Greece needs to leave the euro: Part II

My response to a great article by Martin Wolf in the FT on 6/16/2015 which you can read here.

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Excellent article by Martin Wolf, but not really too revealing on what the options might be. 

Governments are responsible to their voters, not to the holders of the country's national debt.  When you look at that chart of real domestic demand at around 68 percent of where it was in 2008, you also understand that the Greek government needs to stick to it's guns this time. 

The sad thing is that these negotiations have not allowed any latitude for new measures, such as perhaps the conversion of some of the existing debt to consols, or the future sale of some Greek assets (Mykonos?) - they have almost exclusively focused on extracting further austerity measures from the Greek negotiators.

Given the lack of any imaginative initiatives on the part of the negoatiators, the unsuitability of Greece for belonging to the euro area (due to it not satisfying the optimal currency area critieria), as well as it not properly fulfilling the Maastricht criteria for joining the euro in the first place, the Greek government now needs to plan it's exit from the euro.

Despite Mr. Wolf's concerns about Grexit, I really don't think these specific circumstances apply to any other euro area member states, so the prospect of any contagion is minimal..

The really sad thing is that this whole Grexit thng has been kicked so far down the road as far as it has. The can is looking pretty crushed and deformed now, having been kicked so much - so now is the time to take the can off the road and put it in the garbage, or recycle it! 

Greece needs to leave the euro: Part I

I wrote this comment in reply to a great article published by Martin Wolf in the FT today (6/3/2015) which you can find here 

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Good article, but in my humble opinion some misconceptions.  

First, Martin Wolf makes the point that the euro area is not an OCA.  As my research has clearly shown (see my Bank of Finland discussion paper on this issue published 2 years ago  http://www.suomenpankki.fi/en/julkaisut/tutkimukset/keskustelualoitteet/Pages/dp2013_33.aspx), Greece does not have, and never did have, business cycles (or any other cycles for that matter) that are synchronous with the rest of the euro area.  It is simply not a good fit with the rest of the euro area, without (according to the OCA theory) there being sizable offsets which consist of fiscal transfers and much higher labor mobility.  And this is the case both ex-ante, and ex-post.  So, given this empirically proven stylized fact:

Second, the Greek government is simply wasting it's time and energy negotiating something that will not result in any long term membership of the euro - it will just be "another shot of medicine to help the dying patient".  I understand that the fact that the Greek government is actually negotiating is a necessary political pre-requisite to leaving the euro, but let's not drag this sorry Greek tragedy on any further than needs be, as this just prolongs and likely exacerbates the suffering of the Greek people.  

Third, Martin Wolf says that this will have a profound effect on the euro area and reverse the integration dynamic.  Well, hmmm, Greece is a little country the size of the State of Rhode Island in the context of the US - so it's not as if Spain or Italy were leaving. The euro area is 16 years old - and so its longevity won't depend on one small member deciding to leave early on it's evolution.  Also, the UK leaving the EU would have a much bigger impact on the integration dynamic than Greece leaving the euro area. 

Lastly, Wolf clearly wants Greece to stay inside the euro when he says that "This must be seen as a long game".  I mean how long do you want this game to be?  Governments simply don't think long term as their time horizons are short term or medium term at best. So the Syriza government really has the choice of alienating it's supporters and signing up to something that it promised never to sign up to, or pulling Greece out of the euro, which will create some chaos to begin with unless they have a proper plan B in place.  

If I were the Greek finance minister right now (which thankfully I am not), I would be furiously planning and comparing different strategies for a euro exit, as inevitably, that's what is the most likely outcome here.  

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Now in part 2 of this blog, which will come out in the next couple of days, I will outline what I think the options are for Grexit.

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.