• Can the Euro be Saved?

    As Simon Johnson points out here and here, the Euro might be in some trouble. One problem is that one or more of the PIIGS might leave the union but the more serious problem is that Germany might and it seems obvious that without Germany there is no Euro.

    The first potential problem, that some or all of the PIIGS might leave the monetary union is really, in my opinion, no trouble at all. If they left, as the weaklings of the union, the Euro only would only get stronger and more to the point, leaving the Euro only makes things worse for the PIIGS. On the other hand, if Germany decides to issue its own currency instead of bail these countries out then the Euro would surely dissolve. So what can be done about the weak links?

    Well, the point of one of these countries leaving the Eurozone would be that it could begin issuing its own currency. This, of course, would constitute a default on their debt which promise to pay in Euros and in the short to medium run their external payments trouble would only get worse. After all, the new currency would certainly be worth far less than the Euro just for being less liquid and on top of that the whole point of issuing it would be to monetize fiscal deficits. The new currency would have virtually no purchasing power internationally.

    So why might a country consider this? Well, one thing a domestically issued currency would accomplish is keeping the domestic banking system liquid. This will soon be a major problem for Greece. Currently the ECB is accepting Greek government bonds on repo but this will soon end and then the Greek banking system will find itself hard up to obtain liquidity.

    What about government finance? This works out the same either way, only the language we use to describe it differs. In the Eurozone the Greek government will soon find it can’t sell debt externally (probably when the ECB stops accepting it on repo), out of the Euro the same thing will happen so in real terms the only resources available to the Greek government are taxes and domestics buying their bonds. If the Greek government tries to consume more in real terms then it can afford by printing its own currency the result will be hyperinflation, if they try to do this while keeping the Euro the result will be default. In neither case will the government get more resources.

    So what’s the solution? Well, what the PIIGS need to do is get on with the business of defaulting in a coordinated manner and with German backing. What I have in mind would play out in the following way:

    1) The PIIGS get their domestic constituents to agree to a set of austerity measures that reign in government expenditures (this may well be the hardest part). Given those measures, which they commit to going forward, they calculate how much of their existing debt they can afford to pay back. Hopefully it’s a decent number, let’s say 70% for all of them.

    2) They announce that the face value of all outstanding bonds is now reduced to the amount calclulated above, so in our example they write the debt down to 70 cents on the Euro.

    3) With the fiscal austerity measures in place and the debt written down to an affordable level we come to the clincher. The rest of the Eurozone, meaning Germany, guarantees the remaining outstanding debt and and any new short-term debt issuance for a period of time. The guarantee is contingent on the respective governments sticking to the austerity measures. This accomplishes the most important part, the ECB can now accept the debt on repo and keeps the domestic banks funded.

    The point here is that for the most part the deed is done on the existing debt, they bought stuff with paper that promises Euros, they don’t have the Euros. Other than Germany just assuming the debt, something that they would be ill advised to do, default of one sort or another is inevitable. Furthermore, default is only such a disaster for the domestic economy if it leaves the banks without liquidity. This way they can keep the local banks funded, be able to issue more short-term paper to keep their governments running and do it all in a way that should be acceptable to Germany, in particular it shouldn’t actually cost the German treausury any money.

    Finally, they should do this all at the same time. Far better to get it done once then to have each country get run by the market in sequence with some sort of ad hoc fix applied each time. One of the lessons of the countries leaving gold in the 30s was they were best off when they did it together, otherwise the ones still on gold got squeezed after the others had devalued.

    Of course, this is all predicated on the PIIGS being able to get their populations to agree to the auserity measures and this is looking pretty much impossible for Greece. So the prognosis is not that good.

    Adam Purzitsky
    Adam Purzitsky
    Senior Quantitative Portfolio Manager, Co-Fund Manager
    Feb 7, 2010 at 10:48am


12 Comments in total
  • Thanks Adam, great post

    It's a very tricky problem.

    My initial thought was that the PIIGS should just leave the EMU. I see the fundamental problem as the EMU currently not being an optimal currency area, as I think Krugman has hinted at, with no central treasury that could smooth over that problem.

    The PIIGS won't be able to correct current account deficits and avoid the consequent necessity of running low interest rates (blocked by ECB/ZLB) or high deficits (current situation) to support employment without a devalued currency vis-a-vis Germany, or a higher price level in Germany via German fiscal spending, which is unlikely.

    The Germany-PIIGS dynamic seems very similar to the China-America dynamic. In both cases I think that the main solution is for the exchange rate to adjust, or the price level to increase in the saving country, via fiscal spending. IIRC Krugman has called the peg a new gold standard for this reason.

    To put it in terms of some of your earlier posts, is it possible that due to higher saving in Germany and an inflexible exchange rate, the PIIGS are suffering from a negative natural real interest rate? The difference is that while China buys US debt, keeping the whole thing going, Germany does not necessarily buy the debt of countries that it runs a CA surplus with, leading to this crisis.

    Even if the debt situation is handled in the way that you describe that still leaves high current account deficits and unemployment in the PIIGS: unemployment compounded by the effect of austerity measures, and the CA deficits shrinking due to falling imports. I'd rather shrink the CA deficit through increased exports and employment, through devaluation.

    The problem with devaluation though is the Euro denominated debt, which means that any devaluation would have to be proceeded by a default… which brings us back to the problem of having an ultra weak currency and difficulty selling debt externally. There doesn't really seem to be any good choice.

    Overall, if I were one of the PIIGS, I would probably opt for default & devaluation. It seems like there is going to be severe short-medium term pain in either case, but reestablishing a sovereign currency and correcting the CA deficit would probably be better in the long run. To me that's where the analogy of leaving the gold standard points to.

    Posted by: bob
    Feb 8, 2010 at 6:49 am

     
  • Hi bob,

    well, I think you make a good point about the difference between China/US and Germany/PIIGS. I tend to think of China just being GMAC and providig vendor finance to their best customer. Germany doesn't do this and the result is that its customers end up with far less stable financing.

    As for leaving the Euro and issuing their own currencies the only thing I can imagine it actually solving is that it might give them an acceptable way to imose a huge real wage cut on their populations.

    The idea would be simply that they issue the currency at some parity to the Euro (say 1:1), after everyone exchanges their Euros and starts getting their wages in the new currency they let it go in to free fall. Perhaps the populations won't see it coming…

    Of course, even this would probably require some help from the rest of Europe I'd imagine, but it might work.

    For Spain, who weren't even being fiscally irresponsible (unlike say Greece) they really deserve some help.

    Posted by: Adam P
    Feb 8, 2010 at 10:57 am

     
  • Yes, good point about the difficulties of actually leaving the EMU followed by an inevitable devaluation. I agree it does seem pretty unlikely.

    It seems like the Germans have finally seen the light and are going to offer some sort of fiscal relief.

    Posted by: bob
    Feb 9, 2010 at 2:24 pm

     
  • yeah, the only way I see the Euro dissolving is if Germany leaves. They could just start issuing deutchmarks again, the new german mark would then be worth more than the Euro.

    But I don't see that happen politically.

    Posted by: Adam P
    Feb 10, 2010 at 1:39 am

     
  • True. I think Germany will probably be dragged, kicking and screaming, into some sort of bailout… eventually. They are amazingly stubborn though.

    On an unrelated note, I've got something I want to run by you. If you have the time maybe you could do a critique.

    Lately I've had a couple friends get into MMT (groan), most of which doesn't really make any sense to me. One of them sent me a link to this one economist named Wynne Godley, whose analysis I found to be surprisingly good. He's not really an MMTer (although they somehow think that he is), more like an updated Keynesian disequilibrium system combined with a flow-of-funds model descended from Tobin. Some conclusions that he comes to are quite unorthodox, but in other respects the system is actually consistent with a lot of modern economics (ie Woodford on monetary policy, Stiglitz on imperfect markets, etc.). I also found out that Jan Hatzius at Goldman Sachs is a long-time fan of this guy, so it can't be complete quackery.

    Have a look an tell me what you think. Please be as ruthless as possible.

    Here's Godley's annual economic analysis for the last 10 years, the most recent 2008 one is worth checking out:
    http://www.levy.org/vauthdoc.aspx?auth=104

    This is Marc Lavoie's website that has a lot of background info, and powerpoint presentations that summarize their theories:
    http://aix1.uottawa.ca/~robinson/Lavoie/index.html

    Here's a copy of Godley & Lavoie's book. It's a big general theory type of treatise, so it basically covers all aspects of their economic theory and modeling:
    http://tinyurl.com/ye2ra2y

    Posted by: bob
    Feb 10, 2010 at 6:46 am

     
  • one thing I would particularly like to know your opinion on is if the model suffers from collinearity problems

    Posted by: bob
    Feb 10, 2010 at 6:57 am

     
  • bob, I'll try to get a look at the MMT stuff on the weekend.

    Posted by: Adam P
    Feb 11, 2010 at 12:09 pm

     
  • Nice, looking forward to it

    Posted by: bob
    Feb 12, 2010 at 9:41 am

     
  • hey Adam, have you had a chance to check out any of Godley's stuff yet?
    He came up in the comments at WCI today, and I'm still eager to know what you think

    Posted by: bob
    Feb 19, 2010 at 7:53 am

     
  • well, I looked at a couple of the presentations on Lavoie's website but couldn't really tease out what their point is.

    My impression is similar to yours I think, there's not much really new here. The thing is though, the presentations really didn't inspire me to want to learn more about what they're doing.

    As is usually the case, their critiques of "mainstream" econ apppears to only reflect their own lack of understanding of what the standard models are saying (a la Scott Sumner).

    However, they are claiming to be descended from Minsky and Tobin, so maybe there's something in there. I'll try to keep looking but you'll have to give me a couple weeks.

    Plus, I live in the UK so watching Team Canada in Olympic hockey requires me to stay up late, so I've been a bit sleep deprived this week.

    Posted by: Adam P
    Feb 21, 2010 at 1:57 am

     
  • hey Adam

    Hope you're recovered from the USA game:)

    One of the things I like about their stuff is that a lot of it is not really that new, as in they are not afraid to acknowledge that a lot of the 'mainstream' stuff is right and are willing to use it. The 'new' aspects of it are fairly subtle, but I think that they offer pretty good explanations on a few issues where the mainstream has been divided:

    - I like their critique of Mundell-Fleming, which seems to provide a pretty good explanation as to why the Chinese haven't experienced the extreme inflation that a lot of people were saying was unavoidable as early as 2002 based on M-F. I like the idea of endogenized reserves
    - the whole Minsky/Tobin balance sheet approach seems to be compatible with, and a useful way of conceptualizing analysis such as Richard Koo's (Nomura) take on the Japanese deflation that Krugman linked to while back
    - the modified Phillips curve that they use seems to explain the Greenspan 90's, when Greenspan completely ignored the NAIRU and didn't see any of the expected inflation as a result

    Some of the ideas that are a little more out there:
    - since there isn't one perfect general equilibrium, there's not really one natural rate, and it can be stabilized at a number of different values depending on the fiscal stance and other factors. I think this is mainly derived from their rejection of Solow growth models in favor of an endogenous growth model, sort of similar to Romer's
    - it's theoretically possible to fix the interest rate, and instead use a fiscal reaction function to control the price level (this one was only in a working paper – not sure it's fully baked yet)

    Posted by: bob
    Feb 23, 2010 at 4:33 am

     
  • I don't think the Euro can survive without the PIIGS; first, if a PIIGS country leaves, you're going to have a massive amount of Euro short selling as they move back to their own currency and a flood into the market; other countries about to adopt the Euro will see that Germany has no intention of helping in a financial crisis.

    This adds up to complete stagnation of the Eurozone. There'd be no more growth potential in this case, and then, no incentive to have the Euro for anybody.

    Since the Eurozone can't expand, and can't assist countries in a time of crisis, it will prove a very poor replacement for the US in terms of reserve currency, and since it won't be used more, the bubble prices will collapse outright (You know, how $1 worth of goods after taxes buys MUCH more than $1 worth of goods after taxes in Europe…which indicates on a non-investment free trade scheme, the Euro is simply not worth as much because it DOES NOT BUY EQUIVILENT GOODS AND SERVICES IN THE COUNTRY ITS TRADED AFTER TAX POLICY).

    And would most of Europe go for a currency that is much weaker than the dollar in the end while having to listen to Germany? I don't think that's likely.

    So without the PIIGS, while I think the Euro could do decently economically, politically, it'd decay and stop existing.

    Posted by: Anonymous
    Mar 25, 2010 at 4:10 am

     
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