Is France Next?

If this isn't a meltdown signal, I don't know what is (Source: Reuters, 10 Nov 2011; current quote 14 Nov 15:00 GMT+1: 1.49):

All Quiet on the German Front

The interview with Bundesbank President Jens Weidmann in today's Financial Times shows that the walls of German policy blindness are not going to come tumbling down like Jericho's anytime soon. Weidmann is still wedded to the received wisdom:

1. The Euro crisis is primarily due to the fiscal policies of the member states, not a crisis of relative competitiveness, balance of payments, and lack of aggregate demand.
2. A return to the meaningless Maastricht criteria and greater fiscal policy integration would solve the underlying problem.
3. Eurozone countries have to follow Germany's lead in reforming their labor markets. That is, they have to make sure that nominal wages rise significantly slower than productivity in a race to the macroeconomic bottom that is rewarded by export-led growth.
4. German fiscal stimulus would be ineffective. 
5. The ECB acting as lender of last resort is ruled out by the Maastricht Treaty, would reward wayward governments like Italy's by monetarizing their deficits, and would represent a politically unacceptable transfer of resources between Northern and Southern Eurozone countries.

What the received wisdom overlooks is that a firm commitment to act as lender of last resort, when effective, would not need to mobilize resources because it would be a credible deterrent. This is something even a leveraged EFSF can never be, quite aside from the hypocrisy and financial contortions going through the detour of the EFSF represents to implement the same backstops that would be a fall from grace for the ECB to provide. The lesson of this fiasco is that you cannot have a common currency without a lender of last resort, and that implies a certain solidarity and coordination of the member states like in the US.

What it also overlooks is that Germany's labor market reforms are precisely the factor that led to the fiscal crisis of the periphery. They are intimately related, not separate items on the menu. A race to the deflationary bottom in the periphery will only lead to a collapse of German exports to the rest of the Eurozone and a double-dip recession, something not in Germany's interests either. Having wages trail productivity everywhere as a macroeconomic policy principle is a recipe for an aggregate demand disaster in the Eurozone unless you really expect emerging  market export demand to make up the difference. If you don't, the only other possible source of aggregate demand is the German domestic economy.

What Europe needs is higher productivity growth and demand stimulus, not beggar-thy-neighbor wage dumping ("Lohndumping" in German, the root of the Eurozone problem) and fiscal austerity.

Roubini Prophetic Again

Just a short note to mirror the blogosphere:

If you want to know why Italy has been sliding into a debt spiral, it was all predicted by Nouriel Roubini back in 2006 at a tempestuous session in Davos. Once again, it is all a matter of lagging peripheral competitiveness compared to Germany. Read it and weep, since the politicians still think the Euro crisis is due to fiscal irresponsibility that can only be remedied by austerity, austerity, austerity.

Krugman Gets Religion

Paul Krugman, in his blog today "Original Sin and the Euro Crisis", waxes biblical about why the Euro is like a bite from the poisoned apple in the Garden of Eden for Italy. But some wonkist background is required to understand what he is driving at.

Paul de Grauwe (as usual) has a good paper on why the Euro reduces periphery countries like Italy, Spain, Greece to the status of emerging market countries with hard currency debt. This makes them subject to "bank run" like crises of confidence like we have seen with, first, Greece, then Portugal, Ireland, and now Italy. If this continues without ECB intervention or a credible EFSF, it will swallow up France and in the end even Germany. The weaker domino undermines the next stronger one. In a true currency zone with a proper central bank, the latter can deter such runs by credibly threatening to buy up sovereign debt (it can print all the money it needs to do so). The threat is enough to prevent a run; it may never even have to be implemented. Just look at the USA, the UK or Japan, which are more indebted than the Eurozone taken as a whole. Their interest rates have even been falling. The "Rube Goldberg" construction of the Euro means that a cascade of unraveling can happen starting at the weakest link, like a run in a stocking.

In principle the ECB can stop this cold flat. But buying up Italian bonds in drips and drabs will just be wasting money. The ECB needs to announce a credible policy (like the Swiss National Bank did on its exchange rate) to buy up as much debt as needed for as long as necessary. However, this violates the "no bailout" clause of the Maastricht Treaty, as Nouriel Roubini points out in today's Financial Times (Gavyn Wright has further objections of his own). But then, so does the EFSF, so you either abandon the Euro now before more money is wasted, or you end the hypocrisy, stop pussy-footing around, and allow the ECB to do its job right.

Of course, this still leaves the underlying cause of the Eurozone crisis unaffected: the relatively low wage level in Germany (real wages have actually been falling as reported recently in a DIW study), the lack of a domestic expansionary policy there, and the overvalued Euro. The ECB would only be buying time until Germany pushes the switch from "full-speed behind" (self-defeating austerity) to "full-speed ahead" (expansion), something that is still not on the horizon. There's no point in my reiterating the logic of this policy since my 18 January NY Times article, but I'll just point out that Nouriel Roubini, Gavyn Davies (Financial Times), Stephanie Flanders (BBC), Peter Bofinger (German Economic Council, in the Süddeutsche Zeitung), not to mention Paul Krugman, have all been blowing into this horn. Unfortunately, the walls of Jericho, i.e., German policy Borniertheit, have yet to come tumbling down (to belabor another Biblical metaphor).

Fiddling While Rome Burns (or, Where is the Cavalry?)

While European leaders have been fiddling over how to leverage the EFSF rescue fund to prevent contagion to Italian and Spanish debt, Italy has already entered its death spiral, with interest rates on its sovereign debt breaching the 7% mark today. The vague prospect of finally terminating reruns of the Burlesqueconi show has not been enough to reassure markets. Quite the contrary.

Italy is only as solvent as financial markets think it is; its underlying fundamentals during the crisis were not bad at all, in contrast to Greece. In a word, we are confronted with a self-fulfilling prophecy, a crisis of confidence, a bank run. At a high enough rate of interest any country becomes insolvent, even Germany.

But there is a classical solution to this financial unraveling (thanks to Walter Bagehot): the lender of last resort (aka the central bank). In this case, the ECB, which has infinite resources (it can print Euros), political independence (in principle), and can act immediately without the unanimous approval of 17 or 27 squabbling Eurozone/EU governments. A credible, unconditional and unlimited commitment to buy up all the Italian bonds necessary to stabilize the interest rate would put an immediate stop to the run on Italian debt, probably without having to spend much money at all. It's been done before. The Swiss central bank has been holding the line quite well on the appreciation of the franc (a similar but not identical problem). There's no run on the equally indebted sovereigns behind the Pound, Dollar or Yen. So why isn't the ECB riding to the rescue like the cavalry in an old fashioned John Wayne Western?

1. The ECB is chartered to fight inflation, not finance government debt and defend the Euro. The trauma of the German hyperinflation of 1923, when the Reichsbank monetarized the government deficit, still haunts German economists. Two prominent German ECB directors have already resigned on this issue - Axel Weber (who was in line to become ECB president) and chief economist Jürgen Stark. Neither specified what alternative there was to protect the Euro from unraveling except austerity, austerity, austerity, and we now see where that has gotten us. Strangely, the even greater trauma of Brüning's 1931 austerity policy does not seem to haunt German economists.
   
2. The new ECB president Mario Draghi may think he needs the bargaining chip of Italian insolvency to force the Italian government and parliament to pass the structural reforms (to pensions and labor markets) his predecessor Trichet made a prerequisite for ECB market intervention. He's probably right, but Italy may be bond-vigilante roadkill before that happens. Moreover, these reforms would not have any immediate effect on Italy's growth prospects anyway. It's Italy's nonexistent productivity growth that has been holding it back.
   
3. Draghi, as an Italian (although an Italian central bank president who stood up to his own government at the time), still needs to establish his bona fides as ECB president. He can't be seen, particularly to a German audience, as rushing to the defense of his own 'dissolute' country.

So it now looks like the sack of the Euro will happen in Rome rather than in Athens. Well, either way it will be a tragedy within the great European classical tradition. The sack of Rome in 455 ushered in five centuries of darkness. Let's hope that the canceling of the Burlesqueconi show is somewhat less traumatic. (As long as they continue The Simpsons we might just get through those five centuries.)

Coming attractions on this channel: Why Germany is ultimately to blame for the Eurozone crisis (a reality program for statistics nerds and economic moralists)

Internal vs. External Devaluation: The Debate is Being Decided on the Ground

When a country's competitiveness deteriorates for whatever reason (excessive inflation, devaluation of a major competitor, end of a foreign-credit-financed consumption boom) and it runs into a balance of payments problem, the preferred solution of the international community (IMF in Argentina and Latvia, IMF, ECB and EC in Greece, Spain, Portugal and Ireland) has been "internal devaluation." In other words, wages should be lowered domestically to reduce export prices, at constant exchange rates. Unfortunately, this induces a recession due to the well-known but unjustly neglected phenomenon of "debt deflation" and makes matters significantly worse before the export economy can turn things around, if ever.

Nouriel Roubini has recently restated the case (see excerpt below), in an untraceable paper that Paul Krugman  (NT Times blog) has injected into the blogosphere, that this policy usually fails (viz. Argentina and now Latvia). External devaluation is the much more effective alternative - it lowers your export costs on world markets without inducing a meltdown in domestic demand. Unfortunately, this option is denied to the Europeriphery countries as long as they remain within the Eurozone. In this respect having the Euro as your currency is a lot like being an emerging market economy with external debt denominated in hard currencies you don't control. (Once again Paul de Grauwe has an excellent paper on this point.)

Why would international organizations prefer "internal devaluation" to "external devaluation"? To protect international creditors against an accompanying default? In an interview he gave in the Austrian "Der Standard" after resigning as chief economist for the ECB, Jürgen Stark argued that Greece should be subjected to the same demanding but "successful" policies that had worked so well in Latvia. Evidently Nouriel Roubini and Jürgen Stark have been living on very different economic planets these last few years.

In the Eurozone case, the alternative would have been to have the creditor Eurocore countries (i.e., mostly Germany) inflate while the peripheral countries freeze their wages and prices, accompanied by an overall Euro devaluation. A path not taken...

The experiment with "internal devaluation" will not be decided in ivory towers but rather on the ground. The current political turmoil in Greece and the zombie Burlesqueconi government in Italy are just a taste of things to come.

Roubini on "internal devaluation":

The international experience of  “internal devaluations” is mostly one of failure. Argentina tried the deflation route to a real depreciation and, after three years of an ever-deepening recession/depression, it defaulted and exited its currency board peg. The case of Latvia’s “successful” internal devaluation is not a model for the EZ periphery: Output fell by 20% and unemployment surged to 20%; the public debt was—unlike in the EZ periphery—negligible as a percentage of GDP and thus a small amount of official finance—a few billion euros—was enough to backstop the country without the massive balance-sheet effects of deflation; and the willingness of the policy makers to sweat blood and tears to avoid falling into the arms of the “Russian bear” was, for a while, unlimited (as opposed to the EZ periphery’s unwillingness to give up altogether its fiscal independence to Germany); and even after devaluation and default was avoided, the current backlash against such draconian adjustment is now very serious and risks undermining such efforts (while, equivalently, the social and political backlash against recessionary austerity is coming to a boil in the EZ periphery).

The Law of the Accelerating Euro Bailout

I have now discovered a new economic phenomenon: the law of the accelerating euro bailout. Each crisis summit leads to an increase in guarantees, haircuts and bailout loans by a factor x, but its lasts only 1/x months as long as the last bailout before collapsing. The announcement of the Greek referendum yesterday may finally truncate this geometric series to its limit point and bring about the disorderly default of Greece I predicted in the last post. If European leaders thought that Zeno's paradox would postpone the day of reckoning forever in an infinite series of bailouts, they will now have a rude awakening. The tortoise of underlying economic reality has finally caught up with the hare of financial trickery. (At a dinner party recently I was asked to summarize in one sentence what that underlying economic reality behind the Euro crisis was. My answer: German wages are too low. Do the math...)

More and more economists, and even ordinary people, both in the Eurocore and the Europeriphery, have finally come around to the realization that only some combination of the following steps will restore economic balance and reopen a growth perspective out of the threatening debt death spiral:

1. First, Greece  needs to exit the Eurozone to devalue, and second, it needs to default on its Euro-denominated debt. It needs the former to restore export competitiveness (a Greek hotel room now costs twice as much as a rival Turkish one for a Mediterranean holiday, an indication of how much it needs to devalue). It absolutely needs the latter to prevent its sovereign and private debt from ballooning by exactly the proportion it devalues, plus to reduce the debt burden to a sustainable level. A haircut while staying in the Eurozone, or devaluation without default (or vice versa) are no longer enough. The dangers are a domestic run on Greek banks, which incidentally is already in accelerating progress, and inflation, which unfortunately will be unavoidable. In a word, Greece needs to do an Argentina. It will make Greece a pariah state for awhile, but it will at least be a sovereign pariah state with some growth prospects. In the inimitable words of Andrew Lloyd Webber's "Don't Cry for Me, Argentina":
   
   
   I had to let it happen
   I had to change
   Couldn't stay all my life down at heel
   Looking out of the window
   Staying out of the sun
   So I chose freedom
   
   
2. The Eurocore states need to appreciate with a C-Euro, the Europeriphery states to devalue with a new P-Euro.
3. The new zones will have to redenominate their sovereign debt in their new currencies. This will be hell for the C-banks holding bonds from the  P-Eurozone or Greece, and a windfall for P-banks holding C-bonds (minus their losses on Greek bonds), but it now seems the only way to restore competitive balance in lieu of implementing my German domestic expansion/Euro devaluation plan of last January.
4. The three new zones will need central banks that are finally willing to act like ones, that is, act as lenders of last resort for their currencies. The present ECB has been fighting this battle with one hand tied behind its back (see Paul de Grauwe on this) as a policy vestige of the German hyperinflation of 1923. Yes, central banks should not monetarize the irresponsible fiscal deficits of their governments. But no, they need to be able to deter a run on their currency's sovereign debt, like is now occurring in Italy and Spain, with the prospect of infinitely deep firepower.

Call it what you will - an avoidable fiasco (as I did last January), a train wreck, a meltdown. There is little consolation in being a Cassandra proved right. The job now is to get through this nightmare without sinking the ship, by which I mean not only Europe but the whole world economy. I can't help reflecting that the 1931 worldwide financial crisis was set in motion by the bankruptcy of a single bank, the Austrian Creditanstalt, located just a few kilometers from where I am now sitting in Vienna. Complex systems have a nasty habit of unraveling in the blink of an eye if you don't watch them!