We are back onto Greece again today as the crisis deepens. Overnight Spain is appearing to be under bond market pressure and the Germans are calling for even harsher fiscal rules to be applied to keep member states “solvent”. The point is that none of the remedies being proposed will ultimately work. What is needed in the Eurozone is a major boost to aggregate demand. However, the policy direction is to further undermine spending in the member economies as austerity measures are being imposed throughout. This foolish reverence of the Stability and Growth Pact will worsen things. The problem in the EMU is that the basic design of its monetary system is flawed and the accompanying fiscal rules only accentuate those design flaws. None of the remedies being proposed by Euro leaders will work and the bailouts will not save the Eurozone. It has to fundamentally redesign its system or disband.
Paul Krugman’s recent blog – Default, Devaluation, Or What? – published May 4, 2010 raises some interesting questions about the current situation in the Eurozone.
Krugman notes the obvious – that the EMU bailout for Greece will fail:
Consider what Greece would get if it simply stopped paying any interest or principal on its debt. All it would have to do then is run a zero primary deficit — taking in as much in taxes as it spends on things other than interest on its debt. But here’s the thing: Greece is currently running a huge primary deficit — 8.5 percent of GDP in 2009. So even a complete debt default wouldn’t save Greece from the necessity of savage fiscal austerity. It follows, then, that a debt restructuring wouldn’t help all that much — not unless you believe that getting forgiveness on much of Greece’s existing debt would make it possible to take on substantial new debt, which doesn’t seem very likely.
This statement is only partially true. A complete debt default will not save Greece now under current institutional arrangements associated with its EMU membership, given its need to run on-going deficits.
However, default (or renegotiation of its Euro obligations into drachma) would help if it abandoned its membership of the EMU. Ultimately the way the events are unfolding the EMU will not be able to maintain its integrity without significant changes.
But it is true that under current institutional arrangements the bailouts will not work. They will have a short-term palliative impact only on the bond markets but cannot overcome the intrinsic dysfunction in the Eurozone structure which has led to this crisis.
The austerity packages that will accompany the bailouts will also make things worse.
Even the mainstream macroeconomists such as Charles Wyplosz realise the situation is past the point of no return. He wrote on May 3, 2010 that:
Eurozone members, the IMF, and the ECB have announced significant commitments to assist debt-laden Greece. This column outlines a dark scenario in which the plan fails and contagion spreads, necessitating further assistance to other indebted Eurozone governments. That could risk high inflation or debt problems for the entire Eurozone.
The weekend announcement of a new plan for Greece, topped by the ECB decision to accept low-grade Greek debt instruments, is commonly seen as a European success. Quite to the contrary, we may have just planted the seeds of an unraveling of the monetary union.
He emphatically concludes that the bailout “plan will not work”. Why? Because the scale of adjustment that is being imposed on Greece – reducing its “deficit by 11% of GDP in three years” is not a realistic goal.
This point was always obvious. The austerity plan that is being imposed on Greece will increase the budget deficit not reduce it.
Some commentators have argued that because there is so much tax evasion in Greece the automatic stabilisers are much weaker than in other more “tax-compliant” economies. So a sharp cut-back in government spending may induce a deeper recession but the loss in tax revenue will be muted. The data doesn’t suggest that proposition to be true.
The following graph shows the annual percentage change in Greek government spending, revenue and overall GDP growth for the years 2007 to 2009. The data is available from Eurostat. The graph tells us two things.
First, the Greek government cut back spending when it should have increased it as the crisis worsened. Trying to stick within the Maastricht straitjacket has worsened their crisis and a “free” sovereign nation would have been able to mount a more concerted attack on the private spending collapse. Most of the spending collapse has come from private capital formation and exports. Both components of aggregate demand plunged in 2009 (Investment down around 12 per cent and exports down a staggering 15 per cent).
Second, tax revenue in Greece is highly cyclical.
So I expect the budget deficits to worsen as the austerity packages are implemented in Greece.
Wyplosz notes that the austerity plan “will provoke a profound recession that will deepen the deficit” and, given the way the EMU monetary system is structured, the Greek government will have to keep placing debt in the private bond markets. This need is what has brought the Eurozone to this point. It is going to get worse.
So how can Greece possibly satisfy the demands on it, given it is hamstrung by the internally inconsistent EMU Treaty rules? Answer: they cannot!
Within the logic of the EMU, there are only two outcomes: (a) The EU governments keep tipping bailout funds into Greece and then Spain and onto Portugal – without resolving the basic dysfunction in their monetary system; or (b) Greece will have to default.
If you examine the “refinancing” schedule facing Greece given the maturity dates of its debt and the fact that it will run on-going and probably increasing deficits for years to come, you quickly conclude that the financing conditions facing the government will worsen as time goes by.
Wyplosz says that the markets “will further raise the interest that they request to roll over the maturing debt or simply refuse to refinance the debt”. Then what happens?
Greece becomes dependent on the IMF or the EU for further finance in Euros despite the fact that a legal challenge under Article 125 of the European Treaty is almost certain. The bailouts challenge the basic rules that are being imposed on Greece.
The so-called “no bailout rule” Article 125 says:
1. The Union shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project …
Given the bailouts are seemingly inconsistent with Article 125, why impose one of the Treaty rules yet violate another, especially when the rule being enforced will have severe consequences for economic growth and living standards? This inconsistency is further evidence that the EMU is dysfunctional and should be disbanded.
In recent days, the news is creeping out that Spain is lining up to be the next victim of this absurdity. Given the larger size of the Spanish economy, the implied bailouts will be much larger than anything contemplated for Greece.
As Wyplosz notes:
What has been offered to Greece cannot be refused to other Eurozone governments. So, one more time, a (dwindling) group of deficit-stricken countries will have to provide money to increasingly large debtors. In fact, this process means that ultimately there is no national debt anymore, at least for the next few years. In effect, in the market eyes, there will then be just one Eurozone debt. Could markets run on all Eurozone public debts?
This crisis is 100 percent the result of the way the EMU structured its monetary system. None of this is happening in the sovereign nations. Japan has been consistently running significant deficits and adding to its public debt ratio for years. It certainly has problems but they are not of a solvency or financial nature. They face the challenge of promoting real growth and job creation. The Japanese government does not face insolvency.
Krugman says that:
… the only way to seriously reduce Greek pain would be to find a way to limit the costs of fiscal austerity to the Greek economy. And debt restructuring wouldn’t do that. Devaluation would, if you could pull it off.
So devaluation of the Euro against the other major currencies may stimulate net exports. For Greece, export revenue (shipping and tourism) fell sharply during the crisis. But overall, the majority of the EMU trade is within the Eurozone and so a devaluation is unlikely to have a large enough effect.
Further, while the devaluation was taking time to work (there are long and uncertain lags in trade responding to terms of trade changes) economic growth would have to be supported with on-going public deficits which are under attack within the EMU as a result of their SGP criteria.
A devaluation accompanied by a major fiscal initiative at the Eurozone level may help somewhat. That is, if the ECB, for example, agreed to a Euro per capita transfer to each nation of x billion Euro (as a one-off fiscal support strategy) this would ease the borrowing constraints and stimulate each private economy. That might help.
However, the explicit ideological choice not to include any fiscal redistribution system within the design of the currency union suggests that the ECB will never consider such a move.
Further, it would only temporarily stave off the crisis. The basis of the crisis is not the collapse in aggregate demand that has occurred around the world – that has triggered the crisis. The basis of the crisis is in the very design of the Eurozone monetary system. The national governments are unable to respond to a major collapse in demand because of the Treaty rules.
So temporary bailouts will ultimately fail. The solution is to abandon the currency union or cede fiscal authority to a Eurozone government and not constrain that government with any irrational fiscal rules.
Wyplosz thinks that an alternative to the bailouts is “debt monetisation”. He says that:
The Greek debt is about one sixth of the ECB monetary base, already bloated after one year of credit easing. Absorbing part of this debt is doable. In fact, it is being done. The ECB has already on its book a lot of Greek debt as collateral for its lending operations. Having just accepted to continue accumulating more, even though its previous rule would have forbidden doing so after the latest rating downgrades, it would be surprising that much of the debt, now sub-investment grade, does not end up on the book of the ECB.
This would be a sensible option for the ECB to take. They are not financially constrained and can provide the Greek government with sufficient Euros to allow it to stimulate economic growth and resolve the crisis the sensible way. The ECB has bought Greek government debt via repurchase agreements with other banks (including the national central banks in the system). So they don’t technically own these assets. But if the Greek government is forced to default, the loss would be the ECBs anyway and they would face no financial constraints in bearing that loss.
Wyplosz, however, claims that if the ECB took this path then:
… you have the seeds of very, very high inflation.
Well only if the EMU approached capacity saturation and no further economic growth was possible. They might introduce guidelines on government spending to ensure it stimulated real growth rather than built statues of failed leaders! But there is no inflation risk in the Eurozone at present – quite the opposite – the risk of deflation is endemic.
Whatever, none of these proposed remedies will solve the basic design flaws in the monetary union.
To review the arguments I have made against the effectiveness of the common currency and the options facing the individual member states, the following blogs may be of further interest to you:
- Euro zone’s self-imposed meltdown
- A Greek tragedy …
- España se está muriendo
- Exiting the Euro?
- Doomed from the start
- Europe – bailout or exit?
- Not the EMF … anything but the EMF!
- EMU posturing provides no durable solution
The beginning of defaults …?
Bloomberg News carried the story overnight that – Merkel’s Coalition Calls for EU ‘Orderly’ Defaults – published May 4, 2010. This is the first sign that the EMU bosses are preparing for a sovereign default within their system.
The Report says that German Chancellor Angela Merkel appeared on ARD television on May 3, 2010 calling for a process which would allow:
… the ‘orderly’ default of euro-region member states burdened with debt to avoid a repeat of the Greek fiscal crisis … [which] … would ensure that creditors participate in any future rescue …
According to the German Finance Minister Wolfgang Schaeuble, the Germans are seeking “the possibility of a restructuring procedure in the event of looming insolvency that helps prevent systemic contagion risks”.
They also want tighter rules and monitoring of deficits in the EMU to prevent a similar crisis from happening again.
So you realise that they are so caught up in their own rhetoric that they cannot see inside their system and view the rotten core. The same logic that led to the imposition of the fiscal rules in the first place and the failure to include appropriate fiscal redistribution mechanisms to cope with asymmetric shocks is still at work.
They now think that a future crisis will be prevented if they tighten the SGP criteria even further. However, automatic stabilisers do not obey self-imposed fiscal rules. Budget deficits will break the revised (tighter) fiscal thresholds just as they have broken the current limits.
Budget deficits are endogenous because they are significantly driven by private spending. This is not to say that the discretionary element is not unimportant. It clearly is. But when I say the budget outcome is endogenous I am saying that the government cannot with any certainty predict what the outcome will be – ultimately private saving desires will drive the outcome.
But you get the impression from this rhetoric that the process of default is beginning and the so-called haircuts are almost inevitable.
After I considered these offerings I read the latest tripe from Nial Ferguson who has revealed himself during this crisis to be a self-promoting ignoramus – at least when it comes to saying sensible things about monetary systems. But anything to sell a book I suppose.
The Financial Post carried a Q&A session with Ferguson this week (Published May 1, 2010). The introduction revealed that the journalist also hasn’t a clue. Accordingly:
Niall Ferguson’s resumé could put you to sleep. He’s a senior fellow here, a professor of this or that there. But despite hanging out with the elbow-patch crowd, this Scottish intellectual and author smoothly blends history, finance and politics all into one understandable package.
The only correct statement is that he puts one to sleep. Further, no academics wear tweed jackets with elbow patches much these days.
But a more correct statement would be that he blends a distorted account of history and a flagrantly ill-conceived view of how monetary systems operate with an ideological disposition to right-wing politics to interact with his readers/listeners at the level of ignorance and emotion – with the ultimate aim to sell his book by scaring the bejesus out of everyone.
Advancing one’s own agenda by fear is an act of terrorism.
Anyway, in this interview he is commenting the UK economic situation as input into the election campaign. This is what he said about Greece and the UK:
The situation of the United Kingdom in fiscal terms is in fact worse than the situation of Greece … The trajectory of U.K. public debt over the next 30 years, absent a major change of policy, will take it to a mind-blowing 500% of GDP, which is about 100 percentage points worse than Greece. If Britain had done what many right-thinking people thought it should do and joined the euro, the situation of Britain would be worse than that of Greece today. The only reason that Britain isn’t an honourary member of the PIIGS club, along with Portugal, Ireland, Italy and Spain, is that it stayed outside the eurozone and therefore reserves the right to debase the currency as an exit strategy … Britain has a massive fiscal crisis that is just about to break … The situation is so unpromising that I would anticipate the International Monetary Fund having to come into Britain as it did in 1976.
The reference to the IMF intervention in 1976 epitomises the intellectual dishonesty that permeates Ferguson’s work and public statements.
The IMF Crisis for Britain covered the period from October to December 1976 although it had its origins in 1974 after the OPEC oil shocks in 1972 and 1973. The actual IMF loan was in December 1976 to stave off a collapsing sterling. The available documents show that the British government had already decided to implement the reforms that were later attributed as “loan conditions”.
To understand the nature of the intervention it is important to realise this occurred at the cusp of the Keynesian-Monetarist paradigm struggle as the latter was gaining ascendancy among policy makers and the old Keynesian full employment paradigm was being abandoned. This period marked the beginning of the neo-liberal dominance.
The government at the time also succumbed to the poor advice of its policy advisors – to wit, that deficits would “crowd out” private spending and that Ricardian Equivalence was operative and would kill economic growth. They began to articulate what it now known as the supply-side agenda that is characteristic of the neo-liberal period. That is, it is based on the erroneous belief that demand management (via variations in discretionary net public spending) is futile and will only generate inflation. Alternatively, deregulation and tight fiscal policy is the way to stimulate entrepreneurship and economic growth.
The British government of the day fell for this nonsense and in doing so were exposed to the logic of an IMF intervention, which is also part of the “supply-side” package.
So the pressure for an IMF intervention was being pushed heavily by the growing Monetarist lobby around the world.
But more importantly, the sterling crisis occurred because Britain was still running a fixed-but-adjustable exchange rate peg with limited capital mobility. So it was a currency crisis brought on by a failure of the British government to fully float its currency. The drain on its foreign currency holdings was inevitable under these arrangements.
Further the Bank of England had to increase interest rates to maintain the currency peg. This damaged the domestic economy which then pushed the budget further into deficit via the automatic stabilisers.
The so-called government solvency crisis arose because the government refused to float the sterling and abandon its gold-standard rules which forced it to match its net spending with debt placements in the bond markets. The growing influence of monetarism also prevented the UK government from pursuing the opportunities available to them as a sovereign government once the Bretton Woods system had collapsed in 1971.
Many governments hung on to vestiges of the convertible currency system usually by running dirty floats (or managed pegs).
The point is that Ferguson would know this. Whether he understands the significance of it is another matter. But based on his public statements he either doesn’t understand it (ignorance) or does understand it and knows his readership doesn’t and decides to deceive for ideological gain (dishonesty). Either way he doesn’t come out of it well.
The fact is that the UK government faces no solvency risk. There is no currency crisis emerging because the sterling is floating and the Bank of England does not have to shed foreign reserves in its defence.
If the currency continues to depreciate then the terms of trade will continue to improve and net exports will benefit. The on-going deficits will also continue to support some semblance of growth while private investors regain confidence.
As noted above, Greece is stuck in a monetary system that allows it no effective space to manage their own economy and thus grow their way out of the crisis. The UK is totally sovereign (unlike 1976) and can continue to use budget deficits to support growth.
Economic growth is the way that these crises are resolved. Pursuing austerity worsens them.
Ferguson then went on to talk about global politics. He claimed that the President of the US “is no longer indisputably the most powerful man in the world. There is a sense he has to deal with his Chinese counterpart as an equal”. Why? (although who cares!):
Diplomatically, because of the financial interrelationship between the United States and China, the President cannot treat his Chinese counterpart anything other than an equal.
This is just a replay of the myth that the Chinese government among other foreign governments are financing the US deficit and if it sells its holdings of US dollars and/or its US Treasury bills then crisis will worsen and the US government will face rising yields on its debt and eventually the dollar will collapse.
There is no truth in any of these fears. China can only get access to US dollars by running a current account surplus – that is, shipping more stuff to the US than the US ships to them (with allowance for the invisibles on the current account). The accounting for these transactions are straightforward. The US banks representing the Chinese trading firms see rising account balances to the credit of their clients.
If the client then buys US government bonds, the client’s bank transfers the funds to the Federal Reserve bank “Treasury Account”. So the funds move from one account to another. End of story. When the Treasury retires or services the debt, reversals of these accounting operations occur.
The important point is that the US government issues and spends the US dollar. No-one else has this capacity. Further the Treasury bonds that the government issued are bought by whoever with the funds that the US government has spent in the past.
There are no constraints on US government spending imposed by the “nationality” of the purchaser of its debt.
I imagine Ferguson doesn’t understand these issues.
The EMU is entering the next phase of the crisis which will further expose its dysfunctional structure. The bailouts, the IMF intervention and all the talk about orderly defaults cannot overcome this basic design flaw.
The financial markets can drive the Eurozone into the ground – first Greece, then Spain, then Portugal then …. – and the current logic of offering bailouts will not be able to forestall this leapfrogging crisis.
The EMU bosses will have to eventually understand that they have to make fundamental changes to the design of their system or disband it. The Greek government should realise that it is in their best interests to leave the system immediately and start regaining control of their own affairs.
That is enough for today!