Euro Crisis (Again)

Spreads are widening again the euro periphery. It is clear that things could go horribly wrong in the euro area, and so one needs to take this tail risk seriously. That said, I would not hold my breath waiting for a euro implosion. Things will only get scary when there once again is a synchronised downturn; I do not know whether current events are enough to trigger such an event.

UPDATE (2018-05-28): The European governing elites managed to undershoot my already low expectations for their political competence. Thwarting a democratically elected government on the theory that its proposed finance minister might have a secret plan to leave the euro is insane. Who is this guy -- Dr. Evil? Rather than using multi-national institutions to grind the shaky coalition into the dust, they managed to force a straight up and down vote on euro membership -- which is the only way to get a country out of the euro (as I wrote below...).

Book Review: Modern Monetary Theory And European Macroeconomics

Dirk H. Ehnts, a lecturer in economics at Bard College, Berlin, has written Modern Monetary Theory and European Macroeconomics. The book acts an introduction to Modern Monetary Theory (MMT), aimed specifically at the situation in the euro area. This is distinctive, as a great deal of the MMT literature discusses the situation of floating currency sovereigns (which is the preferred position in MMT, as distinct from the rest of the post-Keynesian literature, where some economists are in favour of currency pegs). The later chapters of the book give a historical explanation of the euro crisis, and offers an outline of how the euro area can be reformed. The book is aimed at non-specialist readers.

The Calculus Of Crisis

The last remaining drops of yield  are being wrung out of the global government bond market while bears run amok. Although the adage "He who panics first, wins!" must be kept in mind, it is still not obvious whether or not this a re-run of previous summer silly seasons in financial markets.

The Greek Fix

At the time of writing, the Greek Crisis of (Summer) 2015 appears to be winding down. The economic crisis should calm down, although the political situation appears to be heavily damaged. The crisis will only flare up once slowing global demand pushes the larger euro area economies back into recession. Brief comments follow.

Europe Opts For Can-Kicking Option

The can has been kicked down the road; the only question is how it will go. It is unclear whether the surrender of its national interests by the Greek government officials will survive a parliamentary vote. But if it does, Greece could return to what was considered "normal" last year. The eurocrats would finally be in a good position to take their summer vacations.

Yay For The Schäuble Plan!

Although I am not a big fan of Wolfgang Schäuble (German Finance Minister), his plan for a "temporary" 5-year Greek exit ("timeout") from the euro looks like the optimal solution. Why do I like it? It's my plan, except that I did not specify the "5-year" part. I think the choice of five years as the interval is probably the best choice. (In case it's not obvious, I am not referring to the punitive alternative plan he suggested where Greece hands over 50 billion euros in "assets" so that it can remain within the euro. That alternative was so punitive that the 5-year "timeout" was the only realistic option; in my view, the other one was only there to make it look like Greece would have a choice.)

Update (Sunday evening): Based on leaks, the insanely punitive option has been reduced to merely extremely punitive, and the "temporary Grexit" option I discuss here has been dropped from discussion. Why the Greek government would prefer being crushed by the new set of demands, when the possibility of a relatively clean exit was offered, is a complete mystery to me. The fact that the EU demands are unfair is moot, since there is no way of the political balance shifting in Greece's favour quickly enough to help its economy.

Book Review: Eurozone Dystopia

In the book Eurozone Dystopia: Groupthink and Denial on a Grand Scale, the Australian[*] academic Bill Mitchell (one of the "founders" of Modern Monetary Theory - MMT) gives the history of the euro, and argues that its underlying problem is groupthink. The mental rigidities that have built up around the euro are similar to those that surrounded the Gold Standard, and pose the greatest risk to the common currency when the next global recession hits.

Whither Greece?

Despite the rather excitable headlines, some variant of a can-kicking exercise for Greece still seems like a plausible outcome. The reality is that there is no mechanism to stop Greece from using the euro (but see comment below), and the EU has limited ability to effect a regime change in Greece after the referendum victory. The only plausible durable solution is for Greece to exit, but the Greeks broadly wish to avoid that outcome. The situation will slowly simmer, at least until there is a broader downturn elsewhere. A Chinese stock market crash could be a trigger, but it would need to be validated with effects in the real economy.

Greek Crisis To Interfere With Eurocrats' Vacations?

The Greek crisis is heating up again, with the Bank of Greece releasing a hysterical monetary policy report. Apparently all the problems were caused by elected politicians, and rampant mismanagement by the eurosystem had nothing to do with it. According to orchestrated leaks (which are designed to maximise the run on Greek banks), this weekend is allegedly a "drop dead" date, whereupon capital controls will have to be imposed if Syriza does not capitulate to the diktats of the institutions. The timing is somewhat plausible, as the eurocrats possibly believe that the fallout will be contained, and they will be able to take their vacations in August without interruptions.

UPDATE (2015-06-18):  The EU finance minister talks collapsed in acrimony. Apparently there will be a meeting Monday to discuss the situation. However, this weekend would be a convenient time to impose capital controls. Have a nice day. 

Capital Controls And Greek Euros

I am not well placed to forecast the outcome for Greece. My instinct remains that some form of deal will be cut, that will allow Syriza a chance to demonstrate whether it can undertake some positive reforms while remaining within the euro area. The run on the Greek banking system is the only thing that could derail a "muddling through" scenario. The odds appear to be rising of some form of capital controls being imposed. This could be a temporary measure, or it could create "Greek euros", which would become a de facto new currency.

Responsible Adults Are Still Thin On The Ground...

From my highly distant vantage point, it looks like the meeting of finance ministers just acted as a means of political posturing. This probably should have been expected. My guess is that there is not a large enough a coalition in favour of ejecting Greece, and so some form of "muddle through" will be opted for. In this case, Syriza would be given time to formulate detailed reforms. It was silly to expect that those reform proposals would be ready within days of being elected, as they lacked access to the machinery of state to properly analyse the details.

Where Are The Responsible Adults In Europe?

The political difficulties in Europe overshadow economics, and those difficulties are entirely political. This limits the usefulness of purely economic models for forecasting near-term trends. My instinct is that the verbal fighting between Greece and other European politicians and institutions reflect partisan animosities, which complicates the situation. However, I lean to a hope that Greece will not exit the euro, rather we will have a "muddling through" scenario where domestic reforms continue, but are changed to be less destructive for the economy.

Lessons For Greece From Alberta

The election in Greece has added a new chapter in the ongoing march towards the dismantling of the euro. The rapidity of news coverage and analysis cycles generates the expectation that events will progress quickly, but my feeling is that both sides in negotiations are playing for time. There are strong parallels between what is happening in Greece and the experience within Canadian Confederation during the Great Depression. Unequal political entities faced off within a fixed exchange rate system, and policy was hamstrung by an ideology of "sound" fiscal policy. There are lessons that can be learned from Canada's experience, but one hopes that the outcome in the euro zone will not parallel that of Canada. Canada only escaped its policy trap with the advent of World War II.

ECB Panics, Assumes That Will Help

The European Central Bank (ECB) cut its deposit rate to -0.10% today. My view is that this is a policy error - the central bank is underlining that the situation is bad, and it is being forced to contemplate crazy policies. That is certainly not going to help the Confidence Fairy return to the European real economy.

ECB - Another Step Closer To 0%

The ECB edged closer to ZIRP today, dropping the refi rate to 0.25%. This is surprising, but then, who cares about the difference at this point? It underlines that the ECB is figuring out the eurozone economy is a mess, but that's been priced into markets for a long time.

The only issue I see is that this increases the debate about unconventional policy measures in the eurozone. Since I am skeptical that the unconventional policy measures contemplated by central banks have any impact on the economy, it just ends up being a distraction.

Currency Regimes Matter If Policymakers Understand Them

In this article, Antonia Fatas argues that exchange rate regimes (like the euro) have limited power to explain differences of economic outcomes. It is based on an article by Andrew K. Rose, which looks at the currency regimes of smaller (mainly developing) economies during the global financial crisis.  

Paul Krugman responded here, noting that bond yields only rose due debt concerns in the euro countries. From the point of view of the bond markets, that is a crucial point: a country that does not control the currency of its debt emissions is just another credit market borrower, and can end up facing prohibitive default risk premia. 

Since his article illustrates that point well, I will discuss here the non-interest rate aspects of this debate. The currency regime is a critical component of Modern Monetary Theory (MMT), and so this debate is very important for understanding MMT.

Antonia Fatas’ main point is this:

I have written before my views that run contrary to the conventional wisdom. Many believe that while the Euro might make sense as part of a political process of European integration, it has had clear negative consequences on economic performance, consequences that are obvious when one looks at the effects of the current crisis in the Euro periphery countries. In several blog posts (here or here) I have provided anecdotal evidence that this conclusion is not supported by the data by comparing the performance of countries in and out of the Euro area and also by looking at the consequences of previous crisis when some of the Euro countries still had their exchange rate.

But what happens if one goes beyond the anecdotes and tries to systematically analyze the difference in performance of different exchange rate regimes? Unfortunately this is a difficult task. My own reading of the literature was that the evidence is mixed and inconclusive, there are no strong empirical results that prove that the exchange rate system has a significant effect on economic performance. But most of these academic papers were quite old.

My view is that membership of the euro is a bad idea, and will ultimately prove damaging to the economies of the countries concerned. However, he is correct that these problems may not show up in standard statistical tests. For example, it is possible that you could run a panel regression on GDP growth rates versus currency regimes and find no statistically significant relationship (this may change if we get a few more centuries of data). Why? A statistical test has an embedded underlying mathematical model of the relationship between the variables analysed. However, you need to look at the underlying economic dynamics, and see whether they are compatible with those implicit models.

The analysis by Andrew K. Rose is mainly of a panel of developing economies, and I do not find it controversial that he saw no effect of currency regimes in those economies during the Global Financial Crisis (GFC). The GFC was centered in the developed economies, and the emerging markets were unusually not a source of financial instability. This was the consensus opinion in published financial market research during the crisis. Therefore, I believe this particular analysis has little applicability to the situation of the euro member countries.

Returning to the question of euro members versus the developed economies with free floating currency regimes, I believe that the statistical differences will show up only in the following two areas:

1. Bond yields (as discussed in Paul Krugman’s article). Only euro zone markets have seen central government bond yields decouple from cash rates.
2. Countries with unusually high youth unemployment and underemployment rates (>40%). Although unemployment is too high across almost all the developed economies, the unusual total breakdowns in the employment market have only occurred along the Eurozone periphery.

That said, I find it unsurprising that statistical tests on GDP growth rates (for example) could appear inconclusive when testing whether Eurozone membership is a negative. To see why, we need to look at the economic dynamics as to why this could be so.

Exchange Rates Don’t Matter, Currency Regimes Do

My first point is that exchange rates (i.e., the price of a currency) have a limited impact on developed economies, but the currency regime (e.g., a fixed currency peg versus a floating currency does) does matter in terms of policy options that are open. (I have a bias towards exchange rate movements having limited impact on domestic economic variables; not everyone will agree with that.)

The euro is only a fixed exchange rate system within the member countries. The euro has weakened versus Asian trade competitors, so the euro does not pose a problem for euro zone countries in aggregate when analysing the impact of trade. The periphery faces a too high exchange rate, but they are outweighed in the aggregates by the larger German and French economies that are benefitting from a weaker currency. Therefore, any statistical panel of a trade effect should show a mixed effect, and the sign will depend upon how the countries are weighted within the panel.

However, the currency regime matters in how it restricts government policy (this is emphasised by the MMT theorists). Under normal circumstances, a fixed currency regime presents no binding constraints upon a government. The only time the peg matters is if the markets believe the government is unwilling to tolerate a too-strong exchange rate which is leading to current account deficits. Speculation against the currency will show up in financing problems for the government – it has to have higher interest rates to attract capital to finance a current account deficit. (Conversely, a too strong exchange rate poses little problems; the government can “sterilise” capital inflows without negatively impacting the domestic economy.) Therefore, economic differences only show up when a fixed peg is under attack. This is only a small subset of most observed data sets, and so if we do a statistical test on the entire observed data set, this will probably not show up as being statistically significant.

Observed Economic Behaviour Is Driven By Automatic Stabilisers

When we look at observed economic data, we are not observing how a capitalist economy operates without intervention. The data is the result of the interactions between the private sector and the public sector, including policymakers (fiscal and monetary) who are attempting to steer the economy in some direction. Within economics, this idea is known as Friedman’s Thermostat (as discussed by Nick Rowe in this article). (In my old field of control theory, this is the difference between an “open loop” system, and a “closed loop” system that has control feedback applied to its operation.) Nick Rowe presumably attaches a great deal of significance to the operation of monetary policy, but I emphasise the role of non-discretionary aspect of fiscal policy. In other words, the “automatic stabilisers” of the Welfare State.

My simulation of an arbitrary debt limit shows what would probably happen if the automatic stabilisers were suddenly turned off: the economy goes into freefall. This is effectively what happened during the pre-Welfare State era, when the government sector was too small to stabilise the economy. However, the Eurozone periphery did not turn off the welfare state; they allowed it to operate. Their austerity plans were largely based on cutting program spending. This meant that their deficits exploded above planned levels, and so the economy was eventually stabilised despite the planned austerity. This was made possible by ECB interventions. Since the euro is not pegged to a commodity, it is possible to finance their trade deficits with a fiat currency, and so the periphery did not face truly hard financing constraint.

Policymakers Need To Understand Their Options Within The Currency Regime

In order for there to be a difference in economic outcomes between nations with currency pegs and those with free-floating currencies, policymakers in the free-floating nations have to understand the constraints they face. However, after the worst of the crisis was over, many policymakers in the developed countries acted as if they faced the constraints of a fixed currency regime. The most well-known example is the decision by U.K. policymakers to voluntarily impose the same sort of austerity policies that Eurozone policymakers were forced* to impose. U.K. economic performance suffered as a result.

As a result, the economic performance of the “free floating” currency nations was punished by policies that replicated pegged currency regime performance. Therefore, it should be no surprise that a country like Germany, which did not get hit directly by the credit excesses before the GFC, and for whom the currency peg does not bind policy, could have a “better” performance than a badly-managed “free floating” currency nation. That said, no free-floating nation is likely to replicate the disastrous performance of the Eurozone periphery with their 40+% youth unemployment rates. Therefore, the statistical difference will have to be of the form of looking for extremely bad economic outcomes, and see which currency regime produced them.

* One could argue that the ECB could have allowed policymakers to avoid austerity policies; however, the ECB argued that it was following European law. I have no idea whether there was a legal way to avoid austerity policies, but it was clear there was no political will to do so.

(c) Brian Romanchuk 2013