Tuesday, June 21, 2011

The Greek Solution

This is the flag that has been carried at demonstrations lately in Athens ( - see this link if you don't believe me). It is easy to see what it represents - the EU flag with a Nazi swastika inserted inside the 12 stars representing the 12 member states that originally formed the European Community. The worrying thing about the demonstrations in Athens is that they clearly represent a large portion of the Greek electorate that do not see the solutions to Greece's problems as more austerity with further bailouts coming from the European Union (through the European Financial Stability Fund of EFSF) or the IMF.  And in my opinion they have a point - we have already been through a series of bailouts and things just don't seem to be getting any better for Greece - each round of austerity measures will just make things worse for the people and the macroeconomy in general.

Today an excellent article appeared in the FT by Gideon Rachman, arguing that further European economic integration in the form of a fiscal union with a European Treasury would not solve the Greek problem, and although I am in favor of moving towards fiscal union, I buy Rachman's argument that Greece is not a compelling reason to do so. Politically speaking though, anti-EU sentiment will continue to rise though unless a "Greek  solution" is found - and this must be a lasting solution, not a patchwork solution as has been done so far. Patchwork solutions risk escalating the crisis into a full blown disaster, with the potential for a breakup of the euro, which would be in none of the participants' interest.  

Would any student of economics be surprised that we've reached this impasse regarding Greece's situation in the euro? No, as the optimal currency area theory suggests that countries whose economies move together are better suited to a single currency, and any academic paper that I've seen since the mid-1990s which tries to operationalize this shows that Greece and several other periphery countries don't have economies that move with the core member states of the euro area.

So according to the academic research, Greece should not be in the euro, but we also know that as the Greek public finances were not complete when they were assessed for membership of the euro back in the early 2000s, they really shouldn't have been allowed to join the euro in the first place. And that is the conundrum here - it is clear to me that the Greek problem is not one that should lead to contagion - it just needs to be solved once and for all - but on the other hand in a monetary union it is not possible to treat Greece as an exception as what you do for one member state you have to do for them all - hence the EFSF.

To end this continuing crisis, I think Greece should be given a choice before it shakes political confidence  in the EU and starts to destabilize the entire euro area as an entity ( - and here I'm not talking about contagion but rather that of credibility). So I would propose that Greece be given a choice - one of their choices should be to leave the euro and return to the Greek drachma so that they can effectively devalue their currency to stabilize their economy (after obviously having to default first), and all those Northern Europeans can then plan their (cheap) vacation in Greece for next summer!  The other choice would be to insist that the Greek parliament change their Constitution so that a 2% of GDP primary budget surplus becomes enshrined into law - thus leaving the decision about how the fiscal policy restraint is going to be implemented up to the Greek parliament. In return for doing this the Greeks would have to submit to scrutiny of their public finances by the European Commission but all negotiations regarding debt issuance and rollovers would be taken from the Greek finance ministry and given to the EFSF to negotiate.  In this way no new debt could be issued (by law) and all the markets would be concerned about would be the rollover of the existing debt and whether payments would be made on the debt.  The EFSF would then also be in charge of making interest payments on the debt, with a maximum of 5% of GDP allowed under normal circumstances ( - which would imply a budget deficit of 3% of GDP, just inside the Stability and Growth pact limits). The interest payments would be billed to Greece.

What are the advantages of the first "Greek solution"?  For Greece, obviously getting out of this mess - but that might be the best option if their politicians do not want to tie their hands. The real losers will undoubtedly be the bond holders, as they will have to take a big haircut given that many of the bonds that have been issued or rolled over are denominated in euros, or face almost certain default. The other big downside would be for the euro area which would have been seen to fail in its attempt to keep a wayward member in the fold.  It's credibility would be mud for a few years, but the financial markets are myopic and that would soon pass.

What are the advantages of the second "Greek solution" I propose above?  In my view it clearly leaves the decision about what to do up to the Greeks, but it also makes very clear that Greece has to pass some "retroactive" tests in order to stay in the euro area, tests that are not being imposed on other member states as they did not misrepresent their public accounts in the first place.  Secondly, the financial role of the EFSF is enhanced, and presumably rolling over/issuing the debt will be easier as it is a European institution with much better credit than the Greek finance ministry that is doing the rolling over.  Third, it also starts us on the road to further economic integration, in the sense of tying the hands of politicians at the member state level, and then allowing the EFSF to manage debt issuance.  It is not fiscal sovereignty at the EU level, but it is a move towards financing public spending at a supranational level.

Monday, June 13, 2011

Is a “Perfect Storm” heading our way?

The NYU economics professor, Nouriel Roubini just went on record in Singapore a few days ago about his long term prediction for world growth – and it wasn’t wonderful!  According to Bloomberg reporters he said that there was roughly a third chance of a perfect storm in 2013, where China slows down significantly because of lack of consumption and the unwinding of the real estate bubble there, the US also struggles to break free from its current headwinds of mounting debt and the housing malaise to return to historical levels of economic growth and the EU finds itself revisiting the PIGS (Portugal, Ireland, Greece and Spain) debt problems time and time again which slows that continent down as crowding out occurs from increases in interest rates.  According to Roubini by that time Japan would also have exhausted the extra fiscal stimulus given to the economy after the Tsunami from earlier this year, which adds the icing to a cake that clearly has refused to rise to the occasion. 

So what are the other two-thirds of Roubini's probabilities?  The second scenario with a weighting of roughly a third is a resumption to more usual levels of growth is one of them – clearly a soft landing in China, an upturn in growth in the US and better news from Europe plus a more permanent boost in growth in Japan could all combine to move things along faster than the pessimists expect.  And the third scenario with a weighting of a third again is an intermediate “anemic but OK” growth scenario where the factors in the “perfect storm” scenario are much less severe. 

Forecasting the global economy is, I would assert, harder than forecasting the weather.  At least with the weather you know there are going to be seasons – with the economy you don’t have any idea about when these “seasons” are going to occur. There is the “business cycle” of course, but the consensus for the length of the business cycle is anywhere between 3 and now 10 years.  Once you are 3 years beyond the end of the last recession (which ended in June 2009) which means we’re at June 2012, then it’s anyone’s guess when the next recession will occur. At the other extreme we’re pretty sure that something will happen by 2019, as we have never had a period of more than 10 years of uninterrupted economic growth in the US. 
If we look at the gap between recessions though, it has grown since the Second World War, and so the next recession is more likely to be later, rather than earlier. Given this, I would place less probability on Roubini’s “perfect storm” than the other two scenarios he came up with.  Also the rosy scenario is a little too “rosy” for my liking, in that not all policymakers get it right, and particularly in both China and Japan there is not much of a record of getting the correct mix of policies to really optimize economic growth, plus we now know that there is not a lot that policymakers can do once a bubble has really built up in an economy, so the Chinese might really have difficulties dealing with the aftermath of a popping of their property bubble.

So I would disagree with Professor Roubini’s main forecast, which is of a “perfect storm” brewing for 2013, and would predict that we are much more likely to see problems in one part of the world and growth in other parts over the next few years, but that the “perfect storm” in the form of the next recession is some way down the road, and rather unlikely, mainly because of business and growth cycle factors in 2013. My most likely scenario would consist of more of a divergence in growth around the world, which is not to say that I don't believe in an international business cycle, but more because each region of the world has a different focus and different views about the effectiveness of government policies. These perceptions, I believe, in and of themselves can produce different outcomes.
So a more interesting question from an investment standpoint is where there is most potential for a resumption in economic growth.  Although policymakers do not determine economic growth rates, they do, in my view, have a significant impact on setting the appropriate environment for growth to occur. The developing economies in the form of the emerging markets certainly have the most to gain, but if the US gets this mix of fiscal rectitude and continued modest monetary stimulus from the Fed right, then it too will also benefit. Non euro area European countries still have extremely bright prospects and of course the euro area, if it bites the bullet and develops a Euro area bond or decides to let Greece go, could also benefit. I, like several other commentators, am now bearish on China as their economic problems appear to presage a bursting bubble, and Japan, as I have already stated in this blog, might just be the biggest surprise of them all if they can only get their politicians to act sensibly.

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