Back in November of last year, when Jeff Frieden and I were putting the finishing touches on Lost Decades, we wrote:
Many countries with foreign debts in their own currency reduce their real debt burden by allowing their currency to drop in value, so that foreigners get repaid in less-valuable currency. But Greece and the other PIIGS cannot pursue this option on their own, for they share the euro with other countries, including some of the countries to which they owe money. Given this dynamic, investors and others worried that the European Central Bank would be forced to allow euro-zone inflation to rise — and perhaps even to allow the euro to depreciate — in order to alleviate some of the pain and suffering caused by its members’ debts.
An alternative was for the rest of the euro zone to bail out the debtors. The rationale here was like that of bailing out a bank: a collapse of Greek or Portuguese finances could harm the rest of the euro-zone financial systems. If Bank of America was too big to fail, then so was Greece. And since a deepening of the financial crisis that drew in the entire euro zone would affect the entire global financial system, the International Monetary Fund was also drawn into the rescue. So, just as American taxpayers got stuck with the bill for bailing out banks whose failure would have had dire effects on the economy as a whole, European and international taxpayers got stuck with a €110 billion bill for bailing out Greece. And because the Greek emergency triggered a crisis of confidence in other euro-zone countries whose failure could harm the region as a whole, the European Union was driven into a massive trillion-dollar package for other troubled European debtors.
These figures — and the corresponding problem — seem almost trivial in comparison to the challenges that face the eurozone now. The debt problem of Italy dwarfs that of Greece, and Italy is truly “too big to fail” and sustain the survival of the Economic and Monetary Union (EMU). It is clear to everyone that the policy of muddling through, the operating procedure for the past two years, is not viable. However, that realization has not yet led to a commensurate removal of the political road blocks to a feasible solution.
Here is a graphical depiction of the extent of the debt problem.
Figure 1: European banks have different exposures to sovereign debt. Source: Torsten Slok, Outlook for the US, Europe, China, and Financial Markets, Deutsche Bank, December 2011. Not online.
Most sovereign debt is held domestically in Spain and Italy, but there are substantial cross border holdings for some; note German and French holdings in particular.
The discussion of tightening the bonds of a fiscal union, mainly by enforcing more rigorously the restrictions on budget deficits and government debt. Even if this were to prove successful as a long term means of sustaining the monetary union, the essential question is how to build a bridge to that long term solution. And as Wolfgang Münchau has observed, the short term has a certain immediacy.
As Jim observed yesterday, the Fed’s extension of swap lines to European central banks only solves the liquidity problem; if you think this was going to happen eventually anyway, you would be befuddled (see Krugman) by the extent of the equity market boom (for more on the effect of these currency swap arrangements, see Goldberg et al.).
What will do the trick? Tim Duy has a summary of what is, and is not, on the table. Here’s his list of what you don’t see:
- A path to true fiscal integration, which would imply direct transfers from relatively rich to relatively poor member states.
- Similarly, a new path toward internal rebalancing. A commitment to stronger fiscal oversight implies continued pursuit of rebalancing via deflation in troubled economies. Moreover, as Paul Krugman notes, this will be attempted in the context of low inflation, which only exacerbates and extends the pain of adjustment. This path only ensures deeper recession.
- A coordinated, continent-wide banking sector recapitalization. Note that Moody’s just placed European bank debt under review. Downgrades are almost inevitable at this point.
- An open door for stimulative policies to offset the demand contraction currently underway.
I think item 2 is worthy of more investigation. In the various discussions and presentations I’ve seen over the past few weeks in Europe, there seems to be a surprisingly widespread view that nominal price adjustment can occur even in large countries. I think this is misguided. The proposition that Greece, or Italy for that matter, can achieve more sustainable configurations for wages and prices with average inflation rates around 2 percent or less seems untenable. That is, Italy is not Latvia. (Also, reducing debt loads is more difficult with negative or near zero inflation.)
Item 4 also merits further discussion. When one cuts government spending and increases taxes, both in terms of demand determined models and empirics income falls, so that the decrease in budget deficits is not dollar for dollar for reduction in spending/increases in (e.g.) lump sum taxes. (I.e., in general ,there are not many instances of expansionary fiscal contractions, and the UK is proving that ever more the truth day by day). But when the economies are closely interlinked by large trade flows, a whole set of countries engaging in fiscal consolidation will make the challenge of successful consolidation even more difficult.
To see this, consider the two country demand-determined model discussed here (all the math you could want, here). In a small open economy, the government spending multiplier is given by:
ΔY/ΔG = 1/(1-c(1-t)+m)
Where m is the marginal propensity to import. For a large country (consider a two-country model), the multiplier is given by:
ΔY/ΔG = 1/(1-c(1-t)+[(m*m)/(1-c*(1-t*))])
Where m*, c*, t* are the corresponding foreign country parameters. Fiscal contraction in both countries will reinforce the contractionary effects so that deficit cutting will be self-defeating to a greater extent than in the one-country case. Or as, Deutsche Bank has noted:
Ratcheting up of fiscal austerity, deteriorating bank credit supply, and rapidly deteriorating market confidence is not a backdrop against which to forecast a countercyclical improvement in household and business confidence. Indeed, the latest survey indicators continue to show declining confidence.
Here is Deutsche Bank’s forecast for Euro area q/q growth (not annualized).
Figure 5: from Mark Wall, Gilles Moec, 2011, “2012: A deeper recession,” Focus Europe (London: Deutsche Bank, 25 November). Not online.
I will also observe that it seems implausible that political constituencies will be willing to endure years of austerity measures in order to maintain the euro. As my coauthor, Jeff Frieden wrote in “Europe’s Lehman Moment”:
In Europe as in America, the real question is how the costs of this devastating debt crisis will be distributed. Who will pay — creditors or debtors? Taxpayers or government employees? Germans or Greeks? More realistically, what combination of sacrifices will be politically tenable, both across countries and within countries. The aftermath of every debt crisis sinks into conflict over who will bear the burden of adjustment to the new reality. The sooner Europeans recognize the true nature of the debates they’re having, and the inevitability of working out some mutually acceptable conclusion, the better off they will be.
I think you understate the importance of Italy’s debt being held domestically.
That fiscal multiplier says it all.
The only way I could see them keeping the thing together is for the ECB to level target in the PIIGS and get them (as a group at least) close to the pre-recession price or spending path. This would basically demand that Germany & co. tolerate some combination of a. massive fiscal austerity b. a period of high inflation. Or undo the Euro.
Either way the Euro is toast vs USD…unless it isn’t
And how does your simple two country demand-determined model explain the cause of the European crisis? If it can’t explain the crisis then why should we expect it to be able to explain how to exist the crisis?
What happens next in Europe? I’m trying to work through the game theory decision tree, but here is how this is going to end (I think).
Start with the basic problem faced by the ECB:
The Maastricht Treaty (aka the “constitution” of European Monetary Union) contains three key pillars: a rule against excessive deficits, a “no bail out” clause, and a prohibition against the monetization of government debt (unsterilized ECB purchases of members’ sovereign debt). The first of these pillars was toppled, when Germany and France violated the rule against excessive deficits several years ago. Private lenders subsequently assumed that the Maastricht “rules” were made to be broken. Hence, lending to Greece and others may have been supported by the expectation of a bailout, should the need arise. That expectation (moral hazard) led to too much debt on too generous terms (with exchange rate risk eliminated, Greek bond yields converged fairly quickly on those of German Bunds). Of course, the need for bailouts did, in fact, arise, and the bailouts of Greece and Portugal have pretty much vitiated the prohibition against “no bailouts”.
Two pillars down—one to go.
The third and final pillar of the Maastricht Treaty, the “no monetization of government debt” rule, remains standing. But it is under enormous strain. This pillar is, clearly, the one that Germany feels most strongly about (given Germany’s rather unfortunate history of hyperinflation in the 1920s and all that followed).
The dilemma for the ECB is that, notwithstanding impassioned defences of the clause, it may not be dynamically consistent to enforce. What does this mean? In a nutshell, it is the notion that under certain conditions actions that may be optimal ex ante, may become suboptimal (or positively harmful) if implemented ex post—that it may not be dynamically consistent (rational) to follow through on a pre-existing commitment. Threats to enforce the commitment, meanwhile, may be viewed as incredible.
In the case of Europe, everyone can agree that it makes no sense for a central bank to make unsterilized purchases of government debt. Through the miracle of double entry bookkeeping, that leads inevitably to the expansion of the balance sheet (if assets of the central bank increase, so too must its liabilities—which comprise commercial bank deposits and currency in circulation). And that, historically, has been the path to hyperinflation; hence German intransigence. But, given the failure of the first two pillars, is it credible for the ECB to enforce the third?
In my view, it is not. The ECB is faced with a most unpalatable choice: allow a potentially disastrous credit collapse (the most relevant analogue being the 1929 Fed) and all that might entail, or provide the liquidity to European bond markets (under an indemnification against losses). The latter response would be fully consistent with the role of a central bank and could, I believe, be endorsed by any sensible central banker that is not unduly governed by dogmatic prejudices. We have witnessed a panicked rush for liquidity (which the actions of other central banks yesterday did much to quell, however temporary that palliative may be); if not addressed, that thirst for liquidity will set in motion a chain of events of far-reaching consequences. Moreover, ECB intervention need not lead to hyperinflation, nor even inflation, if after relative calm is restored, government bonds are sold back to the private sector.
The ECB is led by a man who, thankfully, is free of dogmatic prejudices and it is staffed by intelligent, thoughtful men and women. But they are undoubtedly concerned about the potential loss of independence that could come from an expansive program of government debt purchases. Moreover, the ECB cannot ignore the wishes of its largest member, who is likely seeking an opportunity to strengthen the fundamental core of the euro zone through more rigid rules on fiscal policy (a fiscal compact, or constitution). To secure these improvements, that member is prepared to play a game of brinkmanship with its co-members.
So, what does all this imply for how things will play out over the next week or so?
To begin, expect to see more “moral hazard” warnings à la Ottar Issing in yesterday’s Financial Times, raising the stakes and moving the game of brinkmanship to the precipice. Success in a game of brinkmanship belongs to those who can convince their adversary of their determination to prevail, or go over the cliff trying. But this intransigence must be balanced by the offer of an opening or path away from the precipice. That opening has now been extended by Mario Draghi.
At the EU summit next week, therefore, it is likely that leaders will agree to some form of strengthened fiscal union (see President Sarkozy’s statement). This will give the ECB the exit it needs to act as a lender of last resort. But, while it will buy time, this accord will not be a permanent solution. After all, fundamental changes in terms of a strengthened fiscal constitution would presumably require ratification by the people. And, since leaders can agree and the people reject, anticipate continuing uncertainty. That being said, however, if the fiscal authorities players follow through on their commitments (act “as if” they are constitutionally bound), regardless of the status of the ratification propose, this uncertainty will dissipate slowly over time. So, while the outlook will be improved, it will still be sombre.
On the other hand, the strategy of brinkmanship works because there remains a risk of miscalculation ending in disaster, which forces the player with the most to lose and diminished commitment to succumb. Leaders may fail to agree next week; in that scenario, the ECB either “accommodates”, in which case Germany exits, or “hangs tough”, in which case Italy and others exit.
A key issue therefore is what could prevent an agreement. The sticking point will be the indemnification question—Bagehot’s admonition that the lender of last resort facility be restricted to solvent, but illiquid borrowers. If Germany balks at picking up the tab for the potential losses or others refuse the quid pro quo for German participation (haircuts on private sector investors) the euro zone may well still go over the cliff. The question is whether the rest of the world would follow.
Jonathan: At 7% yields, the debt-to-GDP ratio trajectory is explosive. Fortunately, the previously issued debt stock is at lower interest rates, so there is some time for fiscal consolidation to stabilize the debt-to-GDP ratio if credible (and growth does not crash).
Jeff: Well, in 2001, did I need to know that there’d been a negative shock to wealth to know that stimulative fiscal and monetary policy would offset the contractionary impulse?
“In Europe as in America, the real question is how the costs of this devastating debt crisis will be distributed.”
Because the decisions will be made by politicians rather than the markets, the costs will be distributed in the least just ways possible: The politically well-connected are substantially those most guilty in creating the unpayable debt–& most likely to be bailed out at someone else’s expense.
Not all the abbreviations in Figure 1 are clear. GB? ES? ????
Maths may often be short of equations and overwhelmed by variables when dealing with economics.In order to circumvent the problem one may read good maths on wrong assumptions.
Where is the shortage in above maths and logic (i) for interest rates,where is the shortage in the conclusion here:
HELLENIC REPUBLIC
REPUBLIC DEBT BULLETIN March 21 2001 Inflation and Interest Rates of
12-month T-Bills for the period (March 00 – March 01)
Suppressing the euro support support is introducing two variables foreign exchange and interest rates, instead of one.It will be interesting to study Two Country Model and the Keynesian Multiplier with the introduction of i as a variable and the exchange rate as its function.
Then for the rest it requires great patience as whoever can write and read in English has the virtue of a journalist,whoever can go to BIS cross country exposure may become a shrewd journalist.
Whoever can make the distinction between an exposure funded by domestic deposits and exposure funded through money markets may introduce himself as an investment banker.The lien between the two above considerations is the introduction of the broker.
As for the distribution cost of maintaining a country in the eurozone it is de facto reflected in the CB books and government debts.
I’m watching the Euro crisis for parallels with the 1997 Asian crisis. A lesson many Asian (and some Latin American) governments drew from the events of ’97 is that foreign borrowing to finance development leaves a country too exposed to the fickle sentiments of international capital markets. They saw the crisis as underlining the multiple equilibrium nature of financial markets; low interest rates justify confidence in the borrower’s ability to repay just as high interest rates justify a lack of such confidence. Post-’97 we saw a much greater reluctance of Pacific-Rim economies to run current account deficits as part of their development strategies.
Menzie, you’ve forgotten more about the ’97 crisis than I ever learned. Is it fair to characterize the Euro crisis as fundamentally similar, but with the focus shifted from current account deficits to government deficits? Do you think it can have a similarly “chilling” effect on the willingness of governments to run deficits for stabilization or other purposes?
Jeff Frieden wrote:
Many countries with foreign debts in their own currency reduce their real debt burden by allowing their currency to drop in value, so that foreigners get repaid in less-valuable currency. But Greece and the other PIIGS cannot pursue this option on their own, for they share the euro with other countries, including some of the countries to which they owe money.
This is an astounding admission. But what makes it even more astounding is that there are academics who believe such a statement is brilliant.
Consider that you have deposits in a bank. Now let’s say that the bank gets itself into financial trouble by gross mismanagement. But not to worry. Your bank sends you a letter stating:
“Our banks has converted your deposit to our own currency and we intend to reduce our real debt burden by allowing that currency to drop in value, so that you will be repaid in less-valuable currency. But other banks and financial institutions cannot pursue this option on their own, for they pay in dollars to their depositors, including some of the depositors to which they owe money.
“We are sure you will see the wisdom of our actions and will encourage your friends to move their deposits from their dollar based banks to our bank with a much more flexible monetary system.
“Have a nice day.”
Chris:
Maybe GB=Great Britian, DE=Germany, ES=Spain
In the world, at the limits to growth:
http://www.energybulletin.net/stories/2011-06-13/world-limits-growth
Excerpt:
“What everybody wants and needs is a sudden and explosive increase in the production of real goods and services (GDP) to make their continual debt requirements serviceable. But that, even were it remotely possible, would require a big increase in oil flows through the global economy, just as global oil production has peaked and begins its decline. It cannot happen. This means that the global financial system is essentially insolvent now.
“The only choice is default or inflation on a global scale.”
The German fear of hyperinflation comes from a complete misunderstanding of the phenomenon.
Hyperinflation occured in Germany when the Franco-Belgium invaded in 1923 because of non-payments of the war reparations. General strike was declared and GDP collapsed. Government tax collections vanished and the printing press was used. But only after the collapse in GDP.
All historical examples of hyperinflation came after real shocks.
When the French lefy and Schacht put the german finacial system on track, the rest of the ’20’ were prosperous and Hitler’s vote fell sharply.
Until Brüning , with stimulative austerity, brought the house down in 31-32.
Then, and only then, did Hitler rose from buffoon to “stateman”.
The whole official german narrative is false.
Menzie: You’re dodging the question. What does your model say about the current EU situation?
For clarification: “Ricardo” above is not Ricardo Smith-Keynes. He is evidently unfamiliar with the fact that, prior to the advent of deposit insurance, regulation and a central bank that is prepared to provide a lender of last resort facility, banks did, indeed, send his letter. Typically, it was posted on the door informing depositors that the bank had failed and that they would only be recieving a fraction of the the deposits.
Ricardo is right. Many economists seem to love the ease with which fiat currency can be used to swindle & cheat.
Without global fiat systems, the world could never have gotten into the huge debt over-hang which will drag it down for the next decade. No matter how much more they print to obscure the truth of the unpayable debts.
After exhausting the current govt bureaucracy system, we may actually go to free market money & banking, something never tried in this country aside from maybe the 1850s.
So evidently Ricardo and Bryce think creditors won’t take a bath if debtors entirely repudiate debt (i.e., insolvency leading to bankruptcy), but are horrified if creditors take a small haircut through inflation. And then they appeal to very bad history to support their case. Only in America.
I think I would pay a pretty high priced ticket to know what ratio of these people constantly bitching about “fiat” currency pay for 90% of everything they by with a piece of plastic or a digital transfer. Just what in the hell would they have us do, chisel off gold shreds at the 7-11??
Have these idiots ever read a 5th grade book explaining how a barter economy works??? What the f*ck do they think contributedNOW???
People talk about the sports fans who are “armchair quarterbacks”, but they couldn’t haul 1/10th of the ignorant cowcrap the armchair economists do.
slug,
Why should all creditors be penalized instead of those who made the bad loans? You love socialism more than justice apparently.
You’ve asserted that my history is bad. Please supply examples of free market provision of money & banking unencumbered by govt interference in the US.
Bryce Apparently you haven’t learned much from the 2008 financial panic. You cannot contain losses to only those who made bad loans. In a global financial crisis there is no distinction between the guilty and the innocent. In the case of the US, most of the bad subprime mortgage loans initiated in four sunbelt states, but the rustbelt took the biggest economic hit.
If you are so concerned about justice, then why are you so willing to let the innocent pay for the crimes of the guilty? It would be great if we could neatly separate the good actors from the bad, but global markets cannot and do not work that way. To begin with, there is no such thing as an objectively “bad” loan, only loans with conditional risk. Many of the subprime loans were very risky, but the actual risk was hidden thanks to deregulation. Many of the loans were perfectly sound at the time they were originated, but the steep drop in home values and the accompanying recession put the homeowners under water through no fault of their own…just bad luck. That’s how a market operates. And in the case of Italy, Spain and Ireland, their governments were operating under very restrained fiscal policies prior to the Great Recession. Germany contributed to the problem by sending euros to the periphery…and now German bankers are balking at having to take a loss. Inflation will hurt the Germans, but their hands are not exactly clean. If you’re worried about justice, then you should worry about doing your best to protect the weakest and the most vulnerable. Try reading John Rawls over the holidays.
As to your bad history, I see no evidence that you even understand the recent history of the crisis nevermind 1850. If you think that the “free market provision of money and banking” is a guarantee against financial panic, then you might want to read Reinhart & Rogoff’s book “This Time is Different.” It covers 66 countries and 8 centuries.
Slug,
You demean further without supplying any example of free market provision of money & banking. (BTW, I’ve read Reinhart & Rogoff; they aren’t supportive of your point of view.)
Your perception of the 2008 crisis is weird. The global credit bubble was impossible without the loose money activity of central banks [=govt]. You seem oblivious to the central feature of the crisis.
US banks are/were regulated to freaking death. They are so under the thumb of govt regulators while at the same time subsidized by the Fed, that they are essentially fascistic entities rather than market players. No one can be appointed to a bank’s board of directors, no product of any substance can be offered by a bank without regulators’ approval. I’m not saying they are skillfully regulated, but to expect that from govt is to dream.
Remember that several banks took TARP AGAINST their will. Remember that banks holding GM debt acted as co-conspirators with the Obama regime to screw the other GM bondholders; this is strong evidence that they are under the thumb of govt. [economic fascism=the intermingling of private & govt interest]
Bryce: Huh, loose monetary policy — in the euro area? The evidence is much greater that lax regulation was much more to blame.
US banks regulated to death? What world were you on; suggest you read a book, say Lost Decades for some contact with reality.
Bryce The Reinhart-Rogoff story is evidence that financial recessions are not exclusively due to fiat money. The world has seen very bad financial recessions even when there was “hard” money. That was the point of the R-R reference.
There are banks and then there are banks. Many of the old fashioned banks…the kind that Krugman identifies as marble buildings with rows of tellers…that kind of bank is regulated. But what was not regulated were the “shadow banks.” It was the shadow banking system that was out of control and enabled the bubble. They belonged to the wild and lawless west. Canada has a strongly regulated banking system with very little shadow banking. And Canada largely escaped the financial panic.
Piece of advice…don’t take microeconomic models quite so seriously. Keep in mind all of those qualifiers that the professor usually skims over in the first Micro 101 lecture. And remember that Say’s Law does not always hold.
Menzie,
I grant you that the ECB was more responsible than most other banks in the world, but Asian & petro-state central banks depressed long-term interest rates by buying both US & Euro debt. (& of course the illusion that Europe govt borrowing = German govt borrowing also lowered interest rates there below reason.)
Look at the growth of total reserves for all central banks vs. GDP growth for the world for the last 15 years. This is that without which we would not have a global credit bubble.
I will grant also that the huge leverage allowed European brokerages [to which US regulators responded & matched] did add fuel to the fire. But I would still assert that a mature market-provided system of money & banking would never have allowed the global credit bubble that afflicts us now. Europe & America socializing the losses of their banks is the quintessential opposite of that.
I haven’t read Lost Decades, but US banks are extremely regulated. That is just a fact. Badly regulated maybe, but heavily regulated.
Slug,
“Hard money” can hardly be equated to free market. The US govt was involved in all kinds of shenanigans in the late 19th century in spite of having a returned to the gold standard in the 1870s in principle.
Ricardo Smith-Keynes,
You don’t have to worry about anyone getting us mixed up. I have been posting here for some time and I would definitely not include Keynes in my name.
You and slug have the same approach to bad monetary policy: don’t correct it, socialize it.
You talk of banks in the past sending out the kind of letter I suggested. You are right they did, and their depositors bailed on the bank in droves. But now fast forward to your world. Whole countries are sending out such letters. Where do people go for a sound currency?
Over decades the US monetary “experts” have manipulated the whole world into such monetary systems so that today we have no alternative.
Ricardo: If the world were governed by the postulates of the classical economists, you and I would be in agreement. But the world isn’t so; goods prices are sticky downwards. Basing policy prescriptions on an assumption that is inconsistent with empirical observation is to follow the example of Keynes’ Euclidean geometers who chastise supposedly parallel lines that meet for failing to keep their assigned course.
I agree that the global economy is in a bit of a sticky wicket. We are in this mess, however, because of the willingness of some to assume that the world is as they want it to be, not that it is. And, sadly, the situation in Europe could deteriorate even further if those in authority distill their policy prescriptions from flawed interpretations of history and through adherence to rules that are inconsistent and thus incredible.
In our current situation, the goal of policy is (or should be) something akin to the utilitarian credo of the greatest good for the greatest number. There is more than enough adjustment to go around; the objective is to spread the pain as broadly as possible so that the collective adjustment effort is sustainable. If it is not, I fear we will face a new age of policies destructive national and international prosperity–a Nash equilibrium of bad policies.