Comments on the Euro Crisis delivered in the City of Sails!

I delivered these comments as part of a roundtable on the future of the euro at the University of Auckland, New Zealand, in October of 2012.  Enjoy!

"First, thanks to Univ of Auckland for hosting this event and in particular to Prof David Mayes and Mutsumi Kanazawa of the Europe Institute for organizing the event.

The starting point for me is the economic theory behind whether you should adopt a single currency or not.  As any student of international economics will know, Nobel Prize-winning economist, Robert Mundell, formulated the conditions under which it would be advantageous for a country or member state to join a single currency area.  This is known as the optimal currency area theory, and essentially says that your business cycle has to be synchronized with that of the other members of the group, or have some prospect of becoming synchronized, for it to be advantageous to join.

Mundell specified that you could also have some offsetting features that would then mitigate any lack of synchronization with the single currency, namely a high degree of labor mobility or supranational fiscal transfers.  Note that Europe has neither of these offsetting features.

So in 1991 when the Maastricht Treaty passed, it contained legal criteria for joining the euro, which had clearly been put in place by politicians and their civil servants, as at the time it was widely criticized by economists for being inappropriate.  The criteria were i) keep budget deficits below 3% of GDP; ii) keep public debt below 60% of GDP, including falling towards that level from higher levels; iii) keep long term interest rates within 2% of the average of the lowest 3 in the EU; iv) keep inflation rates within 1.5% of the average of the lowest 3 in the EU; and v) stay within the ERM for at least 2 years beforehand.

As you can see these criteria have little in common with Mundell’s simple idea of an optimal currency area, and indeed, not only were the Maastricht criteria misguided, but they also allowed too many EU member states that were not suited to a single currency into the euro area, Greece and Portugal being the prime examples.

To give you an analogy, it’s a bit like saying you’re going to start a bowling club, and although you know that the best members, regardless of their weight, ethnic background, height or hair color, will be those that are interested in bowling, you decide that membership should depend on being over a certain weight, under a certain height, long arms, and preferably black or blonde hair, simply because you might have watched professional bowling and seen that the players tend to have these characteristics, and therefore at the time of membership application these were the features you thought to look for. This is precisely analogous to what happened with the euro area. Those that were let in had to satisfy certain criteria at a certain point in time which had very little to do with whether the member state would be an appropriate member of a single currency.

Now there is also an extension to the OCA theory called the Endogenous OCA approach – it says that because monetary unions usually occur on top of common markets ( - think most federal or confederal states), then using the euro might stimulate more flows of factors of production between the member states, making them more economically integrated with one another which might then lead their business cycles to move more closely together.  In other words, before the fact or ex-ante, a member state might not look as though it’s eligible to be a member, but once it becomes a member or ex-post, it’s economic dynamics might change so that it would be selected as a member under the OCA approach.

So moving back to our analogy with the bowling club, if you let members in who were not very good at bowling but were committed to regular attendance and keen to get stuck in and to socialize and ask other more experienced and better players for advice, they could become good bowlers after a time.  Of course if you used the analogous method to the Maastricht criteria, in other words selecting members according to certain specific features, you would hope that the members you let in would grow longer arms, become shorter and weigh more, and change their hair color.  Oops, maybe my analogy breaks down a little here!

Given that we have this membership problem right at the outset, even before the economic downturn at the end of the last decade, some stresses and strains within the euro area were already apparent.  This is particularly because member states had to continue to limit their budget deficits under the Stability and Growth pact, but obviously when the major downturn occurred the OCA theory really began to highlight the membership problem. 

What I’m really trying to say here is that economics truly matters.  Just like you can’t build a house without obeying some principles of construction ( - unless you like to witness disasters), you can’t build a monetary union without having some preconditions and those preconditions are very neatly laid out in Mundell’s optimal currency area theory.  Ignore them at your peril!

Source:
http://www.guardian.co.uk/commentisfree/cartoon/2012/may/15/eurozone-greece-germany-euro-cartoon

Now when you look at the euro area through this lens, and I’ll be doing exactly this at my research seminar tomorrow, you’ll realize that as there is very limited labour mobility in the EU, and currently little prospect of a federal political system being introduced in Europe, then having synchronized business cycles is key to remaining part of the euro area.  My research shows that certain member states, although they might have been hitting the headlines recently for their economic problems, are much more easily going to be able to stay in the euro area than other troubled member states.  Member states like Spain and Italy, for example, even though they have deep-seated economic problems, have growth patterns that are quite similar to other euro area member states, while member states like Greece and Portugal do not have such similar patterns of growth, and therefore do not fit well, in good times or bad. Some member states like Finland seem to conform to the endogenous OCA view, as Finland started off not fitting too well, but over time it’s growth dynamic now appears to be much more in line with that of the rest of the EU.

So what should happen to resolve and therefore end the euro crisis?  My opinion is unashamedly research based, which is where I think we economists need to hang our hats if we are to have any credibility, particularly given our lack of foresight in other areas of major concern where we failed to take warnings seriously and do proper research to be able to make useful policy recommendations. 

So, in my humble opinion, either one of two things needs to happen.  Either:

1 – we move towards a more federalist structure in the EU, with permanent mechanisms in place for fiscal transfers.  Canada has them set up as a formal policy structure (the “equalization payments”) and the US has them on an informal basis ( - through the US budget).  Either would work, but that is the only way that if we stay with the current members that we’ll see this situation resolved in the long term; or

2 – the member states that do not form part of an OCA, and given that they’ve been members for over 5 years already, show little sign of becoming part of one in the future, need to be told to leave.  As an economist, I don’t care what means are used to get member states like Greece out of the euro – bribe them if necessary – but they need to leave, and leave fast before the situation there spirals out of control and the EU has more than just an economic crisis on it’s hands.

In my opinion the most dangerous path is that the Greeks decide to try and stay, despite the fact that their economy is in meltdown mode, and the austerity packages continue to fail because the economy is shrinking and so tax revenue is falling while at the same time public expenditures and wages are having to be savagely cut, hence reinforcing the downward spiral.  The costs of leaving might be large, but the given that I cannot see any way for things to get better right now, this is the only way to put some light back in the tunnel, so to speak.  

On the EU side, the danger of neither of the options occurring is probably greater than the danger of one of the corrective actions I have recommended.  Why is that?  Because if nothing is done, then internal indebtedness inside the EU must increase as lending to certain member states has to be maintained for them to remain members.  So if the Europeans decide to be polite – then no one is going to ask you to leave given that you want to stay, so the only way to stop contagion to other member states is to keep changing your bailout rules and mounting new lending programs, as we lurch from one emergency to the next. 

As Willem Buiter, who incidentally was one of my Professors at Bristol when I was there, recently said in the FT – if this continues much longer you might start to see Germany, Finland, Austria and others start to make noises about leaving the euro themselves, as despite the advantages of being members right now, if things continue too far down the road of trying to keep the current membership at the expense of the clear OCA members ( - the “hard core” if you like), then the disadvantages of being members may start to outweigh the advantages.  So the scales might then tilt so that it might appear to be the best course of action for these natural OCA euro members to leave.

So, now to put my political economy hat on, there are 2 remaining questions: of the options I have outlined, which a) would be preferable in an ideal world and why; and b) is going to be more palatable from a political point of view.

I think that from the perspective of European integration, a more federalist structure is preferable, as it then means that the OCA problem nicely goes away and no one gets booted out of the club.  Even Merkel has referred to this as being the best long term solution.  The big downside is that It likely means that Europe will splinter, as a federalist type EU governance structure is not something that the UK or many Central and East European member states ( - such as Poland) want. But the EU cannot be all things to everyone, and at some point the EU will have to accept this, and move into a world of what I think of as a permanent state of so-called “variable geometry”.

The upside to the second option, that of asking member states to leave (either directly by telling them to go, or indirectly by refusing to make any further concessions or mount bailouts), is that once done, you don’t have to worry about the euro area being an OCA either, because you lose the member states that were the problem in the first place, leaving the rest of the members to get on with it.  But the downside is really not good.  It means that there will be considerable resentment and bitterness in Greece, Cyprus and perhaps Portugal, if they end up leaving too.  It also means that the EU’s vision of a single currency for the whole of Europe can be essentially written off. Of course with this option you don’t have to consider further integration – essentially you move backwards and recognize that a monetary union without further integration is only viable with certain member states involved.

The most difficult aspect of this whole thing lies in the response to the last question I want to ask today: which of these options is going to be more palatable from a political standpoint?  The honest truth is that neither solution is palatable to the EU at the present time.  I think it will take another crisis of some sort to get them to act, and in the meantime the “hard core” of the EU will start making life more difficult for Greece et al so that it hopefully decides to leave on it’s own accord. That would open the door for others to follow.

So to end with, I see a much bigger danger here if the current trend of the “hard core” making life more difficult for the likes of Greece, Spain and Portugal continues, and that is that member states start to act on the basis not of the good of the whole (i.e. the EU), but in terms of what they themselves want.  This will obviously lead to much less compromise in the EU and will make it much harder to get agreements in other policy areas, as member states are more likely to be unwilling to compromise if they feel that they’ve been bullied or not dealt with fairly when it comes to their involvement in the single currency.

Let’s hope we don’t go down that path.

Thank you for your kind attention." 

A Young Person's Guide to QE3

The Federal Reserve Building, DC.

As we all know, the QE3 is a Cunard cruise ship, but this abbreviation has also the vernacular as the latest installment of the Fed's quantitative easing program. Although the media was very good at reporting the details as far as the announcement went (see here or here for example), there is very little commentary on what QE3 will actually have the potential to do to the economy - so here I'll attempt to shed a little light on that without hopefully offending either political party.

The term "quantitative easing" is used when the Fed can no longer use conventional methods to ease monetary policy further - that is by lowering interest rates.  Interest rates in the US are now extremely low and the Fed has decided that it doesn't want to see them any lower - this is the so called "lower bound".  So the Fed instead resorts (as the Bank of Japan did before it) to unconventional methods, namely "quantitative easing" which occurs whenever the central bank buys bonds which are longer term government bonds or bonds not issued by the government.  When the central bank buys or sells short term government bonds (known as T-bills) this is known as "open market operations" and is the usual channel in which monetary policy operates.  So what were QE1 and QE2?  In late November 2008, the Fed started buying $600 billion in mortgage-backed securities (MBS) - these are pieces of paper that represent bundles of mortgages, and they result from banks packaging together mortgages in big bundles and then effectively selling them on so they can free up their balance sheets. By March 2009, the Fed held $1.75 trillion of bank debt, MBS, and Treasury notes, and this reached a peak of $2.1 trillion in June 2010. Further purchases were halted as the economy had started to improve, but resumed in August 2010 when the Fed decided the economy was not growing fast enough. This was "QE1". In November 2010, the Fed announced a second round of quantitative easing, or "QE2", buying $600 billion of Treasury securities by the end of the second quarter of 2011. 

Ben Bernanke from an Article in The Atlantic Magazine

The third round of quantitative easing, or QE3, which was announced by Fed Chairman Bernanke a couple of weeks ago, was completely different, not because of what the Fed would do, but because of how it would do it. This time the Fed is going to buy $40 billion of mortgage-backed securities (MBS) per month, until the US labor market improves.  Bernanke said essentially that this program would be open ended, and would continue until the economy is well on it's way to recovery. Now what does this mean exactly?  Well, for a start, the Fed is committing itself to buying securitized US mortgages, which as any undergrad student of economics knows will increase the demand for this type of bond, and so will increase price, which will reduce yield.  The immediate effect then of doing this will be to keep mortgage rates very low, as banks will be able to issue up to $40 billion of new mortgages per month without putting any upward pressure on mortgage interest rates.  This in turn, will be a big stimulus to the housing market, one of the key sectors in the US economy.  All well and good so far.

The main problem with the policy though is that the so-called "transmission mechanism" for this form of unconventional monetary policy is not entirely clear, and here's why.  Given that this stimulates mortgage lending (as banks know that they can easily package up the mortgages and sell them on as MBS), this will clearly stimulate both existing and new housing activity, which will mean more housing construction.  So that will, in turn, mean more construction workers will be hired, which should increase employment, and that in turn will boost payroll numbers and bring down unemployment.  But employment in construction, even at the height of the housing boom in 2006 only represented about 8% of total US employment, so that is not really going to have a huge impact on the labor market, plus, many of the hires that do occur for manual construction jobs tend to be illegal or undocumented workers, so this won't feed into the official statistics either.

Of course I cannot imagine what the Fed economists have in mind for the transmission mechanism for QE3, but the only thing I can think of is that a mini-housing boom causes house prices to rise, and that in turn gives rise to so-called "wealth effects". These wealth effects result from people feeling better off because they have a net profit in their property, so go out and and spend as they did back in the 2000s.  There are also likely to be wealth effects arising from the stockmarket as well, as obviously market sentiment has improved in the knowledge that the Fed has backstopped the economy for the moment, and so share prices should continue to firm.  But the danger here is that these mechanisms are very - how might I put it - inexact. Obviously imprecision is not an excuse for inaction, but on the other hand it really is sending the Fed into uncharted territory.

Now please don't get me wrong here - I'd rather the Fed did something rather than nothing, as we clearly need more stimulus from somewhere, but I'm just a little uncertain as to how well QE3 will work.  I guess only time will tell.