Friday, December 16, 2011

Euro area: a strained future

So here we go again – in light of the ongoing and seemingly intractable European crisis, we seem to be back looking at fiscal policy again, and from my vantage point it’s a mess.  After trying to revamp the Stability and Growth pact (SGP) in the first year of the euro area crisis, Angela Merkel and Nicholas Sarkozy (what the FT is calling the “Merkozy” factor) are now embarked on proposing a “fiscal compact” with stiff and rapidly imposed penalties on errant member states - and of course because the Stability and Growth pact had no real legal status as a series of accords ( - they merely clarified the excessive deficit procedure), it’s fines were never taken seriously.  And in any event the member states most in trouble right now would not be subject to the SGP because they are either in recession (Greece), or are running primary surpluses or close to them (Italy, Ireland and Spain). 

In one respect the prospect of a “fiscal compact” I thought would be good: it would finally get rid of the (“stupid”) SGP and move us towards something more sustainable (and hopefully properly designed) for euro area fiscal policy. How disappointing then to find that although (or perhaps because) the announcement of the new “fiscal compact” was made quickly, it’s form is little different from the original SGP except that it will now be enshrined in national laws and have more immediate and harsher consequences. This is extremely disappointing as I know that the Commission has been looking at alternative fiscal policy measures such as debt measures, and yet the Commission was obviously either reticent or was ignored by the French and the Germans when it came to drawing up the outline for a “fiscal compact”.   

In economics we distinguish between stock and flow variables – flow variables being measured over time while stock variables are measured at a point in time.  Clearly the government budget balance is a flow variable as it measures the government finances over a period of time whereas the government net debt measure is a stock variable as it measures how much is owed to non-governmental entities at a point in time. The “fiscal compact” is once again going to focus on the budget deficit, and in “structural terms” ( - that is, adjusting for the position in the business cycle, an uncertain and inaccurate adjustment given our knowledge and ability to pinpoint where an economy is in the business cycle). From an economic perspective it would have been so much more sensible to focus on net debt as this is what the market reacts to.  You cannot adjust net debt for the position of the economy in the business cycle as it is a stock variable and so one could have imagined warning limits on debt levels and then a trigger level where budget surpluses would have to be run if a specific level is breached. Moreover as economic growth affects the level of sustainable debt that could be managed ( - because it is the net debt to GDP ratio that really matters), then obviously one could also imagine a scheme whereby slow growing economies would have lower debt limits than higher growth economies in Europe.  This is an important issue as the desirability of joining the euro will be limited in Central and Eastern Europe if it limits growth prospects.

This SGP design flaw of focusing on the budget deficit is therefore going to be carried forward into the “fiscal compact”, and the only reason I can detect for doing this is the urgency of doing something quickly and also the political difficulty in coming compromising on some new economic measure which countries should focus on – a measure that would likely cause consternation in Belgium and Italy, two countries that are considered part of the “core”, but would definitely be penalized and have to embark upon more serious austerity measures.

The whole reason for this “compact” was to trigger some offset from the monetary policy side, and ultimately for the longevity of the euro area Eurobonds must be issued for the euro area as a whole but Chancellor Merkel could not allow this to be formally agreed to at the summit as this would imply that the central bank in charge of the euro is no longer independent.  Although it is unimaginable that ECB President Mario Draghi would allow the euro area to collapse ( - why would the President of an independent inter-governmental institution allow the whole reason why the bureaucracy exists to disappear?), he is going to have to make some kind of commitment in response to the fiscal rectitude about to be heaped on much of the euro area.  And that response, in my view, is key. It is likely only to be given behind closed doors, and will add an additional dimension to future horse-trading between member states.  Clearly if the ECB makes assurances now, the fiscal measures will be weaker than they otherwise would have been, so the ECB has no incentive to make any announcement until the ink dries on the new inter-governmental treaty.

Two other observations.  First, the assumption that all EU member states should be assumed to be on a track to adopt the euro should be dropped.  It is clear now that the Maastricht criteria were partly flawed (certainly the fiscal criteria are), and given the recent problems with the euro area it would make sense to allow member states to join when they are (or think themselves) ready to join.  The 60% of GDP debt and 3% deficit criteria need to taken out of the entry criteria and replaced with something more like whatever the “fiscal compact” eventually turns out to be. 

Second (and hopefully you read it here first), the UK is now widely expected to go into a second recession in 2 years.  This highlights the problem that all policymakers have (both in the US and the euro area) – that is essentially one of keeping on the right side of the financial markets while stimulating the economy, and properly coordinating both fiscal and monetary policy to ensure the best outcome.  While Cameron antagonized the Europeans, he is not exactly proving to be a good economic steward at home with the City of London likely shrinking during 2012, with a consequent drop in UK house prices.

Tuesday, December 6, 2011

The Mario Bros and the Euro Savings Reality

What a lot of news lately - I was thinking recently that it's almost like watching a soap opera gone badly astray from the original plot!  So in this posting I want to pull together some thoughts on the European situation.

I am doing this because I am frankly tired of reading some of the "doom and gloom" commentaries that other (mostly "glitterati") economists are producing.  Roubini's comments (see here) on Italy potentially leaving the euro area were simply over the top and illustrate that some economists simply don't understand the European project (despite the fact that Roubini is from Italy) or appreciate optimal currency area theory.  And Roubini wasn't alone - just read Krugman's (here), Martin Wolf (here) and even George Soros (here).  This alarmist reaction to what is going on in Europe is not only unhelpful but (as noted by one response to Roubini's commentary) it is alarmist and almost hysterical.  Let's not forget that Italy has a very high savings rate compared to many countries and given the economic downturn their savings rate is likely higher than where it was back in 2009 when it stood at 14% of GDP. So the run up in Italian bond yields is not something to worry about, and this was amply illustrated when the market realized this and quickly shifted it's attention over to Spain when the latest auction of Italian bonds was successful. Italy is definitely not Greece, and Italy's debt, as I recall, was 112% of GDP when they joined the euro area back in 1999, so why should there suddenly be a "crisis" when Italy's debt to GDP ratio is now 118%? 

Here are the national savings rates for various countries as of 2007:

Economics also backs this up, in the form of analysis of savings and investment, along with the funding of public sector debt. Countries that have high domestic savings rates (like Japan, for example), have no trouble funding extremely large public (and private) debts. Countries like the US with relatively low savings rates have  much more reliance on external funding of their public debt, and therefore the international bond markets. Obviously the higher the debt and the lower the national savings rate (as well as other factors such as whether the country has defaulted before, as pointed out by Rheinhart and Rogoff), the more likely it is that difficulties will occur in funding debt. So where does this put Italy? Italy's savings rate is one of the highest in Europe, and although it has been falling, it is still a sizeable chunk of GDP, so that it is unlikely that the Italian government would ever default. Add to that the fact that Burlesconi is gone and has been replaced by a "technocrat" economist (Mario Monti) who was previously an EU Commissioner, with Monti having a cabinet of no less than 7 professors, and the fact that the new ECB President is an Italian (Mario Draghi) and I think you have the recipe for losing a lot of money in the bond markets if you take a bet that interests rates on Italian bonds will stay high.  Indeed, as I didn't manage to get this post up before leaving the US for Africa I have managed to get an overnight 15% return on my bet on Italian bond yields coming down by using the ETN ITLT.

But the main message I want to get across on Europe is that the euro is NOT going away anytime soon, as some commentators seem to think. Although member states should be free to, or forced to leave, Germany, France, Austria, Italy, the Netherlands, Belgium, Luxembourg and Finland do not seem to be pulling apart economically speaking, and if push comes to shove the ECB is not going to allow bond "vigilantes" to threaten its very existence. Collapse, in my opinion, is unimaginable in the current circumstances - but crisis and default are not. The Economist's commentary on Germany's rigidity (here) in seeking solutions to the euro area's problems was instructive but failed to point out that Germany has benefitted from the euro as if it had continued to adopt the Deutschmark it's exchange rate would likely have been higher than current levels of the euro and so their economy has been given a boost through their export sector.

Next post will deal with the perhaps more severe problem of the banking liquidity issue in Europe. 

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