Resolving the euro crisis: Three ingredients and a social contract

Deliberations of the political economy continue to trump macroeconomic considerations in resolving the euro area crisis. Germany's strategy of using crisis panic and market pressure to forge consensus increases the economic cost day by day. In the last two months, the broad based withdrawal of overseas institutional investors marks another milestone. This follows of the heels of European investors cutting cross border exposures reinforced by national supervisors (such as the Austrians capping credit expansion to foreign markets) and even European bodies (such as the European Banking Association's stress tests). Shall this trend implications on how the solution of the euro area crisis should look like? Unfortunately, yes. It seems national borders are getting reestablished in an effort to put Gini back into the bottle. But how can a joint currency make sense if...

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Economics 1-ohhh-1: Reform, not exit, is the right medicine

An often publicly heard policy recommendation is that weaker euro zone members should right themselves through austerity or leave the currency union. In any case, reform---not exit---is the right medicine.  The adjustment program implemented in Greece, Portugal, and Ireland are trying to strike a difficult balance between the necessary and the possible to turn around the economies. Orderly adjustment needs time and solidarity, just as it needed more than a decade and two trillion euros for former East Germany to get close to Western Germany's levels. German reunification like Europe's integration is, then and now, a political challenge and a historical chance. All the economic discipline can contribute is pointing out pitfalls and making good proposals to maximize welfare. The rest hinges on hearts and souls in Europe. In my previous post,...

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Privatization-panacea

Privatization is often thought of as below-the-line savior to the debt problems in the euro area. But a crisis may not the right time to privatize, other than to raise liquidity that cannot be obtained else. From a flow perspective, it would always make sense to hold on to assets that have a higher return than the liabilities, rather than disposing of the asset to pay down debt. From a stock perspective, both assets and liabilities suffer in times of crisis, so depending on the relative drop in value privatization may or may not become more attractive. Usually, prices of equity reacts more strongly than debt to a downturn, but in a situation in which debt is so risky that it resembles equity, the logic may not hold. For Spain, it makes financially sense to hold off with the Loteria privatization from a flow perspective, and (given ECB’s interventions) also from a stock...

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Overlooked factors in the discussion of Eurobonds

Often the argument is brought forward that Eurobonds will be expensive for Germany. The bonds would have higher yields than German Bunds given that  weaker debtors are aggregated into one issuer. Here are two counterarguments. (A third one, higher liquidity, has been made in abundance already.) First, credit fundamentals do not suggest that the euroarea as a whole is less solvent than Germany (see table). Debt levels, cyclically adjusted primary balances, and long-term contingent liabilities from pension and health are roughly on level with Germany. If pre-crisis convergence growth would be restored, the euroarea as a whole would grow faster...

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Economics 1-ohhh-1: Ways to resolve a debt overhang

Without implication, imagine there is a small country within a currency union. This country, let's call it Olive, suffers from too high debt and a liquidity crisis. Imagine there is another, large and solvent country that is called Oak. And on top of that, assume politicians really want to end the crisis. This sounds like a distant imagination, doesn't it? What can be done? Debt crises can be overcome in two ways: (i) growth and (ii) transfers, whereby transfers can take a zillion different shapes with different distributional effects, in particular: (a) inflation, (b) grants by Oak to Olive, (c) default by Olive. Growth is a first-best solution. Instead of producing traditional olives, a coincidental invention allows olive trees to grow gourmet olives with incredibly better taste. The resulting jump in value creation allows Olive to raise more taxes and pay off its...

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Number of the day: Greece deficit

Projected fiscal deficit of Greece in percent of Germany's GDP: 0.8. Second bailout package in percent of Germany's GDP: 4.6. Memorandum: Marshall Plan in percent of US' GDP: 5...

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ECB's Securities Market Program is fiscal action in disguise

The ECB's Securities Market Program (SMP) is, as shown by last weeks resignation of Jürgen Stark, controversial. One striking argument in favor of intervening in sovereign markets is the analogy to a lender of last resort (LOLR), a liquidity backstop central banks provide to banks (see Paul Grauwe's VOX contribution). Yet, I think a stringend application of the analogy points to something else than the SMP as currently implemented. Here are my points: (i) Prevent self-fulfilling runs. The LOLR function is intended to prevent the collapse of systemic institutions that are vulnerable to self-fulfilling prophecies. In other words, banks are given a backstop because they are believed to be vulnerable to irrational bank runs. Does the analogy hold to self-fulfilling sovereign debt crises? Secondary market purchases do not provide liquidity to the issuer, but...

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Fiscal policy is not alchemy

The Jackson Hole conference featured a noteworthy paper by Eric Leeper, a professor from Indiana University, on the economic foundations of fiscal versus monetary policy. While he characterizes the latter as science, he calls the former alchemy. The selection of this paper comes across as backlash against the first bout of critique of the economic profession which was directed against monetary policy by the Greenspan ear. Now it is the turn for fiscal policy. Leeper's paper highlights some undoubted facts, such as that monetary policymakers are backed by an army of economists producing impeccable scientific work about monetary policy. Fiscal policymakers can only dream of that in their ministries. (Yet, it takes wonder why others, for instance professors like himself, have not filled that void which would promise higher returns on scientific insight than the crowded...

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