thatcher being swept to power, redoubling the pace of the reform process through the 198os.  This cut huge swathes through much of British industry – making the current economic crisis in the UK look like a picnic, whatever the GDP figures say.  It took about a decade of pain from 1976 before clear benefits started to show.

A similar hard road awaits the southern European economies.  Leaving the Euro and devaluing won’t help (during the Thatcher years, to continue the comparison, the pound stayed high), and is institutionally much more difficult than most Anglo Saxon commentators assume.  Europe’s politicians know this, and so aren’t looking for quick fixes.  They are looking at a process of near continuous crisis in which the institutions, and political culture, required to make the Euro work are gradually put in place.   Greece may be a casualty – it faces a real danger of being expelled from the Euro and probably the Union as a whole (it’s difficult to disentangle the two).  It is slowly but surely being isolated to make that option less and less of a threat to the zone as a whole.  But unlike many British commentators assume, Greece will find life no easier outside the Euro.

Martin Wolf’s gloomy article in today’s FT illustrates the difficulty Anglo Saxon commentators have in viewing the scene – and Mr Wolf is no shallow commentator.  He makes reference to the comparison with Britain, thus:

This leaves “structural policies”, which is what eurozone leaders mean by a growth policy. But the view that such reforms offer a swift return to growth is nonsense. In the medium run, they will raise unemployment, accelerate deflation and increase the real burden of debt. Even in the more favourable environment of the 1980s, it took more than a decade for much benefit to be derived from Margaret Thatcher’s reforms in the UK.

Structural reforms are dismissed as taking too long.  But is there any other way that such necessary reforms can be taken forward?  Surely the British case illustrates that miserable economic performance for an extended period is unavoidable?

How different from the US approach!  By comparison, the US’s economic problems are nowhere near as great as those facing southern Europe: at the core the US economy remains wonderfully competitive.  But they have a terrible problem of government finance and social justice, which neither politicians nor public want to confront.  Instead we get a series of short term fixes, which look decisive, but which simply increase the scale of the problem that has to be tackled later.   Americans have to choose between higher taxes and reduced Medicare and Social Security benefits, or some combination of both – and yet neither are seriously on the political agenda.

In the fable the hare loses the race because he is so confident he takes a nap.  A similar misjudgement by America’s political class, abetted by British and American observers is in the process of unfolding.

 

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The Euro end game

It’s been a tough year for Europhiles, especially those, like me, who have always supported the single currency and thought Britain should have been part of it.  Most of them have been very quiet, and no wonder.  Whatever one says quickly has the feel of being out of touch and in denial.  And now this week the Economist asks in a leading article  Is this really the end? that has been tweeted over 1,200 times and picked up over 500 comments.  In today’s FT Wolfgang Munchau article is headlined: The Eurozone really has only days to avoid collapse (paywall).  Is now the moment to finally let go, and admit that the whole ill-fated enterprise is doomed?

There is no doubting the seriousness of the current crisis.  While most of the headlines have been about sovereign debt (especially Italy’s) what is actually threatening collapse is the banking system.  It seems to be imploding in a manner reminiscent of those awful days of 2007 and 2008.  The Germans’ strategy of managing the crisis on the basis of “just enough, just in time” seems to be heading for its inevitable denouement.  Unless some of their Noes turn to Yeses soon there could be a terrible unravelling.

The most urgent issue is to allow the European Central Bank (ECB) to open the floodgates to support both banks and governments suffering a liquidity crisis.  “Printing money” as this process is often referred to, seems the least bad way to buy time.  Two other critical elements, both mentioned by Mr Munchau, are the development of “Eurobonds” – government borrowing subject to joint guarantee by the member states – and fiscal integration – a proper Euro level Finance Ministry with real powers to shape governments’ fiscal policy in the zone.  Most commentators seem to be convinced that some sort of steps in both these directions will be necessary to save the Euro.

I have a lingering scepticism about these last two.  I thought that the original idea of allowing governments to default, and so allowing the bond markets to act as discipline, had merit.  The problem was that the ECB and other leaders never really tried it before the crisis, allowing investors to think that all Euro government debt was secure.

Still the short term crisis is plainly soluble, and most people will bet that the Germans will give the ECB enough room to avert collapse.  But that leaves the zone with a big medium term problem, and two long term ones.  The medium term one is what to do about the southern members whose economies are struggling: Spain, Portugal and Greece especially, with Italy lurching in that direction.  The stock answer, which is to enact is reforms such that their economies become more competitive, seems to involve such a degree of dislocation that we must ask if it is sustainable.  This treatment is not dissimilar to that meted out by Mrs Thatcher to Britain in the 1980s (an uncompetitive currency was part of the policy mix here, deliberately or not), for which she is still widely loathed.  And she was elected (though “democratically” is a stretch given Britain’s electoral system).  How will people react to unelected outsiders imposing such treatment?  Better than Britons would, no doubt, since there is so little confidence in home grown politicians , but it’s still asking a lot.

And that leads to one of the two long-term problems: the democratic deficit.   A lot of sovereignty is about to be shifted to central institutions, and it won’t be possible to give electors much say.  The second long term issue is dealing with the root cause of the crisis in the first place, which is how to deal with imbalances of trade that develop within the Euro economy.  Germany simply cannot have a constant trade surplus with the rest of the zone without this kind of mess occurring at regular intervals.  But there is no sense that German politicians, still less their public, have the faintest grasp of this.  For them the crisis is the fault of weak and profligate governments elsewhere.

So if the Euro survives the current crisis, there is every prospect of another one down the road, either political (one or more countries wanting to leave the Euro and/or the Union) or financial (say an outbreak of inflation).

My hope earlier in the crisis was that it was part of a learning curve for the Euro governments.  As they experienced the crisis institutions would be changed and expectations made more realistic, such that zone could get back to something like its original vision.  I am afraid that there is a lot more learning to do.

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Does the Euro need a Big Bazooka?

It is a commonplace amongst Anglo-Saxon policy makers that the Eurozone leaders need to use a “big bazooka” to solve the currency crisis that is engulfing the continent.  David Cameron has been particularly conspicuous in using this expression.  Is it all it is cracked up to be?

So what is a bazooka?  Originally it was a tubular musical instrument made famous by the comedian Bob Burns in the 1930s (Mr Burns and instrument in second picture).  It then became the colloquial name for an American tubular hand-held antitank weapon introduced in the Second World War (the illustration above is in fact of a more modern and shorter weapon).  This was a revolutionary innovation, using recoilless technology and the so-called HEAT armour-penetration system – which allowed infantry to threaten tanks in a way not previously possible.  The Germans quickly copied it with the bigger and better panzerschrek (“tank terror”).  They also developed countermeasures, including thin armoured outer skirts to their tanks, which set off the HEAT system before it could inflict serious damage.  In the 1960s the weapon became obsolete, replaced by more powerful technologies.

A “big bazooka” in the current context is used to mean the deployment by the state (central banks and/or governments) of overwhelming financial resources to bail out troubled banks and others in a financial crisis.  The idea is to break a vicious cycle of declining confidence in banks and others, whereby lack of confidence becomes a self-fulfilling prophecy as creditors seek to move their money into safer places.   The mere proposition of such resources can be enough to break the cycle, if credible, and prevent the resources ever having to be deployed.  The Americans can proudly point out to the use of the technique to solve a series of financial crises, from the Savings & Loan crisis of the 1980s, to the LTCM collapse of the 1990s and the Lehman crisis of 2008. Such tactics are conspicuous by their absence in the Euro crisis, fiercely resisted by the German political class in striking unanimity.

There is an irony that the original bazooka was quite a small weapon – but I suppose it was big for one held by a single infantryman, and the German version conveys all the imagery the metaphor needs.  A more telling parallel is that the bazooka, revolutionary when introduced, steadily became obsolete as the world got used to it.  No doubt the Germans will point out that the American use of “big bazooka” tactics on repeated occasions shows that there is a flaw.  The American financial system suffers a systemic crisis every 10 years or so.  This is the first such crisis the Germans have endured since their currency was refounded after the war – and that is because the Germans aren’t running the show.

The have a point.  The financial markets are amazingly short-sighted – for example that idea that the US and UK are safe havens because their central banks can overcome any crisis by “printing money”, or monetising debt, in the manner of Zimbabwe.  But the long term logic always wins in the end.  There seems to be a slowly dawning realisation amongst Anglo-Saxon commentators (for example last week’s Martin Wolf column, as well as the Economist) that the German position in all this amounts to a strategy, “just enough, just in time”, and not the absence of one – even if Mr Wolf grumpily calls it “too little, too late”.  The short-term costs of the German strategy are doubtless higher than the American way – but the longer term position is much less clear.

 

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Solving the Euro crisis means a stronger ECB

I do not regret paying my access fee to the FT website.  This morning there are two excellent articles on the Euro crisis from the two regular Wednesday morning columnists: Martin Wolf and John Kay.  It has helped clarify the way ahead for me.

Mr Kay comes in at high level to give an overview of the crisis.  It is not comfortable reading for supporters of the Euro project like me, but, as usual for this author, pretty much spot on.  The main problem is not that the currency area lacks appropriate institutions at the centre, but that local institutions in many member countries are not strong enough to cope with the pressures of being in the single currency.

The eurozone’s difficulties result not from the absence of strong central institutions but the absence of strong local institutions. A miscellany of domestic problems – rampant property speculation in Ireland and Spain, hopeless governance in Italy, lack of economic development in Portugal, Greece’s bloated public sector – have become problems for the EU as a whole. The solutions to these problems in every case can only be found locally.

So the answer will not come from strengthening the EU’s central institutions.  This goes back to the original design of the Euro: the whole idea was to put pressure on governments to reform themselves, by denying them the easy escape route of devaluation. Unfortunately the EU’s politicians forgot this in the first decade of the Euro, so no real pressure was brought to bear, making the crisis infinitely worse once it hit.

This article does not say much about how to go forward from here, beyond suggesting that grandstanding at summits like today’s may be part of the problem rather than the solution.  Mr Wolf’s looks at one aspect of how to manage the crisis itself.  This in turn in is based on a paper by Paul de Grauwe of Leuven university, who literally wrote the textbook on the Euro (I know, since I read it as part of my degree course).

Professor de Grauwe points out an interesting fact: the bond markets are much harder on the Euro zone fringe economies of Italy and Spain than they are on the UK, even though the underlying positions of the countries is not all that different.  The difference is that the UK markets are stabilised by having the Bank of England as a lender of last resort which is able to deal with liquidity crises (i.e. an inability to raise cash for temporary reasons rather than underlying insolvency).  The European Central Bank does not do this, or not enough, for the Eurozone economies.  Mr Wolf, who structures his article as an open letter to the new ECB president Mario Draghi, argues passionately that it should.  This would stop the contagion spreading from the insolvent economies of Greece and maybe Ireland to solvent but challenged economies like Italy, Spain and indeed France.

This must be right.  The Germans, who are the main sceptics, must be persuaded – and convinced that such interventions would only apply to liquidity crises and not solvency problems, and that the ECB has the integrity and independence to tell the difference, in the way that politicians never do.

Giving the ECB a wider and stronger remit will be a big help.  This should extend to supervision of the European financial system (preferably for the whole EU and not just the Eurozone).  This will help deal with one of the biggest problems for modern central banking – that of coping with spillover effects, as described in this thought-provoking paper from Claudio Bono of the BIS (warning: contains mild economic jargon, such as “partial-equilibrium”).

So a reconfigured ECB will help the Euro through the crisis and prevent self-fulfilling prophesies of doom in financial markets having to be solved in grandstand summits.  That still leaves the longer term problem of how the less competitive Southern European economies can have a long term future in the zone.  But then again, I think they would have just as challenging a future outside the zone – even if it were possible to devise an orderly exit mechanism for them.

 

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