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!

Blood, Toil, Tears and Sweat: The Euro Stops Here

The last time Europe tried fiscal austerity to solve an international financial crisis (under Heinrich Brüning in Weimar Germany, 1931), it took 20 years and 50 million deaths to recover. Germany’s current finance minister, Wolfgang Schäuble, seems to want to go down in history as Brüning’s 21^st century reincarnation, although at the moment he is only advocating austerity for the Eurozone periphery, the PIIGS (Portugal, Ireland, Italy, Greece and Spain). While it has become clear to the financial markets and even Christine Lagarde of the IMF and Tim Geithner of the US Treasury, that not only does fiscal austerity, perhaps counterintuitively, not solve the debt crises of these states, it actually makes them worse, Schäuble has hitched his banner to the morality tale that if bloodletting has not worked, then insufficient blood has been let, and that we must persist with the failed therapy until the patient has succumbed (with due respects to Paul Krugman for the metaphor).

What Schäuble and many others fail to realize, is

1. The Euro crisis, with the single exception of Greece, was not caused by the fiscal irresponsibility of the Eurozone states before the world crisis of 2008 (Spain and Ireland were paragons of fiscal rectitude until then – see particularly Paul de Grauwe on this point), but by an accumulation of private debt in housing and consumption booms from which Germany primarily benefited through export surpluses.
2. Germany is not merely a passive beneficiary of a lower exchange rate by virtue of belonging to a currency zone of countries with weaker export performance. It is also a central perpetrator, since its unit labor costs (wages  divided by productivity) have danced completely out of line with the rest of the Eurozone in the last decade. And not primarily because its productivity has grown so much faster, but because wages have been static, while the periphery has experienced considerable wage and price growth. This disparity between the wage-restraint core and the inflationary wage-regime periphery is the ultimate cause of the Eurozone crisis. Neither party can be considered guiltless in this dance, and they can even be thought of as symbiotic during the boom phase, but ultimately they are incompatible in a currency union (this was already pointed out by Calomiris in 1998).
3. The model of world economic growth of the last 20 years is unsustainable. This divided the world into export growth-led countries with low consumption shares (China, Germany), high consumption, high trade-deficit countries (USA, Eurozone periphery) and commodity-based, trade surplus (primarily oil) exporters (Australia, Brazil, OPEC countries, Russia, Norway). The increasing inequality of income since the 1980s led to a growth-incompatible lack of underlying effective demand that was compensated by an accelerating and unsustainable accumulation of (mostly) private debt from the exporters to the consumers, mediated by a global financial sector playing an elaborate shell game (see e.g. Ragan 2010, Stiglitz et al. 2009).

As appealing as  the imposition of fiscal austerity after the baby has fallen into the well is to simple-minded economic moralists, and I would be the last person to argue that states should not spend their revenues wisely, it is collectively self-defeating in a world financial crisis. This fact, known in the economic literature as debt-deflation, was already expounded in Irving Fisher’s classic article in 1933 (which incidentally still reads like a résumé of the current crisis). But austerity is being propounded not only because of simple-minded moralism, but because key actors are unwilling to abandon taboo aspects of their growth models:

1. China will not let the RMB appreciate, thus relieving inflationary pressure without having to apply the monetary brakes, because it would challenge its existing export-led growth model that allows rural workers to migrate to industrial cities but at low levels of domestic demand.
   
2. Germany is terrified of letting wage growth return to its underlying productivity trajectory for fear of losing international competitiveness, a problem it successfully finessed with wage stagnation and welfare reform after reunification and the ascension of the Eastern European members to the EU.
3. The USA is unwilling  or politically unable to reverse the neoliberal tax and financial system “reforms”  and the decline of worker bargaining power that have only benefited the upper 5% of the population, and invest in needed infrastructure, education, health-care reform and (energy and environmental) technologies. Congress is ideologically deadlocked on these issues. The country is wedded to a high consumption, fossil fuel, financial engineering economic model, with information technology the only bright spot.

Since there seems little likelihood that the political system will address these underlying issues anytime soon, current strategies (quantitative easing, timid stimulus packages, austerity) range from “pushing on a string” (QE) to downright counterproductive (the Greek bailout coupled with austerity). Since these issues will reassert themselves one way or another, they will ultimately force the politicians’ hands and impose some kind of solution, just like they did in Argentina in 2001. My short-range forecast is as follows:

1. Greece will enter a disorderly default within the next few weeks and will quit or be ejected from the Eurozone. This will be the best thing that could happen to the Greek economy, and if domestic banks are closed in a timely manner to prevent a withdrawal of domestic savings before a forcible restoration of the Drachme, its financial system can come out of this intact.
2. To limit contagion to the rest of the Eurozone banking system and restore relative competitiveness, Germany and the other core Eurozone countries (the Netherlands, Austria, Finland, Luxemburg, possibly France and Belgium) will adopt a Core-Euro (C-Euro, instead of the politically uncomfortable DM) currency, which will rapidly appreciate.
3. The rest of the Eurozone will devalue to a Peripheral-Euro (P-Euro). 
4. The resulting tsunami of debt adjustments between the core, the periphery and Greece will be a challenge to master, but is a superior solution to the present underfunded EFSF system that would otherwise have to swallow its own tail, continually bailing out one failing peripheral country after another until the core creditors themselves would be financially and politically undermined.

For all the hopes originally attached to the Euro project, it was doomed from the start and has morphed from a mutually enriching to a mutually impoverishing form of integration. The question is whether, at a world and not just a European scale, time remains to reestablish a new, mutually enriching world economic order before Humpty Dumpty irreversibly shatters. The last time the world economy shattered for lack of a coordinated response (the 1930s), it certainly took an inordinate amount of blood, toil, tears and sweat to put the pieces back together again. Are we prepared to go through this again?