Posts tagged ‘euro area’

22 May 2012

Some euros are more equal than others

John Kay on the inherent flaw in the single currency once a route to euro exit is created for peripheral countries:

The growth of indebtedness of the weak euro currencies to the strong has already happened and is continuing. When Europe’s leaders claim the continent is now better placed to withstand a crisis they mean only that this accumulation has been largely transferred from the private to the public sector, mainly the European Central Bank. Since there is potentially no limit to the willingness of the private sector to exchange weak euros for strong, the only limit to the process is the patience of German and Finnish taxpayers. So check whether the euros you hold are eagles or owls before others do.

I don’t expect the Germans would call time on the euro. It would be too destructive and would trash the country’s reputation for decades. (Though they’re willing to engage in brinksmanship, with suggestions they may have considered voting against allowing the Bank of Greece to do ELA for its banks – the only mechanism I can think of, assuming they could convince two-thirds of the 23 ECB council members to back them, to actually force a country out of the euro.)

But as I’ve said beforeand as Wolfgang Münchau argued earlier this week – you don’t need a Rubicon-crossing initial euro exit for this to happen; only a continuing asymmetry between a continental currency and national deposit guarantee and bank resolution authorities.

This is the immediate problem Europe needs to fix.

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18 May 2012

Would a Greek default immediately lead to a euro exit? No.

A lot of the discussion of the Greek elections has focussed on the strong performance of anti-programme parties such as Syriza (17% on 6 May), Independent Greeks (11%), the Communist Party (8%), Golden Dawn (7%) and Democratic Left (6%) – and their expected further gains (particularly Syriza) on 17 June. This is what’s prompted the fears of an imminent exit. But would an anti-programme government necessarily mean a euro exit?

I can see two parts to this question. Firstly, is there a political incentive for a newly-elected anti-programme government to exit the euro? And secondly, is there an economic transmission mechanism whereby a disorderly sovereign default rapidly forces Greece out of the euro? I’m thinking only about short-term events here – i.e. if a default happens shortly after 17 June, would a Greek euro exit be announced within the next few weeks?

On the political point – anti-programme parties are on the rise, but polls show most Greeks (c.80%!) remain pro-euro. And most votes on 6 May went to pro-euro parties: of the seven parties that made it into parliament, only the two most extreme – the Communists and Golden Dawn – are explicitly anti-euro.

One or more of the anti-programme parties could form a government after 17 June. If they stick to their pledges, this would lead to a drying up of EFSF/IMF loan tranches, an inability to meet Greece’s bond maturities and interest payments as they fall due, and a need to balance the budget overnight to make up for the lack of external funding.

But these parties aren’t yet arguing for Greece to then leave the euro at that point. Indeed, you can imagine that short-term political incentives would make them even less wiling to agree to a euro exit once they’ve formed a government.

The first move in a euro exit would be to freeze bank deposit withdrawals, which would no doubt irk voters; the final move is the actual devaluation, reducing the purchasing power of those very same voters. If you think the Greeks are rioting over austerity, wait to see what they do when their government does these things to them. Meanwhile, all those other anti-programme pro-euro parties outside the government would be going for the jugular, lamenting the prime minister’s awful decision to impose this unnecessary additional hardship on the voters when all they really wanted was someone who could go to Brussels and Frankfurt and negotiate a different deal. There is not, therefore, an obvious political reason why a euro exit would quickly follow on from a sovereign default.

So I therefore wonder: is there an economic reason?

Martin Wolf gave one view in today’s FT:

[…] a cessation of external official funding could trigger a disorderly collapse. The government would default. The European Central Bank would argue that Greek banks no longer possess good collateral, which would prevent it from operating as a lender of last resort. There would be comprehensive bank runs. Athens would impose exchange controls, introduce a new currency, redenominate domestic contracts and default on external contracts denominated in euros.

In Wolf’s scenario, it’s the collapse of the banks that forces Greece to exit. I can certainly envisage such a channel:

  • lack of central-bank funds would lead to a system-wide bank run, as depositors try to get their cash out before the banks collapse;
  • euros would now be hoarded under mattresses or outside the country, out of fears over bank solvency and redenomination respectively;
  • ultimately forcing the government to introduce a new currency just so that ordinary day-to-day transactions can actually take place in Greece.

Yet crucially, I think Wolf is mistaken in suggesting that all central-bank funding would be cut off at the point of a sovereign default. Yes, the Greek banks would no longer be able to use their defaulted Greek government bonds (GGBs) to access ECB facilities; but would they not just turn to Bank of Greece ELA as an alternative? They’ve done this once already, in March/April, when their GGBs briefly became ineligible for ECB operations after the PSI and so they moved them all over to Bank of Greece facilities. And there doesn’t seem to be a constraint on ELA – the Irish did €100bn of it, after all.

Anyway, if the Bank of Greece can continue funding the Greek banks after a sovereign default, I don’t think there’s the same obvious short-term mechanism that will force Greece out of the euro. This isn’t to say that there aren’t other things happening: as I said the other day, central-bank-addicted ‘zombie banks’ don’t default, but they also don’t lend, so the medium-term outlook for Greece would remain fairly grim.

But the point I’m trying to make is that a Greek default soon after 17 June doesn’t necessarily mean a Greek euro exit will immediately follow. Greece could exist in a kind of limbo for while. Indeed – there could be many months between a disorderly sovereign default and an eventual euro exit!

And during that lengthy interlude, could we be hopeful that cooler heads might prevail?

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17 May 2012

Bank runs in the periphery: why they matter and how to stop them

Lots of attention over the last few days on deposit outflows from Greek banks, an acceleration of the slow-motion bank run of the last two-and-a-half years that saw €95bn of deposits leave the country’s banks between September 2009 and March 2012 (i.e. more than one-third of Greek banks’ peak €282bn stock of deposits).

In spite of the deposit flight, the Greek banks have continued to fund themselves through ECB/ELA facilities. So why exactly does this matter?

Tyler Cowen explained the point well in this article looking at similar deposit outflows from the Irish banks:

This flight of capital reflects a centuries-old economic principle known as Gresham’s Law, sometimes expressed casually as “bad money drives out good money.” In this context, if two assets — euros inside and outside Ireland — are not equal in value in the eyes of the marketplace, sooner or later the legally fixed price parity will fall apart.

If enough depositors fear frozen accounts, the banks will be emptied out, and they also will require additional government bailouts, on top of the bailouts for the bad real estate loans. The banks come to resemble empty shells, conduits for public aid but shrinking and unprofitable as businesses — and, to a large extent, that is already the case in Ireland. Portugal is moving in this same direction, toward being a land inhabited by zombie banks.

Essentially, if you think about bank deposits as distinct financial assets, it becomes clear that the value you would place on a euro held in a bank with a low risk of default is different to that of a euro held in a bank with a high risk of default. But as there’s a fixed legal parity between the price of a euro in the two banks, which prevents prices adjusting, the quantity takes the full brunt of the adjustment instead:

Within a currency union, this problem is usually solved through bank deposit guarantees. We’re content to treat sterling deposits in HSBC, RBS or Manchester Building Society as equivalent assets, despite the very different business models of these banks, because the UK Financial Services Compensation Scheme (FSCS) stands behind their retail deposits (at least up to a limit) – and the UK government ultimately stands behind the FSCS.

But within the euro area, deposits guarantees are still done on a national basis. Deposits in German banks are guaranteed by the German authorities and deposits in Greek banks by the Greek authorities. And the German deposit guarantee is patently going to be more creditable than the Greek scheme –  particularly once euro exit concerns are brought into play.

The pre-crisis assumption that bank deposits in different parts of the euro area were equivalent was therefore clearly as misguided as the assumption that different euro area governments had the same (low) credit risk. And, as with credit risk on euro area governments, I don’t see how investors will ever go back to the old assumption unless there is a fundamental change to the structure of euro area banking.

Alongside some form of eventual fiscal union, I therefore think the euro area will need to introduce a form of mutualised deposit guarantee as a necessary condition for preventing a future crisis once this one is over. Indeed, it may even be a necessary condition for ending the current crisis, given the lending and growth implications for Europe of this breakdown of the monetary system. Returning to Tyler Cowen:

It’s the zombie banks that doom the current European bailout plans. On any single day, or even for a year or two, an economy can survive with zombie banks, but over time functional domestic banks are needed to allocate credit.

If they don’t find a way to return to a situation were euros in German banks and periphery banks are valued equally, deposit flight and the consequent dearth of credit will continue – and bang would go hopes for Spain.

14 May 2012

The first days of the Greek exit

Given widespread discussion of a possible imminent Grexit (aka ‘Greek exit’) – including by some European officials – it’s worth briefly sketching out what it would look like.

In terms of actually introducing a new currency, I think this is a massive logistical challenge that would take months – just in terms of printing notes, distributing them, reprogramming ATMs, etc, let alone the legal quagmire. But in the immediate aftermath of the decision, I would expect all of the following three things from Greek and European leaders:

(1) Greece would pass emergency legislation introducing capital controls and creating the new currency in legal (if not yet physical) form. This would unilaterally violate the Maastricht Treaty, which provides for free movement of capital between EU members. The widely-expressed legal view is that there isn’t a legal mechanism for quitting the euro, unlike for quitting the EU – so this Maastricht violation might be the first step towards an EU exit and consequent application to rejoin the EU or EEA post-Grexit.

(2) The New Drachma would start trading at a shadow exchange rate, even before it exists physically. The currency would no doubt depreciate heavily against the euro.

(3) The institutions of the euro area would have to announce, immediately, a massive extension of support to the remaining periphery. There’s been a lot of talk – e.g. from the Dutch finance minister today – about the ‘firewall’ Europe has put up since the start of the crisis. This counts for absolutely nothing: if you’re a depositor or investor in Portugal/Ireland/Spain/Italy and you see Greece exiting and people with money in Greece frozen there by the overnight imposition of capital controls – in spite of two years of protestations that there will be no Grexit – then the rational thing to do would be to pull your cash immediately and ask questions later. In the short term, the policy response would have to include:

  • a clear public announcement by the ECB that they’re willing for banks in the remaining periphery to become reliant on central bank cash on whole different scale to what we’re used to (as a result of depositor flight and wholesale funding freezes), including larger banks there, and probably as part of a jointly-guaranteed Eurosystem scheme (which means loosening Eurosystem collateral standards) rather than nationally-guaranteed ELA funds;
  • pre-approved second EFSF programmes for Portugal and Ireland to ensure their funding (if required) through to late in the decade and precautionary credit lines for Spain and Italy; and
  • perhaps most controversially, some sort of explicit commitment by the ECB to deploying its balance sheet to support any euro area sovereigns that need it, either through: (i) an explicit cap on secondary market yields for euro area states; or (ii) giving the EFSF a banking license and letting it borrow as needed to fund euro area states.

None of this sounds pleasant. But they’d have to act like this after a Grexit because the consequences of not acting would be too catastrophic – and I’d bet in this situation (and here’s sticking my head out…) that the imminent continent-wide economic catastrophe and consequent changing electoral arithmetic would lead even the Germans to sign up to this programme.

I think Greece could leave. But if this doesn’t jolt the institutions of the euro area into belated action, nothing would.

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7 May 2012

Super Sunday (2) – Inconclusive in Greece

Yesterday’s Greek election delivered an inconclusive result, as many feared. With almost all votes counted, New Democracy (centre-right) has fallen to 19% of the vote from 33% three years ago and Pasok (centre-left) has crashed to third place with 13% down from 44%, behind the Syriza party (radical left), which is up to 17% from less than 5%.

On this basis, the two parties that supported the EU-IMF programme (ND and Pasok) would have 149 seats between them in the 300 member parliament, so would lack a majority to pass austerity measures required to unlock future tranches of the bailout loans. Even if they had a couple of extra seats, I’d wonder about the crisis of democratic legitimacy that an ND-Pasok coalition would engender – implementing further austerity with the backing of only 32% of voters (contrast with the 59% who voted for the UK’s two coalition parties in 2010).

A second election seems likely, but is far from certain to deliver a more pro-programme result. Indeed, if Syriza can win over around 131,000 voters out of the almost 1 million who voted for the next three anti-austerity left-wing parties (the Communist Party, Democratic Left and the fantastically-named Anti-Capitalism Left Cooperation for the Overthrow), then Syriza would overhaul ND as the first-past-the-post winner and benefit from the 50 bonus seats that the top-placed party receives – completely changing the context for the next parliament’s coalition negotiations and making a left-wing coalition much more likely.

A final note on Super Sunday. Buttonwood rightly points out that it is primarily this Greek result, rather than Francois Hollande’s win, that has riled the markets this morning. This of course isn’t to say market players are thrilled about Hollande. But we shouldn’t conflate the market implications of the Greek and French results, as some of the press coverage this morning seems to have done. The Greek election does raise serious questions about the sovereign’s solvency (even post-PSI) and perhaps the country’s euro membership.

France, though, will have merely unsettled people by promising a bit more political disagreement at a time of uncertainty when the markets are desperately seeking short-term stability. But if bond traders want stability, they should move to North Korea. My view remains that a more-balanced ‘good cop, bad cop’ dynamic between France and Germany may be a necessary condition for preserving the euro – and so the long-term outlook for the single currency may have been enhanced by the French voters’ choice.

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6 May 2012

Super Sunday (1) – It’s Hollande

Francois Hollande, as expected, has won the French presidential election run-off, with 52% of the vote.

In terms of first thoughts, I can’t agree with the Telegraph’s claim that this raises ‘fresh question marks over a eurozone break-up’.

The possibility of increased Franco-German divisions at the euro area’s top table are worrying some people. But the consensus seems to be that Hollande’s ‘renegotiation’ of the fiscal compact to favour growth can be done through compromises that don’t involve having to reopen the text of the treaty.

Indeed, I don’t fundamentally accept the claim that Franco-German divisions are a bad thing for Europe; diverse opinions can be a strength.

I still buy into Mark Leonard’s argument about Europe being a kind of modern-day political Hydra. To quote his example of how disagreements in Western Europe during the 90s led the post-communist countries to so radically reform their economies prior to their EU accession:

British and Nordic enthusiasm for enlargement in the East allowed the countries of Central and Eastern Europe to ‘keep faith’ as they embarked on painful processes of internal reform. At the same time, French doubts allowed the European Commission to exact concessions from them in the protracted negotiations for accession. The key feature of this ‘good cop, bad cop’ dynamic is that, even though the disagreements are genuine, the core objectives of all European countries tend to be the same […]

I think the euro area needs an equivalent dynamic to develop if it’s to convince the peripheral countries to reform their economies without dangerously eroding support for the euro among their voters and politicians – i.e. Hollande’s enthusiasm for growth, Eurobonds, etc, can allow the periphery to ‘keep faith’ in the single currency, at the same term as Merkel’s bailout scepticism extracts concessions from these countries to correct their fiscal imbalances and undertake needed economic reforms.

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5 May 2012

Three facts and a national accounting identity

I want to begin by stepping back from all the details and acronyms of the euro crisis –  LTROs, NCBs, ELA, SMP, EFSF and all the rest of it – and looking at some high-level macro facts.

This isn’t to suggest the details are unimportant. Far from it: I’m currently making a living out of understanding market and institutional details and how they influence events, so it’s in my interest to talk up their importance. But I think we should start out by understanding the big picture. So here are three macro facts that influence my overall view of the crisis.

Fact (1) – The euro area’s governments on average are less indebted than those of the US, UK or Japan.

The chart below shows general government net debt (historic and latest IMF forecasts) in the euro area, compared to the US, UK and Japan. You can see that debt levels in the euro area are the lowest of the four economies, which is in fact an improvement from pre-crisis relative to the US and UK.

Fact (2) – The euro area’s external balances are slightly positive, compared to current account deficits in the US and UK.

The chart shows that, overall, the euro area does not have a big current account adjustment to make relative to the rest of the world. In fact, the euro area exports to the rest of the world slightly more than it imports, in contrast to the US or UK.

The combination of (1) and (2) is the starting point for saying that the euro crisis is the result of a political coordination problem, not inexorable economic logic. If it were legitimate to analyse the euro area’s economy on a ‘consolidated’ basis – in the (implausible) extreme, if the euro area were to make the same decision as England/Wales/Scotland or New York/Texas/Florida, to become one big country – then the fiscal aspect of the euro crisis would disappear overnight (and with it, much – though not all – of the banking and growth crises that accompany it).

But such ‘consolidated’ analysis doesn’t make sense until the political coordination problem is solved. It doesn’t matter that the euro area’s net debt is a (relatively) healthy 68% of GDP when, for instance, three of its member states (Greece, Italy and Portugal) are individually liable for net debts of or above 100% of their individual GDPs. Which leads on to the third fact, concerning the scale of the imbalances that need to be addressed in the near future through further coordination.

Fact (3) – Within the euro area, Greece, Cyprus and Spain have  large fiscal and external imbalances still to address. Ireland also has a large fiscal (but not external) imbalance and Portugal has a large external (and medium fiscal) imbalance.


Let’s reflect on this for a moment. The current account matters because it tells us an economy’s reliance on foreign capital – since the flip side of a current account deficit is the capital account surplus to finance it (from the balance of payments identities).

The euro peripherals got into trouble in 2009-2010 because they’d been running large fiscal deficits (to some extent a consequence of the 2008 banking crisis) that they funded by issuing debt to foreign investors. When those foreign investors started to worry about the solvency of those governments, these foreign capital inflows would have ground to a halt and current accounts would have had to adjust immediately. Under a floating exchange rate, this would have meant a currency crisis and probable default on foreign-currency debts. Under a pegged exchange rate, this instead requires an adjustment in domestic imbalances – governments would have immediately had to cut spending and hike taxes to balance their budgets and remove the need to borrow from foreign investors, with wrenching effects on domestic demand (as in the euro-pegged Baltic states during 2008-2009).

But within the euro area, other mechanisms came into play (to briefly go into some of the institutional detail of the euro area). Specifically, EFSF-IMF lending to peripheral governments and Target 2 ‘lending’ by the Bundesbank to the peripheral national central banks (NCBs) took the place of some of the previous capital inflows. Bruegel recently published an excellent paper explaining how these official sources replaced foreign private investors after the ‘sudden stops’ in capital inflows to these countries.

Why does all this matter? Well, to wean themselves off official (EFSF-IMF and Target 2) support, Greece, Cyprus, Ireland, Portugal and Spain still have adjustments to make. But the first four of those countries only account for 6% of euro-area GDP. Frankly, the degree of political coordination needed for the other 94% to support them as they adjust really isn’t that great. And if some of those four countries were to decide to call it quits, the rest of the euro area should be able to continue pretty much okay without them. (Rather, it would be the exiting countries that are likely to suffer the most.)

Italy isn’t mentioned here for a reason: looking at the data, its fiscal deficit (3.9% of GDP – 70th largest in the world last year) and current account deficit (3.2% of GDP – 94th largest in the world last year) really aren’t that big.  Italy has a large stock of debt, which is concerning given low trend GDP growth (i.e. low growth in the ability to service those debts). But it can both address the slow-growth problem and correct the current account deficit through ‘low-hanging fruit’ reforms to labour and product markets, such as those being introduced by Mario Monti’s technocratic government (though Italy may need to rededicate itself to the Monti programme given recent signs of slippage).

This leaves Spain. Spain is where I think the real euro-area problem sits – the fiscal deficit is huge already and the government may face further costs to support the moribund banking sector. Meanwhile, unemployment is already at 24.4% and the economy is formally back in recession, yet the government somehow needs to reduce spending / increase taxes by a further 3.2% of GDP in this year alone to meet its 2012 deficit target of 5.3% of GDP. An EFSF package may be needed to recapitalise the banks or set up a bad bank to segregate their bad loans. Spain is certainly the big challenge to the future of the euro area.

And a national accounting identity

Even in the case of Spain though, there are reasons to think things aren’t quite as bad as they might appear. Look at how far to the left of the chart Spain is from the red dashed line that shows where the fiscal deficit equals the current account deficit. From the national accounting identities, we know that the current account deficit (X-M) is equal to the sum of private savings (S-I) and public savings (T-G) – in other words, for one sector (private, public or rest-of-world) to run a deficit, another sector must run a corresponding surplus. The fact that Spain’s 2011 fiscal balance (-8.5% of GDP) was so much worse than its current account balance (-3.7% of GDP) shows that the private sector is running a large financial surplus (+4.8% of GDP). This is the private sector deleveraging after its pre-crisis borrowing splurge, which contributes to the weak growth environment.

But as long as the private sector wants to run these surpluses, doesn’t it mean there is some sort of natural domestic buyer base for Spanish government debt? At the very least, Spain’s nowhere near Greece, where the ultimate source of funding for the 9.2% of GDP fiscal deficit last year was the rest of the world (the current account deficit was 9.7% of GDP) and so the government is entirely reliant on the generosity of the other euro members.

I’d be interested in other people’s thoughts. Spain clearly has a fiscal imbalance problem. But it seems to be under fewer pressures than other countries to rapidly eradicate its budget deficit, because it’s not actually as reliant as they are on foreign capital. And in fact, as long as the Banco de Espana is able to keep building up Target 2 liabilities versus other euro-area NCBs, isn’t Spain able to continue running modest current account deficits (albeit hopefully at a reducing rate), even in the face of a sudden stop in private capital inflows? And doesn’t this mean that in Spain’s case there is more scope for a ‘Plan B’ of, not a fiscal splurge, but at least a slower fiscal adjustment that need not further undermine an economy that’s already in recession? This is partly why I’m not quite as pessimistic as some people about the ability of Europe to sort its (i.e. Spain’s) mess out.

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5 May 2012

Introducing the ecoptimist

Hello and welcome to my blog – the ecoptimist.

In my job, as a macroeconomist based in London, we understandably spend a lot of time thinking about ‘tail risk’ scenarios of what could happen if the euro crisis goes nuclear. This is often to the detriment of considering ‘central’ scenarios in which Europe muddles through the crisis and sets up institutions that will make a repeat much less likely in the future.

From conversations over the last few weeks, I’ve started to wonder whether this focus has led some of my colleagues to lose sight of what a realistic scenario for the euro area might look like. The pessimistic focus of our work, along with a sometimes over-simplified 24-hour newsflow, frames the way that we view the wider outlook.

As a result, I know a lot of people who now expect – not fear as a tail risk, as I do, but actually expect as a central scenario – that the euro area will break up in the next few years amid economic depression, social unrest and nationalistic rabble-rousing.

But can that really be something to expect? In other words, does Europe really fail in 50% + 1 of the probability distribution of possible outcomes?

I think not. In fact, I’m cautiously optimistic about the longer-term outlook for Europe, albeit acknowledging that there will be bumps in the road over the next few months and years. I’ll elaborate on this in future posts. But suffice to say, I think that Europe’s problems are more about political coordination than inexorable economic logic – and I think these coordination problems are far from as insurmountable as many clever people assume.

Over the next few weeks and months then, I’ll try to back up this assertion (and others!) with facts, data and analysis, along with a healthy dose of quality economic news and research from across the web. These are certainly interesting times for Europe and the world – and I’m sure I’ll have plenty to talk about!

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