The Future of the Euro Area: Growing Closer or Falling Apart?

Last time, we argued that monetary expansion is necessary to pull the PIIGS out of recession and the debt crisis. In the final post of this series, I’ll discuss the outlook for the European Monetary Union. While this crisis is an opportunity to address the deep-rooted problems in the eurozone, European leaders must decide at what cost they’re willing to preserve the currency union.

An Opportunity to Achieve Closer Integration

After two world wars, Europe came to realize that prosperity can only come with continental peace and stability. Since then, closer cooperation and integration have been Europe’s goals. The eurozone was set up in the late 1990s as part of the efforts to promote peace and integration.

However, the eurozone has always had structural problems, since it comprises vastly diverse economies which without fiscal union shouldn’t be allowed to use the same currency. The problems, which were obscured in good economic times, have been exposed in the financial crisis. It’s now clear that the absence of two institutions threatens the stability and sustainability of the eurozone.

First, to improve financial stability and market confidence, Europe needs a unified banking authority that monitors the industry and recapitalizes troubled banks when necessary. Second, a central authority with power over taxation, which ensures fiscal responsibility and provides a framework of fiscal transfers, is necessary to any sustainable monetary union.

Their absence has long been an obstacle to European integration, but only in a crisis can these structural problems be addressed. The current challenges have made it clear that the continued existence of the euro depends on the success of reforms. This sense of urgency and the high stakes involved have presented Europe with a perfect opportunity for closer integration.

Conflicting Interests among Euro Members

However, integration incurs painful sacrifices and is easier said than done. On one hand, the peripheral countries have to endure the pain of austerity measures and labor market reforms, which include cutting welfare spending to improve labor market efficiency and reduce economic distortions. Germany, on the other hand, is burdened with costly bailouts.

On top of the sacrifices, euro members have found it extremely hard to reach an agreement due to conflicting interests. Basically, Germany wants to spend the least possible to prop up the eurozone, while other euro members (with the exception of the Netherlands) are trying to get the most from Germany. Given the difficulty of cooperation, few concrete steps have been taken to solve the crisis.

Indeed, European leaders are still deeply divided on how to save the euro. Though deposit insurance may be the only way to save the currency union, Germany’s reluctance to insure over 2 trillion euros worth of deposits in Italy and Spain is perfectly reasonable.

Germany opposes the idea of euro bonds as well. The objection is justified though. The issuance of euro bonds will take the pressure off politicians and slow down structural reforms. More importantly, countries like France and Italy propose debt mutualization because they want Germany to share the cost of future spending. No wonder Germany rejects the deal.

Meanwhile, Germany is taking measures to minimize losses in the event of a breakup. Some argue Germany is bailing out Greece for its self-interest too. By propping up Greece’s banks, Germany can spread out the debt burden of Greece across all euro members.

Ironically, what was intended to create peace and prosperity has turned into a dysfunctional partnership that threatens the world economy. But it’s hardly surprising that every euro member is protecting and fighting for its self-interest. After all, the eurozone is composed of independent sovereigns with people of different national identities.

Breakup not the End of the World

If euro members lack the commitment to closer integration, then the exit of some countries, or even a breakup of the euro, is the only feasible option in the long term. Both a German exit (which some believe to make more economic sense than a Greek exit) and the exit of the “Club Med” countries could work.

In the case of a German exit, politicians can sell the idea abroad as a noble sacrifice to correct the imbalances within the eurozone. Internally, they can persuade voters that an exit means they no longer have to waste money on rescue packages.

The bottom line is the same rule applies in love and in politics: If different parties can’t settle their differences, then a breakup is all for the best. And a breakup of the euro doesn’t have to be the end of European cooperation. Members can remain good friends even after breakup, just like what couples do.

P.S. Sorry for the delay of this post. I was busy preparing for the CFA exam, and I just had a trip to Phuket last week. Now I’m ready to blog again. Please stay tuned for a series of new posts on personal development next week!

(Entry 4 of 4 in the Update on the Euro Debt Crisis series)

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The Need for More Monetary Expansion in the Eurozone

In the previous posts, we’ve talked about the costs and benefits of a Greek exit. This post will argue that if the eurozone is to continue, more aggressive policies by the the European Central Bank (ECB) are desperately needed.

  

Germany’s Recession and Recovery in the Early 2000s 

Even if Greece exits the euro and the ensuing financial contagion is limited, the euro area still faces a lot of tricky problems. For the eurozone to survive, the ECB needs to stop its obsession with inflation and focus more on growth. Monetary expansion is needed to counteract the contractionary impact of fiscal austerity, though Germany seems unwilling to accept this fact.

As Paul Krugman argues, when Germany was in a recession in the early 2000s, its recovery was aided by a current account surplus against the peripheral countries that are in deep financial trouble now. In the early 2000s, Greece, Ireland and Spain enjoyed strong economic growth. The low interest rates set by the ECB were optimal for Germany but too low for these 3 countries.

On one hand, the low interest rates helped Germany recover. On the other hand, the low interest rates led to high inflation and even higher growth (to the point of overheating) in the PIIGS. In economic boom, the PIIGS bought more exports from Germany, adding an extra boost to Germany’s recovery. 

Expansionary Policies to Pull the PIIGS out of Recession 

Now the monetary policy is again optimal for Germany, but not expansionary enough for the PIIGS countries. Last time the PIIGS helped Germany return to growth, and now is the time for the reverse to happen. 

Under monetary expansion, Germany and the Netherlands will experience relatively high inflation. While this may be unpleasant internally, wages and prices in the South will be cheaper in relative terms as a result. This is exactly what Europe needs to solve its key problem – the large productivity gap between Germany and the troubled economies in the South. With cheaper, more attractive exports, the PIIGS can sell more to Germany and the rest of the world, getting out of recession.

Though deflation and wage cuts in the South can narrow the gap too, deflation is contractionary while wages are sticky in the short run. Hence, it’s much better to have inflation in the North instead of deflation in the South.

Indeed, the ECB should help narrow the productivity gap with more aggressive policies. Easing measures can restore cost competitiveness of the PIIGS, which is the first step to less unemployment and economic recovery. In turn, recovery will help governments control the public debt and achieve balanced budgets.

Liquidity Injection to Support Banks

Signs show that the ECB is moving in the right direction. The long-term refinancing operations (LTRO) in December and February injected liquidity in the markets by offering banks unlimited short-term loans at interest rates as low as 1%. Many commentators think of the LTRO as the European version of quantitative easing.

In addition to boosting the economy, injecting liquidity is also a measure to strengthen the firewall and prevent contagion. The ECB can inject liquidity by, for example, guaranteeing to buy unlimited amounts of sovereign bonds in the event of a Greek exit.

In this way, the ECB can ensure that banks won’t collapse because of sour sovereign debt. This is important because credit freezes if banks fail, which will result in a further economic slump in Europe and probably the rest of the world.

The real question is who should take the responsibility to bail out troubled banks, and the answer is the ECB is in a better position to do so than the euro countries. Government bailouts will add to the public debt and risk increasing borrowing costs for the state. Obviously, this isn’t helpful and will only aggravate the sovereign debt crisis.

(Entry 3 of 4 in the Update on the Euro Debt Crisis series) 

 

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Grexit: Hard Choices and Inevitable Tradeoffs

Last time, we talked about why a Greek exit has become more likely and how policymakers are preparing for it. However, whether to exit or not won’t be an easy decision. A Grexit entails costs and risks, or else it’d have occurred a year ago. In this post, we’ll discuss these costs and risks, first for Greece and then for other euro members. 

The Costs for Greece

Given that recent polls show about 80% of Greeks want to stay in the eurozone, it seems they’re aware of the costs, which are listed below.

(1) An exit destroys Greek savings. A Grexit means euro deposits in Greece will have to be redenominated in Greece’s new currency. Given Greece’s high trade deficits and weak public finances, its new currency will be worth a lot less than the euro (with some estimates of a 60% depreciation). Such a depreciation will incur a huge loss for the Greeks.

(2) Contracts will have to be redenominated under the new exchange rate, which will result in a chaotic transition. Under a large, sudden depreciation, the cost of inventories and the loan burden to external creditors will shoot up. Many business will face bankruptcies.

(3) Though devaluation can restore competitiveness in the long run, rapid inflation makes lives difficult in the short run. Nevertheless, some commentators argue the economic contraction after default and devaluation, though severe, won’t last long. They often point to Iceland as an example. The country, which suffered from a credit crisis and a collapse of the financial sector back in 2008, is now on a steady path of recovery.

(4) Anticipation of an exit causes an outflow of Greek deposits to foreign countries. To protect their savings, Greek depositors prefer to save in a German bank (where savings will still be denominated in euro with purchasing power intact) rather than to save domestically (where savings will be redenominated and depreciate by a great deal). This is why Greece’s deposits have fallen from $236 billion last December to $214 billion now. If the situation continues, banks will collapse and Greece’s financial system will be wrecked.

 

The Costs for the Rest of Eurozone
 

A Greek exit will be tough for other euro members as well because of the following reasons.

(1) It may cause bank runs in other peripheral economies. Worried that their countries will ultimately follow the same path of Greece, Spaniards and Italians may take deposits out of domestic banks and put them in foreign banks. Again, this will severely damage the banking system of the respective countries, making the breakup of the euro area more likely.
 
(2) The risk of contagion is a serious threat to the European economy. Since many European banks have exposure to Greek debt, Greece’s default and exit may spark a confidence crisis and cause a credit crunch. Though European finance ministers are working hard to build a firewall to deter the spread of contagion, and European banks have been offloading Greek assets in the past few months, these efforts may not be enough. The slump in stock markets around the world in the past two weeks suggests businesses and investors aren’t that confident in the effectiveness of the firewall.

(3) Grexit means the eurozone wasted lots of money to bail out Greece. In the last two months alone, the eurozone lent $140 billion to Greece in its bailout efforts. European leaders may not want to give up right after such large-scale bailout efforts, especially when Grexit means the rescue loans won’t be paid back. However, one can argue that it’s time to stop the bailout and cut loss before it’s too late.

(P.S. Interestingly, some have proposed a conspiracy theory on why Germany doesn’t want Greece to exit. The fear is Greece’s exit will turn out to be a success and help the country return to growth. Observing Greece’s successful experiment, Spain, Portugal, and other distressed countries will want to follow suit and exit the euro. This will lead to the collapse of the euro.) 

Time to Make Hard Choices 

Given these costs, whether Greece stays in or leaves the euro isn’t an easy decision. However, after months of procrastination, Europe is finally at the critical stage where it must face inevitable tradeoffs and make hard choices. And a Greek exit is definitely an option to consider.

To me, Grexit is the only way out for Europe, because there is no way economies as diverse as Germany and Greece can stay in the same monetary union for long. It simply isn’t sustainable. Greece can’t restore competitiveness and will die a slow economic death if it remains in the euro. Other euro members can’t prop up Greece and its financial sector forever, especially when Greece most likely won’t be able to afford to pay back its loans. A Grexit is necessary despite its short-term pain, and what is important is to have an orderly exit and contain contagion to other countries.

(Entry 2 of 4 in the Update on the Euro Debt Crisis series) 

 

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A Potential Greek Exit from the Euro

This post, first in the series, will discuss the possibility of a Greek exit from the euro. Given the results of the Greek general election, an exit has become an increasingly likely outcome.
 

Greece’s Legislative Election 
 
Many Greeks are fed up with contractionary austerity measures imposed by eurozone leaders. That’s why, in the election on May 6, many voters turned to support the Coalition of the Radical Left (known as the Syriza party). The Syriza party, which opposes austerity, tells voters that Greece can stay in the euro even if they reject the bailout package. This strategy won the Syriza party a lot of support and a lot more seats compared to the last election. On the other hand, the PASOK, a pro-bailout party which was previously the largest party in the Parliament, suffered a heavy defeat. 

But the May election didn’t produce a clear winner. After failed attempts to form a coalition government, Greece is heading to a second-round election on June 17. Polls show that pro-bailout parties is likely to lose the election again in June.

Potential Exit from the Euro

Following the election results, a Greek exit (or Grexit, as some now call) has become a lot more likely. If the anti-austerity parties win the second-round election and they reject the bailout package, Greece will probably be kicked out of the eurozone. Even if the Syriza party doesn’t win and the election results in another stalemate, Greece won’t be able to put together a coalition in time. The terms of the bailout package will surely be breached, and a Greek exit will still be likely.

Despite what the Syriza party says, talks of forgiving Greek debt are fantasy. The party is only making promises they can’t deliver in order to win votes. Debt forgiveness will send a perverse message to Spain, Ireland and Portugal that the eurozone rewards defiance by writing off a country’s debt. To ensure these countries will comply with the austerity programs previously agreed upon, Germany and other euro members won’t allow the moral hazard of forgiving Greek debt.

But maybe an exit is in Greece’s interest. A commentary on Der Spiegel, a German news magazine, persuasively argues that leaving the euro is the only effective way for Greece to regain competitiveness in the long term. The article points out that default can help reduce Greece’s debt burden, while devaluation can restore cost competitiveness and boost net exports. The eurozone benefits as well since it doesn’t need to spend more money on Greece’s bailout.

Preparation for the Grexit

Greece is a small economy (in terms of GDP) in the euro area. Grexit doesn’t have to be catastrophic as long as the aftermath doesn’t spread to bigger economies. The policymakers are starting to manage expectations and prepare financial markets for a potential Greek exit.

Christine Lagarde, Managing Director of the International Monetary Fund, told the press that the IMF must be “technically prepared for anything.” In the past few months, Europe’s economic and regulatory institutions have been building firewalls and recapitalizing banks. They hope this can prevent contagion to Spain and Italy if Greece exits the euro.

(Entry 1 of 4 in the Update on the Euro Debt Crisis series) 

 

Grexit: Hard Choices and Inevitable Tradeoffs   Next >

   

Update on the Euro Debt Crisis

In view of the new developments in the past 2 weeks, I’d like to update on the eurozone debt crisis.

This 4-part series will first discuss the benefits and the costs of a Greek exit from the euro. Then it’ll argue why the eurozone needs more aggressive monetary expansion if it’s to survive. 
 
Finally, this series will discuss the future of the euro area. If the euro countries lack a commitment to closer European integration, then the exit of some countries – or even a breakup of the eurozone – is probably the best outcome in the long run.

Part 1  A Potential Greek Exit from the Euro
Part 2  Grexit: Hard Choices and Inevitable Tradeoffs
Part 3  The Need for More Monetary Expansion in the Eurozone
Part 4  The Future of the Euro Area: Falling Apart or Growing Closer?
  
Hopefully, these posts will shed some light on how the crisis will unfold in the coming weeks and months. Thank you and please feel free to leave a comment.
 

The Eurozone Crisis: Differences between the U.S. and the Euro Area

In the previous post, we’ve talked about the problems of a diverse group of countries sharing the same exchange rate. However, this leads to a question. If a currency union is such a bad idea, why does it work well in the United States? 

The American Currency Union 

You may not have thought about it, but in fact the United States can be viewed as a currency union as well. After the American Revolution in the late 18th century, the former British colonies, coming together to establish the federal government, chose to use a common currency. 

The reason is the United States is a fiscal union with a centralized tax collection system, as well as a political union where the citizens share the same national identity. When a state government (such as California) lacks money, the federal government will help by transferring money from states with healthier public finances (such as New York). The New Yorkers are okay with helping out the Californians because of a sense of national belonging. Besides, since states are required by constitutions to balance annual operating budgets, fiscal discipline can be ensured. 
 
As Kenneth Rogoff points out, a currency union is unlikely to be successful without political integration and potential fiscal transfers. Since there are many different national identities and many sovereign nations in the eurozone, it’s hard for a common currency arrangement to work.

(Comment: This echoes an article about cultural ties on the Economist in January. In today’s globalized world, differences in nationalities, cultures and languages still play an important role in all aspects of life, including business and finance.)

The Lack of Political Union in Europe

It’s understandable why the Greeks and the Irish are angry. They don’t understand why countries like Germany and France have the right to dictate the terms of Greece’s and Ireland’s domestic policies when they themselves are autonomous sovereign states. On the other hand, since the rescue efforts will cost German taxpayers lots of money, they have little desire to lend to Greece. Plus, Germany is worried about the moral hazard created by bailing out the PIIGS countries, which may lead to even more fiscal indiscipline in the future.

(Comment: Though German politicians want to save the euro to avoid a financial meltdown, they need to be responsible for the German voters. The result is ineffective and indecisive political leadership, which is often criticized by commentators. 

To save the eurozone, imposing fiscal union may be the only option. In the current situation, wealthy countries are only willing to lend to the distressed economies under the condition of fiscal austerity. Understandably, some may view this as a threat to sovereign autonomy. These nation states have already given up control over money supply, interest rate and exchange rate in order to join the currency union, and it’ll be scary if they’re now forced to forgo fiscal power as well. However, maybe this is precisely the level of political integration needed to sustain a currency union.)

Austerity that Crushes the Economy

(Comment: What is more worrying is some European politicians fail to grasp that fiscal discipline is a long-term practice. Austerity at difficult economic times is likely to further contract the economy and reduce tax revenue, which won’t help improve fiscal health either. Even if public debt is controlled, a contraction of economic activity won’t help reduce the government debt to GDP ratio, which is a benchmark indicator for the sustainability of a country’s public finances. While European leaders hope to restore confidence and motivate consumers and businesses to spend more by reducing public debt, it seems this plan is unlikely to work.

What is needed in bad economic times is fiscal stimulus, especially when monetary policy isn’t an available tool. For example, in the early 2000s, Germany exceeded the deficit limits to weather the economic downturn. The fiscal expansion helped the German economy to get back on track back then, and it’s also what the PIIGS need right now.

Sadly, this is easier in theory than in practice. The real question is where these debt-laden states can find money to finance public spending, given that they’re struggling just to meet their debt obligations. To have a feel of the severity of the crisis, consider the debt problems of Greece. Without austerity measures, the Greek government may face bankruptcy immediately.)  

Is the Worst Over yet for Europe? 

The European financial industry is vulnerable to collapse. To understand this, let’s look at Figure 1 (which is from this website) and compare the European financial industry with the American financial industry. As we can see, the assets of American banks are just a small portion of the American economy. Therefore, when necessary, the U.S. government or government agencies can insure or even purchase the troubled assets from American banks.

On the other hand, the assets owned by European banks constitute a much higher proportion of the economic size of the host countries. Worse, these assets include the sovereign bonds of the PIIGS, which may turn out to be worthless. This makes it hard for a European country to rescue its banks when things go wrong.

(Comment: If the eurozone or the European Union can rescue the banks collectively, this may not be such a serious problem. However, the national identity problem kicks in again, and any proposal to prop up the banks of another country will face stiff opposition at the home country.)

This poses a serious systemic threat to the European economy. In the United States, the trigger is the burst of the housing bubbles, and the dynamite is the fall of Lehman Brothers. In Europe, if Greece exits the eurozone, it’ll only be a trigger. The collapse of any major European bank will be the dynamite.

(Comment: In the meantime, many analysts believe that what we’re seeing is only the calm before the storm. More concrete steps needs to be taken to solve the deep-rooted problems. Whether Europe can defuse the bomb remains to be seen, but there is reason not to be too optimistic.)
  
(Entry 6 of 6 in The Global Economic Landscape in 2012 series)

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The Eurozone Crisis: Not a Matter of Fiscal Irresponsibility

A currency union has inherent problems, as mentioned last time. But despite these structural problems, when a crisis like this happens, people naturally want to find someone to blame. So, is any country to blame for the current mess? Are the PIIGS responsible for dragging down Europe with their heavy government debt? 

The PIIGS as Victims, not Free Riders

When it comes to the sovereign debt crisis, we often think of the struggling countries as welfare states. Not only does welfare expenditure put a huge burden on public finances, under the welfare system the citizens don’t have an incentive to work hard, so these countries are to blame for the economic mess they’re in.

These criticisms may all be true, but we’ve missed an important part in the picture. Though Germany doesn’t want to admit it, the Greeks and the Irish aren’t entirely wrong when they blame the Germans. To a certain extent, Germany does gain an unfair advantage from the cheap currency – which boosts its net exports and enables it to earn more foreign money – at the expense of less productive countries in the eurozone.

(Comment: The euro crisis is not really a matter of fiscal irresponsibility. As shown in Figure 1, some of today’s distressed nations only had a small public debt burden at the onset of the crisis. By the way, since Greece’s government debt was very high – at 143% in 2010 and 161% in 2011 – it’s left out of the chart to ensure the other data points are clearly shown. For an explanation of the difference between net debt and gross debt, please refer to this article by two professors at INSEAD.

Figure 2 shows that Spain and Ireland in fact ran budget surpluses from 2005 to 2007. They’re not free riders but are victims suffering from the lack of an adjustment mechanism to deal with recessions. They’re the casualties of the structural problems in a suboptimal currency union.

Whether competitive economies like Germany and the Netherlands benefit from the euro is a debatable question. Some argue that they’ve lagged behind similar countries that chose to stay out of the eurozone, such as Switzerland and Sweden, in economic performances since the launch of the euro. But others refute that such comparisons are inaccurate because they can be easily manipulated by selecting different periods of data. Still, unless the financially distressed nations exit the euro, it looks like a lot of the surplus earned by Germany over the years will be spent on the rescue funds. So it isn’t fair to say Germany is a winner either.) 

The Downward Spiral for Less Competitive Economies 

Of course, this isn’t to say the PIIGS countries don’t benefit from euro membership at all. However, with an overvalued currency and slow productivity growth, these countries can’t compete in the world economy. The lack of competitiveness is reflected by the persistent current account deficits. Though the PIIGS did quite well economically in the first half of the 2000s (see Figure 3), once the economy started to slow, they were sucked into a downward spiral.

(Comment: To understand what triggered the downward spiral, we first have to understand what led to the boom period. As seen in Figure 4, inflation was high in Greece, Ireland and Spain before 2008. Under the “one-size-fits-none” nominal interest rate set by the European Central Bank, real interest rates were low in these countries. This fueled asset bubbles and led to the excessive accumulation of private debt, and was why they enjoyed fast growth before 2007.)
 

After the bubble burst in 2008, growth has slowed dramatically (see Figure 3) and unemployment rates have soared (see Figure 5). As a result, tax revenue falls and government spending on social welfare increases. Given the lack of adjustment mechanisms in a currency union, this can easily spiral into a vicious circle. As we now know, four years later net public debt in the PIIGS, especially in Ireland, has skyrocketed to record levels (see Figure 1).

The culprit of all this mess is the single exchange rate. After all, people in the PIIGS are free to choose a laid-back lifestyle. What they need is a currency that can reflect and match the national competitiveness, not an overvalued currency that raises both private and public debt.

Benefits of a Currency Union

(Comment: Given the risks and downsides of a currency union, you may wonder why the eurozone was formed in the first place. A currency union does have a few benefits. For example, it can deter speculative attacks and promote trade and cross-border investments.

For more detail, you may refer to Robert Mundell’s theory of optimum currency areas. Its central thesis is currency borders don’t necessarily have to follow national borders, because if there is high labor mobility in a region, freely floating exchange rates aren’t necessary to adjust for imbalances. This provided the rationale for the creation of the euro. However, it’s now clear that without a common language and a common social welfare system, the labor mobility in Europe won’t be high enough to correct economic imbalances.) 

(Entry 5 of 6 in The Global Economic Landscape in 2012 series)

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