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 capital mobility came to an end? By letting this crisis fester, solving it will become more difficult.

Previously, it was thought that three essential ingredients are sufficient to rectify the currency union. First and most importantly, structural reforms have to be implemented to allow the convergence towards an optimal currency area. These should lead to comparable levels of competitiveness, implying a long-run equilibrium of balanced current accounts. Second, a transfer mechanism has to be established that facilitates the convergence process and helps individual members cope with asymmetric, temporary shocks. Eurobonds are one possible way to effect transfers by softening the intertemporal budget constraint imposed by markets. Third, an enforcement mechanism must prevent moral hazard arising from transfers. To this end, fiscal restraint is imposed through the European semester and a possible treaty change. However, it remains to be seen whether these measures have enough bite.

Unfortunately, these ingredients are no longer enough. Enforced fiscal restraint is unlikely to bring the different euro area members towards the same level of economic strength. The festering of the crisis has damaged policy credibility and unanchored fiscal expectations. The thrust of the Maastricht Treaty can be interpreted as an implicit contract between the national authorities and the EU private sector. As long as the former guarantees stability the latter provides capital across borders to finance investments necessary to enhance productivity and level out living standards across the euro area. Protecting bond markets from the precedent of a default on senior bonds in Ireland was part of this implicit contract.

Both counterparts, the private sector as well as the public sector, have violated this contract, leading to its termination. Banks fuelled consumption and housing booms instead of productive investment. After an initial attempt to save the contract (through fiscal stimuli and generous bank interventions in the aftermath of the subprime crisis), the public sector failed to hold up its commitment under the contract and entered into a protracted crisis. Politicians started to demand a restructuring of Greek sovereign debt.

Enshrining fiscal stability through the three essential ingredients above will solve the problem only in part. Capital allocation through market forces in the euro area has lead to a boom-bust cycle. Lack of confidence may not allow to renew the contract. And even if renewed, it remains doubtful that capital flows on their own bring about convergence. Additional ingredients are needed. Most importantly, structural reforms will need to make labor markets (whose liberalization lagged the liberalization of capital markets) much more flexible. What may be needed is a social contract within and between the electorates of member countries that brings the European people closer together, catalyze greater labor mobility and make Europe truly European. Politicians may find it harder to achieve this than a contract with the financial sector. Sadly, they don't even try.

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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, I discussed ways to tackle the debt problem through growth, inflation, transfers or default. In conclusion, I warned about the hidden costs and distributional effects when politicians fish for solutions that are popular with the electorate. In what follows, I argue that the same applies to an exit from the currency union.

Imagine again three countries that form a currency union: A large and strong country, called Oak, whose currency enjoys high credibility. The credibility has lead to internal exchange rate stability (another word for low inflation) as well as external exchange rate stability (another word for a strong currency). Then there is small Olive with a weak currency and inflation, and a large Pepperoni with a likewise weak currency and inflation. These three join into a currency union at reasonably competitive exchange rates, largely adopting Oak's stern monetary policy. What's next?

Only if the currency union is a credible construct will the benefits materialize. Only then will interest rates drop to Oak's level, as does inflation. Why is that? Olive and Pepperoni inhabitants start to believe that the central bank in the currency union is now guarded by oaky officials destined to fight inflation. Instead of expecting an endless spiral of higher prices and a depreciating exchange rates, internal and external price stability become engrained in the people's expectations. No longer do they need to ask for high interest rates on their savings to protect their savings against inflation, no longer do they need to flee their country and deposit their financial savings in Oak. No longer are interest rates high on investment loans. In response to the currency union, capital inflows and investment pick up, in turn creating demand for Oak's exports. This is what happened after the creation of the euro zone to the mutual benefit of all member countries.

If the currency union is not a credible construct, these benefits will not materialize. There is no point in having a currency union (or other fixed exchange rate regime) that is not believed to be lasting. Imagine Olive is being hit by a shock, whether it is self-inflicted (laziness to maintain the orchards until the olive trees are beyond recovery) or not (discovery of better tasting olives in another country). After the shock, the country would suffer from lower demand for their output (dead trees in orchards don't yield a harvest or traditional olives rot on the shelves while imported better tasting ones sell like, well, hotcakes). Banks across the currency union with loans to Olive would suffer losses because farmers are unable to repay their loans. If in this situation, the credibility of the currency union is called into question, the situation would get worse: Olive farmers would shift their savings out of the country, the banks in Olive would become illiquid, and there would be no credit for those farmers who are willing to invest in orchards. (Tendering their existing trees, or planting those with the better taste.)

This is why the integrity of the currency union is crucial. Even worse, the confidence effects are not limited to Olive. Once inhabitants of Pepperoni notice that Olive's exit from the currency union is considered, they would also empty their bank accounts given Pepperoni is known to be a weaker economy than Oak. Pepperoni's inhabitants would anticipate their exit from the currency union in expectation that every country is eventually hit by a shock. With Pepperoni being larger, the currency union would unravel in its entirety. The benefits of the currency union would get lost whether or not the currency union is formally ended or not.

Is it possible to operate a currency union in which there is not full trust? Many countries continue to do so, yet, mostly against the advice of economists. Heavy-handed regulations and ensuing distortions can maintain an exchange rate regime that lacks credibility. However, this usually leads to repeated crises and deadweight losses. Measuring these economic losses is often impossible. Thus, it is probably possible to manufacture an exit of Olive (while preserving the membership of Pepperoni) while curtailing the visible costs through regulations and the like. But, once again, the costs will be high yet hidden. Hence, let's not get fooled that exit is a costless solution, neither to Oak nor to Olive. Those who call for the disintegration of the euro zone should be aware of the political and economic damage they are inflicting on all.

Finally, a note on the benefit of devaluation to Olive upon exiting the currency union. Besides the direct costs to Olive (currency losses of savers, rescue of the banking system, etc.), the question is whether the devaluation does the trick. Given the economic and social pain of an internal devaluation (i.e., lowering domestic prices and wages), the external valuation (i.e., currency devaluation) is indeed an instant pain relief. That is why most countries enjoy high growth rates after a devaluation. Yet, many of them suffered repeated crises with repeated devaluations, and all the unpleasant things that happen during crises. Why does pain relief not do the trick? Because the pain relief treats a symptom, not the cause. The cause are usually inflexible labor markets, inefficiently large public sectors, lack of contract and law enforcement, limited competition, and the like. These must be addressed by reforms.

Structural reform is the right medicine for Olive. Exiting the currency union is not.

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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 perspective:

• From a flow perspective, Loteria’s profitability massively exceeds the cost of debt service. Loteria’s return on equity is about 17 percent. Compare this to average yields of Spanish government bonds of 4-5 percent!
• From a stock perspective, Loteria’s expected sale value has fallen by 20 percent (from EUR21 billion to EUR17 billion) since December 2010. Assuming that at in December 2010 a privatization-debt-buyback deal would have been optimal (which is doubtful anyway), the sale would still make sense if bonds would have also dropped by 20 percent. This is not the case (the 10 year benchmark dropped by about 6 percent), and would only become the case if 10-year yields would rise from currently 5.2 to more than 7.5 percent.

Thus, governments should be cautious when wishing for higher privatization to fill below-the-line financing gaps. Notwithstanding legal obstacles, a better solution to utilize government assets would be to securitize and bring them onto the balance sheet so they can be used as financial collateral to acquire funding.

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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 than Germany, although current potential growth estimates suggest that growth paths are roughly at level. And with the US Treasury’s AA+-rated and Japans AA--rated bonds yielding on par or less than Germany’s AAA Bunds, a non-prime rating should no longer sound the death knell for eurobonds.

	Euroarea	Germany
General government debt (percent of GDP, 2010)	85.1	83.2
Cyclically Adjusted Primary Balance (percent of GDP, 2011)	0.5	-0.2
Growth in public health and pension expenditure (ppt of GDP, 2010-30)	2.3	2.2
Historic GDP growth (real, 2005-10)	2.4	2.2
Potential GDP growth (real, 2011-16)	1.3	1.6

Sources: Eurostat; IMF Fiscal Monitor and WEO.

Second, the counterfactual of yield compression in the eurozone 1995-99 may be overlooked. If yield compression for peripheral issuers rests in part on an implicit guarantee from eurozone membership, so it is likely to be borne by Germany. (I know that substituting whacky monetary policy for Bundesbank policy is another factor.) But partially, if peripheral bond yields declined due to the implicit solvency backstop, German yields must have increased. Isn’t it surprising that Bunds yielded lower than gilts until the onset of the ERM II fixing (see figure)? Also, non-resident holdings, while increasing for all countries, accelerated more for other euroarea countries than Germany (see figure). This supports anecdotal evidence that investment flows after the euro introduction were directed away from Germany towards other euroarea countries, possibly lowering their relative yields. With eurobonds, this demand would be unified into one instrument.

Thus, if the eurozone is saved, and countries brought back from crisis, I don’t see a strong argument why eurobonds would yield those 100-200 basis points higher that are cited by others (e.g., ifo).

Source: Bloomberg

Sources: IMF Investor base dataset; CPIS.  1/ Data include France, Italy, Spain, Greece, Portugal, Ireland.

2/ Data include all euroarea countries (without Germany) but excludes  the financial centers of Luxembourg and Ireland

Sources: IMF Investor base dataset; CPIS. 

1/ Data include France, Italy, Spain, Greece, Portugal, Ireland. 

2/ Data include all euroarea countries (without Germany) but excludes 

the financial centers of Luxembourg and Ireland

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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 debts. Everybody would be better off and there are no obvious distributional consequences. (Although those with savings for their retirement would also prefer to buy gourmet olives from their savings, but have only saved enough to afford traditional olives. In terms of the economics of happiness, tough luck!)

This is where we run out of Wunderland solutions. Gourmet olives remain a dream. Realizing this, politicians go on to examine transfers. Transfers can be seen as tax collected from some and handed out to others.

First, there is the inflation tax. Assume that the central bank has successfully been captured by politicians (another tough fact of life) and helps out by getting inflation going. (Of course, this is not as easy as it sounds.) Prices rise, and so does the current value of (olive) output, while the current value of promised future payments declines. This is nothing else than a tax on future payments, whereby the tax is higher the further the payment lies in the future. Creditors with long-term (fixed rate) savings lose most, while debtors with long-term (fixed rate) debts gain most. Usually, government debt and pension savings have the longest duration. Hence, inflation redistributes wealth from creditors to debtors, and mostly so from pension funds (owned by the working population) to governments. This subtle way of wealth distribution takes place across the entire currency union, not only in Olive! Besides the question of stocks (of savings and debt), there is also a question of flows (of income and consumption): prices rise before incomes do, hitting in particular low wage earners. Finally, as is the case for all taxes, inflation has distortionary effects. In particular, inflation leads to higher interest rates, elevating the cost of investments, and thus lowering productivity growth across the monetary union. But politicians still love inflation: it is a very subtle tax, and the electorate may fail to see the true cost of it--unless the central bank completely loses its credibility and an inflation spiral gets out of control. So, political cost for politicians may be low. But costs from economic distortion in saving and investment as well as credibility costs of the central bank are substantial! Hm, doesn't sound too good, does it?

Second, there are unconditional transfers, or grants. The distributional effects are explicit: taxpayers in Olive win, taxpayers in Oak lose. Full stop. The crisis should be over, and Oak may actually suffer less than thought: To the degree that Olive's creditors are actually residents of Oak, the inter-country transfer turns out to be an intra-Oak-transfer. In other words, Oak redistributes wealth from all taxpayers to some creditors. Thus, to some degree the transfer is self-serving and may be cheaper to Oak than the distortionary inflation tax or the mess that may come out of a default (see below). The problem is not the feared reach into poor-Oak-taxpayers' pockets (figurated in large letters all over tabloid newspapers), but a conceptual one: critics claim that transfers induce "moral hazard": A transfer saves Olive's politicians from the pain of cleaning out their olive orchard, and the problem is more likely to repeat itself. This critique is not entirely true. Any crisis hurts Olive's government no matter what. Therefore, they have the incentive to bring their orchard in order. But they probably won't turn it into an Oak grove. Depending how well the ex-ante disciplining mechanisms are that force each member of the currency union to keep its orchards, groves, or whatever in best order, transfers are the least disruptive solution. This is the idea behind the fiscal union.

Third, there is default. Olive would just walk away from its debts, keeping all olives for herself, in fact imposing a tax on all creditors. If it is known who the creditors are, it is easy to identify the direct distributional effect of this wealth transfer: the creditors are often banks and pension funds. Ergo, wealth is being transfered from depositors and pension savers (who partly may not be residents of Olive, but rather Oak) to the government. The solution does not sound so different from transfer by inflation except that the transfer is much more direct and has less repercussions across the entire monetary union... hang on! Really? Conventional wisdom is that default is extremely costly because it sends a shock wave through the entire domestic economy. Contagion occurs because the government defaults on banks and pension funds, these default on depositors and pension claimholders, these in turn default on their mortgages, and so on. Why does the same not happen with the inflation tax? Because inflation shrinks everybody's assets and liabilities, distributing the burden very evenly. With default, eventually the burden will also be distributed through the system, but by means of small explosions that go off here and there. Key for avoiding this chain reaction is to identify the first line of vulnerable entities and protect them. For instance, Oak gives Olive a bridge loan to "buy time" and allow the banks to build warchests (e.g., capital buffers for banks). Or, Olive builds a central reserve to help the victims (e.g., a bank recapitalization fund financed by, er, well, probably Oak). This sounds difficult, and it surely is. The politics of it are messy, and this is about where we are right now. Ex ante it is not clear what the distributional consequences and deadweight losses are. Default taxes tend to shake up the political elite, and this may actually be the nasty truth of the political economy because backbench politicians often gain from shake-ups. (Just read "Freakonomics" to learn why small drug dealers love to kick off gang wars.) Unless well planned, the ultimate distortionary effect of a default can be substantial: incomplete information about the contagion channels ("who is an emperor without clothes?") can lead to a general loss in confidence (not only in Olive, but across the entire currency union). This will disrupt financial intermediation or, in other words, discourage saving and investment, and lower productivity growth. Avoiding this requires strong political will and as much excellent technical planning as execution. In an idealized world, the distributional consequences could be very limited and direct. The inconvenient truth is that in most cases it turns messy at some point.

Assuming that there are no gourmet olives, there will be a tax on Oak: Grants like default like inflation are all taxes. Whatever the tabloids try to convey to Oak's taxpayers, there will be some costs to preserve the currency union. And just because the costs of a grant from Oak to Olive is so obvious, there is no good reason to believe that the hidden costs from default or inflation are any lower. Grants are not a bad choice if the disciplining devices avoid moral hazard. Default is not a bad choice if the defense shield against contagion works. And inflation... well, unlikely to solve the problem anytime soon.

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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: 5.0.

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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 keep their secondary market yields low as to help them issue cheaper. To the degree that the SMP enables deficit financing as buyers on the primary market sell the next day to the SMP (something that may well be going), the SMP undermines Art. 123 of the Treaty which forbids deficit monetization. Once the issuer cannot access primary markets, he has no reason to care about gyrations of secondary markets. A stringent application of the analogy would open the refinancing windows to sovereigns, which however is ruled out by Art. 123 of the Treaty to avoid the monetization of deficits.

(ii) Avoid systemic crises. The LOLR backstop is mainly justified by the systemic nature of banks. They are thought to be the backbone of the economy. During the crisis, backstops were extended to other entities that were thought to be systemic, such as automobile manufacturers. But how systemic are sovereign bond markets? Peripheral sovereign bonds have largely lost their benchmark function vis-a-vis local issuers, which trade "through" the sovereign curve. Again, no reason to worry about gyrations of secondary markets.

(iii) Liquidity support. The LOLR is providing liquidity, not solvency support. To that end, the central bank uses collateral rules and can (in many cases) provide further emergency liquidity to solvent institutions, with a supervisory body in charge of monitoring the debtor's solvency. In case of insolvency, a systemic but viable debtor could receive a capital injection from public coffers, but not from the central bank but the fiscal. How does this compare to the SMP? The ECB has no clearly communicated guidance about the solvency of the sovereign debtor. There is no institution supervising sovereigns in the euro area, or an explicit or implicit recapitalization assurance or collateral.

While the analogy in principal is appealing, it seems neither the conditions nor the instrument are defined the right way. Sticking to the analogy, the ECB could also buy corporate bonds and provide liquidity support to pension funds and other investors in the sovereign bond markets!

To make the SMP work in an analogy to the LOLR, the ECB (or another watchdog) would need to develop and apply a threshold of solvency, receive fiscal guarantees towards maintenance of the debtors' solvency, and (after changing Art. 123 of the Treaty) buy on primary markets or open the refinancing window to sovereigns. Shifting any losses to the fiscal would reshape the SMP into a pure liquidity operation of unlimited dimension, which the enhanced EFSF or ESM is lacking.

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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 field of monetary economics.) Leeper's core hypothesis is that the alchemy results in fiscal policy that is arbitrary and fails to anchor expectations.

While his analysis of fiscal policymaking reads somewhat biased, I rather challenge the foundations of his thinking. (It is more fun.) First, how relevant is it to anchor agent's expections? And second, there are significant differences between monetary and fiscal policy.

On the first, Leeper omits to provide a definition for anchoring "fiscal expectations" in analogy to expectations over the future price level that central banks are trying to influence. In monetary policy, an anchor is crucial in presence of fiat money. Fiscal policy is anchored by hard bounds, such as the debt capacity (in presence of an independent central bank). And if the underfunding (or the expected sky-high public debt accumulation) of public pension schemes is an example of unanchoring "fiscal expectation", I wonder what the economic significance is: even if agents save more of their disposable income in expectation of the state walking away from their pension obligations, is the effect so much different from a government that anchors expectations by fixing the problem? Such government would likely tax the disposable income higher (reducing the agent's propensity and ability to save) and, well, save it.

On the second, Leeper is pretty sloppy in going over the essential differences between monetary and fiscal policymaking. There is no "inherent symmetry", or at least Leeper plays down their differences. Most importantly, many monetary policymakers enjoy what has been coined "central bank independence", a luxury a finance minister can only dream of. Fiscal rules, an institutional setting that limits the discretion of fiscal policymakers, are a substitute. Fiscal rules may be imperfect, but they are on the rise (see for instance this IMF paper). Similarly important, fiscal policy is a tool of public policy which pursues multiple objectives; monetary policy pursues one or two. The "morass" of scientific knowledge about fiscal policy may be a reflection of its manifold objectives. Maybe this is a merit rather than a stain on the fiscal policy profession. The concern about distributional effects is a key consideration in fiscal policy. On this account, monetary policy research has so far has looked the other way (aside from research on inflation and poverty in less developed countries). And ultimately, fiscal policy enjoys a myriad of tools, as opposed to (traditional) monetary policy. In the vein of distributional effects, it is not necessarily a fiscal "flip flop" when outlays for unemployment benefits during a slump are later refinanced from higher taxes for the top income bracket, such as in the UK.

Altogether, Leeper puts the spotlight on deficits in rigorous fiscal policymaking. That is fair, and more resources ought to be devoted to it. But it is not fair to call it alchemy at times where monetary policy is entangled in colossal experiments by itself.

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