The Key to Eurozone Stability Isn’t Monetary

The Eurozone debt crisis has raised important issues in the profession of economics. With regards to monetary integration much knowledge has been developed thanks to the crisis. Economist have virtually all rallied to the idea that  monetary unions exacerbate competitive imbalances. The Proof is in the widening gap of current accounts between the germanic like economies and the profligate periphery economies. Germany has never exported so much while the PIIGS have not suffered so much in a while. While the causes of the crisis are apparent to almost everyone (except maybe the Greeks) policy prescription differences abound. The prevailing view is to infuse massive amounts of liquidity into sovereign debt markets to stop the liquidity haemorrhage. The theory that the Eurozone is in a temporary liquidity crisis has strong proponents such as Paul Krugman or Roger Bootle. While Ireland has a strong growth profile and Italy does have a primary surplus that could justify monetary stopgap policies the problems of the other Euro profligates cannot be tidied over by temporary monetary measures because their issues are of a structural competitive order.

Once monetary policy impotence is accepted two policies approaches remain. The first is fiscal integration. A lot of economist advocate Euro bonds to alleviate market pressures on individual member finances. The obvious problems pertain to moral hazards. One of the causes of the crisis was that the reduction in sovereign interest rates because of decreased currency risk would induce profligacy. Such a phenomenon would be continued and compounded by Eurobonds. A fairness issue would also arise as lower debt countries would pay for the debt spending of others and AAA rated countries would actually pay heftier interest than they deserve. A problem in construction is also obvious. Eurobonds would be a substitute investment for sovereigns, unless Eurobonds replaced sovereigns entirely they would cannibalize demand for sovereigns and might actually help increase sovereign yields as German bunds have done to French Bonds today.

Instead of pooling liabilities to decrease individual sovereign risk, why not pool assets? This might be somewhat more palatable to German hawks. One way of pooling assets would be to federalize Unemployment Insurance. All members could pay into a fund that would back payments of insurance payouts. This would further effectively create an internal counter cyclical government spending stabilisation. As some states power ahead the transfers would automatically alleviate budgets in ailing economies. This already exists in Canada to great inter-provincial budgetary stability, the proof being that Quebec’s yields are at historical lows although the province has comparable debt levels to many PIIGS. Unfortunately as with all insurance schemes moral hazards subsiste, but the idea remains a good way to alleviate massive intra monetary union budgetary differences.

Fiscal integration however will not in the long term eradicate structural problems. The crux of the Eurozone problem is quite simply competitive differences. For a monetary union to survive in the long run productivity must balance out across its membership. Standardizing macro-prudential or regulatory frameworks across the zone is a good idea, but only when the policies standardized across the monetary union are good. Mis-regulation at a central level is worst than at the individual problem, imagine what the Eurozone sovereign debt crisis if everyone had emulated Greece or Spain’s policies. Diversity and regulatory competition is good so long as it leads to emulating of best practices. That countries aren’t emulating Germany is testament to political and not economic issues.

The only issue remaining is that of markets prevented from punishing political cultures conducive to bad policy. Greece has a political culture conducive to demagogy and fiscal populism. Markets are sending Greeks a message, “change your ways or suffer” that the European Union prevents this pedagogical process from unfolding is the real long term risk to Eurozone stability.

European Quantitative Easers Let’s Talk

The Eurozone sovereign debt crisis is posing a real challenge to Europe’s policy makers. The un-abating liquidity squeeze on government borrowing is threatening to turn into a solvency crisis in which more Eurozone countries are at risk of defaulting on their debts. The interest rates at which governments are currently borrowing are for the most part unsustainable, with countries like Italy and Spain borrowing at dangerous levels previously reserved for the smaller members of the PIIGS group. Broadly, two schools of thought have emerged with solutions to the problems at hand, one we will call the Monetary Keynesians and the other the German School of thinkers. The former are represented by such personalities as Roger Bootle of Capital Economics, the famous Dr Doom Nouriel Roubini and the New York Times Econom ic’s Nobel Prize winner Paul Krugman, while the latter are represented by the likes of the resigned ECB Governing Council members Axel Weber and Jurgen Stark.

The first group is advocating using the printing press and nationalizing (or federalizing) distressed sovereign debt. That is to say they want the Eurozone, through the ECB, to print money to by debts that can’t be paid back by member countries who spend more money on goods and services than they produce. The excuse found to justify this action is that the fledgeling economies are actually able to produce enough wealth to sustain their social systems but that because of a temporary bleep of liquidity issues they need temporary help. Nothing could be further from the truth. France to name just one of the irresponsible countries (although not yet a crisis country) has not passed a balanced budget since 1973! Greece has lied about its overspending for years prior to the crisis and the Eurozone as a groupe only managed a budget surplus in 2001 in the last 20 or more years. What does this say about European fiscal rectitude? it says that it doesn’t exist the Eurozone has always had a structural deficit. The sovereign debt crisis has been in the making for a long time, the Keynesians excuse that it is a temporary problem needing papering over is bogus.

Not just bogus but also internally inconsistent. Keynesianism calls for counter cyclical fiscal policy, while american liberals like Paul Krugman say that pro growth spending is positive in bad and good times alike. In any case the Greeks have proved that policy wrong. Another solution proposed by the less hawkish of economists is to have the ECB double down on its LTRO or renew its sovereign bond buying program. Imagine the ECB mostly backed by Germany buying Spanish, Portugese or Italian bonds. Now imagine investors believe that the problem remains unfixed and that primary deficits can’t be fixed by liquidity improvements, yields will continue rising and bond values will continue dropping. The ECB will either have to print money to paper over its loss sparking inflation or it will have to beg the big Eurozone economies to bail it out. Now assuming Europeans remember what low growth high inflation looks like (see 70’s and 80’s) they will surely stay true to their feelings of entitlement and choose to pressure the Eurozone core to pay up.

Now the Germans, Finnish, Dutch et al. have already shown their distaste for profligate Mediterraneans’ bail outs, so does anybody really think the ECB will go down that road? Well you’d be right if you think it might happen, with all the German resignations at the ECB, the institution seems to be loosing its hawkish edge. Forget the stellar inflation busting record under Trichet, the ECB is going south.

These are disappointing times for some economists, the world is awash with exemples of virtuous macroeconomic policy and yet some continue to advocate tried and failed policies or policies that are untried and risky. Why does no one point towards Canada where austerity in the nineties have led to stable government expenditure levels today, or Germany where austerity was imposed, unit labour cost were lowered and how about Estonia which consolidated spending massively in the face of a deep contraction in output and today is one of the Eurozone’s fastest growing economies. The Eurozone periphery is small enough that deep primary-surplus generating government spending contractions wouldn’t affect he currency zone as a whole too deeply. Portugal and Greece could have been the next Estonias, instead talks of bailout and quantitative easing has inspired periphery politicians to stall and not make the necessary decisions for growth.

The PIIGS, France and all other fiscally week Eurozone countries need to do three things: stop dithering and waiting for someone else to bail them out. They need to emulate Mario Monti’s drive for competitiveness, shoot for growth and competitiveness. Then they need to emulate the tiny Estonian country and actually start generating budget balances through lower expenditure and not through heightened taxes. What the rest of the World needs to do is stop giving ball-less politicians excuses for their failures and easy solution proposition. The road to wealth has already been traced, it’s time Europeans stopped pretending they are smarter than the rest of the World and American liberals need to open their eyes to the reality that free lunches dont exist and the hard road is the better road!

Here’s a Suggestion Mr Carney

The governor of the Bank of Canada Mark Carney has again continued to scold and give lessons to Canadians. He does this in his Monetary Policy Report of April 2012 where he reiterates some of the comments this blog criticized in a previous post. Those comments were that Canadian exporters needed to retool and refocus and that Canadian consumers needed to slow their pace of debt accumulation. The focus of the ‘retool, refocus and retrain’ mantra is largely advocated so as to increase Canadian firm’s ability to compete internationally and export. While this blog has already stated its objection to paternalistic economic communication from government institutions towards the private sector, this blog does accept Carney’s view that Canadian prosperity is underpinned by healthy trade numbers and international competitiveness. There is one criticism the Governor could have levelled that balances private sector independence and improved competitiveness, that critic should be less debt supply and it should be levelled at governments.

Talk of trade competitiveness unfortunately always boils down to currencies. In Canada manufacturers and commentators are always complain about the high Canadian dollar and how many jobs it kills. Leaving aside the fact that a high currency has as many benefits for a country as it has costs, a currency artificially above its equilibrium (or below it for that matter) is however  a concern. Let’s assume that the Canadian dollar is artificially overvalue, who might the culprit be for this imbalance? The Loonie isn’t a reserve currency so that can’t be it. Contrarily to McGuinty’s opinion oil isn’t to blame either. As the Central Bank report notes, Canadian oil is sold at a steep discount to certain international oil benchmarks, meaning that eastern Canada imports at high prices while the west exports at cheap prices, so the impact of higher oil prices only marginally affects the Canadian currency. In any case studies have refuted the claim of the Loonie being a petro-dollar. So who exactly is contributing to the Canadian dollar remaining above par with the US dollar?

To answer that question the certain economic facts need to be reviewed. Commentaries on trade and currencies often emphasize a restricted number of causes for currency fluctuations. Currency movements need to be understood in terms of foreign exchange market equilibrium. Every currency trade impacts the prevailing exchange rate but every trade does not just involve a quick speculation or an oil contract purchase. Much purchasing and selling of currencies involves savings diversification by institutional money managers. To give some colour to this point in 2007 before the crisis hit, foreigners shed roughly ~10 Billion of government paper while exporters sold just over 460 Billion dollars of exports. Since the beginning of the crisis over 400 Billion of Canadian government financial papers have been sold to foreigners. What does all this mean? Government budget surplus reduces the supply of government debt available to foreigners for purchase, a government deficit increases the supply. Since foreigners must buy Canadian dollars to purchase both export goods and government debt, Canadian governments’ profligacies are partially to blame for the high Canadian dollar. Part of their issuance of debt has been sold to foreigners increasing the demand for the Loonie and crowding out exports of goods and services.

Some might be tempted to point to Europe to refute these assertions. They would note Europe’s deficits have widened since 08 while the Euro has generally fallen. This is easily explained by sovereign risk. Canadian government debt is perceived to be a safe investment while much of the Euro area’s debts are considered very risky. Investors the World over generally prefer to buy Canadian debts than those from the PIIGS as they could be described as better quality products. Essentially Canada’s two most popular exports have now become oil and debt, small wonder manufacturing in Ontario can’t keep up. So if Mark Carney is so considered with the twin problem of profligacy and competitive weakness why isn’t he calling for Government austerity?

Bretton Woods Stress Disorder Again?

Did you hear? China is manipulating its currency to enrich itself on America’s back. Were you not aware that the Euro was actually German machinations so that it could out-compete the area’s periphery for its own gain?

There is a lot of talk out there of currencies being used as a form of weapon in the 21st century’s new form of favourite international warfare; economic warfare. Everybody seems to be guilty of partaking in this ‘non-violent’ form of confrontation. China has an undervalued currency pegged on the US dollar. To be fair, over a dozen other countries do too. Half of western African countries have pegged to the Euro as well as a few notable others. Accusations have been leveled against Germany for unduly profiting from the competitive weakness of its monetary partners since the 1992 Maastricht Treaty (and especially since the Euro crisis of 2011). Various central bankers and government officials around the World have called quantitative easing intentional currency manipulation, essentially accusing the US of cheating (the Bank of England and European Central Bank would also be guilty of this in such a framework). Essentially there has been a lot of posturing and indignation flying around focused on this one issue of currencies. I think remembering what a currency really does for an economy could help cool the air.

Some people like to say that currencies function as market mechanisms. Now nothing could be further from the truth. Just because there is a semi-unregulated currency market does not mean currencies are free market instruments. Just like a carbon market is not a liberal concept because trading is free. The collapse of the Bretton Woods system occurred because nations couldn’t compete in a relatively free trade environment. Certain nations were more competitive and the others did not have the political will to increase national competitiveness. A new system arose quite naturally whereby a floating currency did all the work of correcting competitive imbalances. As a nation comparatively slid into economic incompetitiveness its currency would be reevaluated downwards by a free currency market to insure a semblance of equilibrium of balance in trade terms. Essentially governments outsourced the responsibility of putting into place national competitiveness to the markets to avoid labour disputes and imposing fiscal rectitude to national budgets.

So when China pegs its currency to the US’s it is in fact just returning to a Bretton Woods type formula. If a trade balance exists between the two countries it is because the two governments do not share the same appreciation for macroeconomic rectitude. While the US splurges as a nation China saves. While in the US labour movements have the legal upper hand on business (see GM, Chrysler bankruptcies and Boing labour conflicts) in China pro business policies abound (sort of). In essence, the Chinese government does not shy away from imposing strict macro prudential policies on its economy, America elects Democrats instead. So the US’s complaint really resides in its political dithering with regards to economic policy. China’s currency policy is just one of limiting the risk to business of currency volatility. A policy US corporations should be in total agreement with if unclouded by nationalistic sentiment. To sum up a free floating currency is just a political tool to avoid hard decisions domestically.

Let’s remind ourselves of the cost of a free floating currency when a country is profoundly uncompetitive like Greece and even the US. When a country runs successive and deep current account deficits it means the country is chronically living above its means. A free floating currency would drop to correct this phenomenon. Increasing the price of foreign goods to impose a contraction in national living standards. So a country would in theory spend less on imported goods (food, clothing, cars and other discretionary items) to afford overspending in other goods (typically healthcare, education and other entitlements). So next time you see your native currency drop, odds are good that to afford government social programs you and all other individuals will need to buy cheaper food, flimsier cars and smaller houses. I wonder if electors aware of these dynamics would so liberally demand government services if they understood it meant less beer Friday night and less outings to the restaurant. Now some social democrats might argue it’s the price to pay for equity. Remind the next one you see that poor people are disproportionately affected by increased inflation on consumption goods. If they think value added retail taxes are regressive tell them government services induced current account deficits are more so (lost jobs, lost buying power).

So if one believes the Chinese won’t give up the peg and the Euro will survive (both highly likely outcomes) another solution is necessary. The US to take as an example, are doubly guilty of digging there own grave. The US worker remains the most productive of the World by any metric, so why does does the Chinese worker out-compete him (as demonstrated by the gaping trade deficit between the two countries). The reason is because the Americans are doubly competitive. How so? One of the US’s greatest exports with which virtually no country can compete is its government debts! No other financial instrument is more prized than the US’s Treasury Bonds. While the merchandise and trade balances can be negative the balance of payments always equals zero.

So all countries are faced with a straightforward choice; export goods and services or export financial paper (of which government is generally the largest component). Since the US issue so much debt that everybody buys the money cannot be spent on goods! If Barack Obama really wants to double exports in 5 years he can do it in a heartbeat by refusing to sign the next debt level increase legislation to hit his office. Obviously this implies hard political choices which I don’t mean to discount so caricaturally. China’s peg works by purchasing US financial assets, stop issuing them and China will not be able to buy them. The peg will then collapse without outright adoptions of the US dollar. Since China is so hell bent on controlling its internal economy, sacrificing the totality of its monetary policy sovereignty to another country is probably not in the cards.

The lesson while somewhat different for the PIIGS is essentially the same. Get competitive or get punished “à la Grecque”. Stop living above your means. Whether in a monetary union or even in a free floating currency regime, free lunches don’t exists, you’ve got to pay the piper someday. So Brazil and Canada pipe down will you, stop blaming your woes on currencies that refuse to act conveniently to your politics. To the US, ”Buy-American”, quantitative easing et al. are really cheap tricks. To any and all thinking of tariffs and quotas, please look at what happened last time that was tried. So to all China haters in the US or Germanophobes in Greece and the like, blame yourself for being ungovernable first, everybody else is just trying to do their jobs, time you started doing yours.

Cius