Friday, October 21, 2011

Explaining Europe

Ryan Avent of The Economist magazine manages to explain the whole Eurozone problem in one paragraph, and the solutions in the next:

Why not blame Germany?

...The crisis in the euro zone is not mysterious. People are proposing lots of different solutions to the problems because they're trying to hit on the magical combination of policies that will win political support from key players—notably the German government. But we know what the matter is. Many members have too much debt. Prior to the crisis, all euro-zone countries were able to borrow on terms which suggested that markets believed the full faith of the euro zone as a whole to be behind individual members, and some governments borrowed too much. After the crisis, markets weren't so sure about what the full faith of the euro zone meant, and spreads between the bonds of different euro-zone governments diverged. For the past year and a half, some euro-zone economies have struggled to make their way out of trouble within the confines of the union: without the ability to depreciate their currencies or set an independent monetary policy. The austerity adopted to try and balance budgets gutted internal demand, leaving those struggling economies dependent on external demand for growth. But where an independent currency would have fallen to help markets clear, euro-zone members were forced to make their adjustment through declines in nominal wages—a difficult and painful process even in countries like Ireland, which have very flexible labour markets. Other euro-zone governments have offered enough help to prevent an implosion of the financial system, but not enough to do much about massive unemployment problems in places like Spain and Greece. Without growth, closing budgets through austerity is like trying to climb a falling ladder...

...There are lots of ways to attack this crisis. It could be solved easily enough if the ECB began behaving as a national central bank would. It could be solved through a move to a true fiscal union. It could be solved through Rube Goldberg plans that approximate one solution or the other. It could be solved through massive external support. All that's necessary to solve the crisis is to show markets that the money is there to pay off the creditors. Show it to them, wave it in their faces, and they'll calm down. Then you can take the next step and talk about reforms, integration, and what have you. Germany, through its sheer size, its political clout, and its influence on the ECB, can make sure the money is there to end the crisis. No other euro-zone economy can. It's my understanding that Germany enjoyed its strength within the euro zone when times were good, surpluses were huge, and it was splashing out cash to the periphery. Now it seems to want to shrug and pretend it never asked for its dominant position. At a minimum, it seems willing to use the crisis and its strength to force as much of the cost of adjustment on others as possible, in a fashion that's clearly dangerous for the global financial system.

Short and to the point, and cuts through a lot of the bull I’ve been reading in the last few months.


  1. George Soros has something similar at Project-Syndicate as well:

    Not as concise, but the plan is the same. Calm the markets, then reform. With the yields as they are now, no amount of money is going to be able to service the debt.

  2. Check out Ambrose Evans-Pritchard - I think he's the best commentator on Eurozone problems.

  3. What caused the crisis?

    Well, you had the European Central Bank leaving interest rates too low for too long - catering mostly to the German situation, to the neglect of the PIIGS.

    This led to huge economic imbalances between the Northern and Southern states - and this being a microcosm of the imbalances between East Asia (particularly China) and America (both China and America operating on a pseudo-peg, thus in some ways similar to a single currency).

    There was a recent article in the Wall Street Journal which pointed out that having floating currencies is the real innovation (~40 years since Nixon closed the gold window). Fixed exchange rates had always been the "natural" regime.

    I think it is now a good time to properly delineate the differences between a fixed exchange rate regime, and a floating rate regime - their respective advantages and disadvantages.

    My preference is indeed for a fixed exchange rate regime, but – as the past century has shown – such a regime is only sustainable provided monetary policy is appropriate. Unlike the gold standard, the euro doesn’t fulfill this condition.

    Appropriate central bank policy goes beyond imposing the European Stability Growth Pact. The views of mainstream economists was that the main consequence of increasing the money supply was CPI inflation, while underemphasizing or being oblivious to other form of economic distortions that it creates (e.g. current account deficits, damaging the price system, asset bubbles, etc.).

    It may therefore be claimed that a floating exchange rate regime is perhaps better than fixed exchange rates so long as we live in a world of improperly managed fiat currencies.

    There are only two pathways.

    (i) If the EMU is to be retained, then the Northern states would have to bail-out the PIIGS. The PIIGS had problems, but they aren't fully culpable - given that monetary policy did not suit their conditions.

    (ii) Disbanding the EMU. Ambrose Evans-Pritchard suggests the Northern states using a new Deutschmark/Thaler, while the other states (with France) would continue to use the existing euro.

    The ECB goofed up big time, and yet to rectify for their mistakes, some are proposing to grant them even more power - when it is clear that they do not fully know how to employ existing tools nor the consequences of their actions. That being said, central bank instruments are necessarily 'blunt'...

    Moving towards a fiscal union has tremendous implications for national sovereignty for the European nations. This issue is less of an economic but a political one. Of course, some do envision the European Union to be a federal state like America - I think that is difficult to achieve, given the differences in their history, culture and temperament.

    Either way, it is probably better for other nations including Malaysia to deal with 20 different European nations than a single unified European Union. Just ask the Swiss...

  4. I think the cause of the crisis goes beyond prolonged low interest rates. It is more fundamental than that. For Greece, it is mired with corruption, lack of competitiveness, and quite frankly, a very lazy population. I think it is more of a crisis of competitiveness. While you may argue from the currency point of view, yes, having their own currency can help "improve competitiveness", but this is only a short-term solution. Being able to depreciate your own currency will not solve your long-term structural issues. The Greek's really need to dig deep and change their attitudes.

    This is the same for Spain and Italy. If you look at their budgets, they have been managing their fiscal policy rather well. The problem is in their current account. These countries have been running CA deficits (with the exception of Greece, which runs twin deficits). This points towards the lack of competitiveness in exports. While you may argue that affluence allows you to import more goods, let us just look at Germany. They are still able to maintain a strong CA surplus. And we all know how competitive the Germans are.

    This currency and fiscal union thing is only going to be a stop-gap measure. If the Eurozone countries do not take a serious look into improving their competitiveness (which means giving up some of their welfare policies like 30-hour work weeks, 5-day weeks, huge pensions etc), no amount of fiscal union or bailouts is going to stop this from happening again and again.

  5. Yes, but the current account deficits are induced by the inappropriate monetary policies which the European Central Bank are running. It's similar to the situation between America and China.

    That is not to say that every balance of payments issue can be attributed to monetary policy. The point is that monetary policy can lead to economic imbalances, and current account deficits are one possible manifestation of that.

    From this perspective, I disagree with the moralizing tone of Germany. The PIIGS are really less culpable for the EMU problems.

  6. Some nice articles further elaborating on my point:

  7. There are a lot of parallels between what is happening in the EMU today and the Bretton Woods era. Goh Keng Swee's "Wealth of East Asian Nations" is a particularly good resource, though he is not necessarily correct on every point.

    There was effectively a single currency then, and replace Greece with America and Germany with... well, Germany and the rest of the world (including the French, Swiss, Japan).

    The American dollar had to be depreciated - there were only two ways to bring it about: one was to revalue the price of gold, thus retaining fixed exchange rates; the other was to have a system of floating exchange rates. The second option was deemed more politically viable, though even from its inception it has never worked according to the ideal.

    The Bretton Woods system and its subsequent break-up revealed the massive differences between fixed and floating exchange rates.

    Depreciation is really a debt write-down. America's debt burden was massively reduced after Nixon closed the gold window.

    This is what the Southern European states need. However, if they are to remain in the EMU - this debt write-down would have to be done via bailouts, and they would be caught in a monetary deflation scenario thus preventing economic recovery. This deflationary spiral could get out of hand, potentially leading to more bailouts. This is how fixed exchange rate regimes work - however, the gold standard ensured that such required adjustments were fairly small in magnitude, so these episodes were not that painful. (this is unrelated to the Great Depression - that's another story, which was caused by the goofing up of government and central banks.)

    The only other feasible way of a debt write-down is to breakup the EMU - this would allow the South to depreciate their currency (the existing euro), while the North will have a higher-valued new currency. If there is to be economic recovery for the Southern states, this is the only pathway.

  8. Good comments all, I've hardly anything to add. You guys might want to read this though. Historically, fixed exchange rates may have been the norm, but they are not "natural".

  9. I am not disagreeing with the issue of excessively loose monetary policy. The question is, why? I don't think it is acceptable to attribute it simply to poor monetary policy.

    I would say that there is certainly more than one reason that has led to what they are facing today. As I said, the problem that the PIGS are facing extend far further than the era of low interest rates. The corruption and general laziness has been going on for decades (long before the Eurozone). This is just what I found to be glaringly "absent" from the general debate. Greece, Spain, and even France have tried to implement shorter work weeks, shorter working hours decades ago and it has finally caught up to them. People from China are not only earning lower wages, but they are working 7-day weeks. Of course, it is not a truly fair comparison, but it is an example of the lack of competitiveness of the Eurozone countries.

    The problem has only been exacerbated "recently" due to their inability to depreciate their currency to remain competitive. And depreciating the country's currency is a form of suffering (in my opinion). After all, a strong currency (in the long run) indicates strong economic fundamentals.