Myths and facts of the Euro crisis part 4 – how to save the Euro – an analysis by João Madeira

As shown in the previous text the run on bank deposits and sovereign debt of periphery countries justified the need for an intervention to change the negative expectations in debt markets and to help interest rates converge to the good equilibrium (governments pay lower interest rates and repay their debts). The creation of the EFSF and EFSM was appropriate. This policy act has been viewed negatively by citizens of the Euro centre and the periphery alike. The view of the centre citizens is that their governments accepted paying the debts of the periphery countries. The view of the periphery citizens is that the centre countries are imposing on their countries too severe austerity measures. Both views are wrong.

Centre governments agreed to temporarily lend money to the periphery at below market interest rates (since, as argued previously, the periphery seems currently a victim of a self-fulfilling prophecy). It is in the own interest of centre governments to avoid a needless default of the periphery’s sovereign debt (since centre countries banks own a large part of that debt) and there are good prospects of an adequate return to such loans. With the help of the centre, Euro periphery governments on the other hand avoid having to adopt even more severe austerity measures. Everyone gains from these interventions. Unfortunately the creation of such funds proved insufficiently to deal with the problem.

 

Figure 1: Bank deposits growth rate
Figure 1

Currently it is not just the Euro periphery governments which face severe financing difficulties. Figure 1 shows the bank loan growth rate of several Euro countries. As one can see there is a bank run in Euro periphery countries like Greece and Ireland (and also to less extent Portugal) with clients removing their savings from banks.

It is known that no bank would be able to fully return the deposit money of all their clients if they were all to do so at the same time (because the deposit money is being used in long term investments). All would be hurt. It is therefore necessary to prevent bank runs. Therefore the ECB interventions in December 2011 and February 2012 of providing three year loans to banks at low interest rates were also necessary. Unfortunately these interventions were also insufficient. A plausible explanation is that banks owe a lot of the sovereign debt of periphery governments and therefore to solve the bank run problem also involves solving the periphery sovereign debt problem. Another reason is the concerns with a potential Euro exit of some of the periphery countries. In this aspect I think that European leaders did not act in the best way. A Euro Greek exit has been mentioned as the inevitable consequence of a default on its debt (I think as a way to persuade Greek citizens to not vote for populist leaders that oppose austerity measures and also as a way to create political pressure in favour of a fiscal union supported by many politicians).

There is however no motive to link the use of a currency with the repayment of debts (when an American citizen defaults on its mortgage this does not prevent him/her continuing to use the dollar and when the state of Arkansas defaulted on its debt in 1933 it was not forced to abandon the dollar). I think a default on sovereign debt may become a necessary measure for the Greek government (or others in the periphery) but this should not imply a Euro exit. By establishing a connection between the repayment of debt and Euro membership European politicians contributed in a needless way to the worsening of the run on banks. The fear of a Greek exit from the Euro is in my view aggravating the economic situation in Greece (why would a company pay its suppliers today in Euros if there is a chance it can pay them tomorrow in Drachmas instead? Suppliers are aware of this and therefore reduce credit to clients).

Since prior interventions failed to address the problems of sovereign debt and run on banks, further stronger measures were needed (especially because financial markets are highly interlinked and therefore very vulnerable to contagion; one should recall that the Great Recession started in a small section of the USA mortgage market and from there spread to the US and European financial sectors – that is, there is the risk the current periphery problems will spread to the Euro centre and even beyond the eurozone). It is in this context that one should look at the recent ECB intervention on September 6, 2012. The ECB is proposing to buy debt in unlimited quantity, from the countries in difficulties, as long as such countries commit to adopting structural changes in order to increase long run growth perspectives (a problem which, except for Ireland, has plagued most European countries for a long time).

This seems to me to be the best solution to the eurozone problems. An alternative solution could be to allow the default of sovereign debt of periphery countries. If this leads certain banks into bankruptcy as a result then new investors would be invited to buy their assets maintaining their responsibilities to depositors (the old shareholders and other creditors would suffer the losses). However, this would be a risky solution; one needs only recall what happened after the Lehman Brothers bankruptcy.

Another possible solution, desired by many, would be a fiscal union. This would however be very complex to implement (it would take years to negotiate) and the fears of centre countries to adopt it seem understandable. One other solution would be for the ECB to simply buy the sovereign debt of those countries facing difficulties unconditionally. However, if those governments did not repay their debts the eurozone would go through a period of high inflation (the outcome would be a real loss of value of the savings of Euro citizens and it would certainly be costly to return to an environment of low inflation – in the USA, the necessary credibility needed to conquer inflation in the early 80s was achieved with large interest rate increases by the FED leading to a severe recession with unemployment reaching levels not seen in decades).

The solution chosen by the ECB can be quickly implemented and with the scale that is deemed necessary (it has therefore a good chance of solving the bank run and sovereign debt problems) and by requiring long term structural changes to the beneficiary countries it attempts to ensure these will be able to repay the debt (avoiding not just a future inflation problem but also achieving finally a way out of the European growth stagnation problem – there was a significant differential between the eurozone periphery and the centre in the 90s and unless structural reforms are made, periphery countries will not likely be able to borrow again at rates as favourable as those of the centre, as occurred during the first decade of the Euro).

Another important measure under discussion is that of the creation of a eurozone banking union. If there had been greater shared responsibility for deposits, supervision and regulation the current problems would not be as large (particularly in the cases of Ireland and Spain). It is also relevant to improve the regulation of the financial sector (which was at the core of the Great Recession).

To remove the implicit government subsidy to large financial firms is very hard (particularly after the bailouts of recent years, certainly everyone expects governments to rescue systemically important institutions) but it is important to reduce it (possibly through living wills which would give regulators a plan for shutting down complex financial firms).

Due to such difficulty, it seems necessary to me to also have regulation which separates commercial banking from more risky financial activities (as proposed by the Vickers commission and the Volcker rule) and/or higher capital requirements (as required in Basel III). This is also not an easy proposal, since one does not wish excessive regulation to prevent financing of good investment projects and also because the complexity of financial activity makes it hard to detect infractors.

 

Figure 2: Current account balance in percentage of GDP
Figure 2

Could a Euro exit also be a good solution for some of the Euro periphery countries? I’m of the firm opinion the answer is no. Figure 2 (above) shows the current account balance in percentage of GDP for several countries after 2008. The graph is a good illustration of some of the evidence mentioned previously. Despite having lost competitiveness similarly to periphery countries, the Netherlands has a trade surplus (an indication that periphery deficits are indeed, for the most part, not the result of an exchange rate misalignment). Iceland, whose currency fell sharply in value in 2008, is also an interesting case. One can see how significantly its current account improved subsequently as a result. However, this did not solve the core problem (its current account stopped improving since mid 2009). If one looks at recent data it is possible to see that Iceland is the country with worse current account balance of those considered. On the other hand, Portugal has obtained consistent and sizable improvements in its current account.

It doesn’t seem to me therefore desirable for periphery countries to exit the Euro. The benefits of currency devaluation would disappear after a relative short time period (two to three years, possibly less…). In the long run it is improbable that there are benefits of devaluation (Kalyoncu, Artan, Tezekici e Ozturk, 2008, looked at devaluation episodes in 23 countries and found long run output growth to be affected in only nine countries, in six countries there were negative long run effects and in three there were positive long run growth effects).

If a periphery country decides to leave the Euro the costs will certainly be high. Banks will enter bankruptcy although their foreign debts will stay denominated in Euros whereas their domestic assets would be redenominated in a new currency of lesser value (this would certainly negatively impact credit availability to citizens and businesses alike). There would be a massive bank run on deposits. There would be litigations for years to decide which contracts should remain in Euros and which should see conversion to the new currency. A Euro exit would certainly be a traumatic event. Would it be worth it for benefits that would perhaps last only two years (Rose and Yellen, 1989, results even question whether there are significant effects in the short and medium run)?

That is, the creation of the Euro may not have been a good idea, but currently exiting the Euro looks to me to be certainly a bad one. There are many that compare the Euro to the gold standard in place at the start of the Great Depression. There are certainly similarities but many differences as well. The gold standard was more than a fixed exchange rate system. The gold standard prevented countries in recession from adopting expansionary monetary policy. This does not happen with the Euro (since the start of the Great Recession the ECB has reduced its target rate significantly and expanded its balance sheet substantially).I also do not think the Euro is condemned to failure due to the absence of a fiscal union (Ireland maintained a fixed exchange rate with the UK between 1922 and 1979 without major problems).

Are there other alternatives to Euro periphery countries to austerity and structural reform? The ECB reference rate is still higher than those of the BoE and FED, so there is still room for further expansionary monetary policy on its part. However when interest rates hit close to zero, monetary policy becomes increasingly difficult (see for example John Cochrane’s blog post of September 4, 2012).

Another much debated idea is that of fiscal stimulus. Keynesian theory predicts substantial multipliers when interest rates are at the zero lower bound. This can certainly be an option for countries like the UK, USA and Germany but certainly not for the Euro periphery since these governments cannot obtain financing at low interest rates (but it should caution against the dangers of too much austerity). Even for the USA and UK I have serious doubts whether fiscal stimulus is a good choice. The empirical evidence of large fiscal multipliers is quite a controversial issue in economic research (Barro, 1991, did not find substantial multipliers; for a recent survey of favourable evidence to fiscal stimulus I recommend Romer’s 2011 Hamilton College’s lecture). The success of such policy would also depend on increasing government spending during the recession and then reduce spending (to avoid future increases in distortionary taxes) once the private sector returns to a robust growth path.

But would it be easy for future governments to cut public spending? Would it be easy for future governments to cut civil servant wages or pensions? It seems to me the answer is no; politically it would be much harder to make unions and pensioners accept cuts when the economy returns to robust growth (in practice the increase in government spending would likely become permanent). Another problem is that financial crises can lead to prolonged recessions (one needs only recall Japan’s lost decade). Certainly it could prove problematic for even countries like the US, UK or Germany to sustain large systematic deficits for a long period of time.

I don’t believe therefore there is a magical cure that would enable Euro periphery countries to avoid adopting austerity measures and structural reforms. The return path to prosperity isn’t easy but I certainly believe in the ability of Euro periphery countries to achieve it (the Irish example in the 90s shows well how adopting good institutions can quickly change a country’s wealth creation dynamics)

 

João Madeira

University of Exeter

 

References:

Data for figure 1 can be obtained from the ECB website:

http://www.ecb.int/stats/money/aggregates/bsheets/html/outstanding_amounts_2012-07.en.html

Data for figure 2 can be obtained from the OECD website: http://stats.oecd.org/

John Cochrane’s blog can be found here: http://johnhcochrane.blogspot.co.uk/

Barro, Robert J. (1981). “Output Effects of Government Purchases,” Journal of Political Economy, vol. 89(6), pages 1086-1121, December.

Kalyoncu, H., Artan, S. ,Tezeciki, S. & Ozturk, I. (2008). “Currency Devaluation and Output Growth: Empirical Evidence from OECD Countries.” International Research Journal of Finance and Economics, 14: 232-238.

Romer, C. (2011). “What Do We Know about the Effects of Fiscal Policy? Separating Evidence from Ideology”, invited lecture at Hamilton College, November 7.

Rose, Andrew K. & Yellen, Janet L. (1989). “Is there a J-curve?,” Journal of Monetary Economics, vol. 24(1), pages 53-68, July.

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