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The Euro – A Monetary Strangulation Mechanism

In my previous post I claimed that the ‘Greek crisis’ essentially is not about Greece, but rather that the crisis is a symptom of a bigger problem namely the euro itself.

Furthermore, I claimed that had it not been for the euro we would not have had to have massive bailouts of countries and we would not have been in a seven years of recession in the euro zone and unemployment would have been (much) lower if we had had floating exchange rates in across Europe instead of what we could call the Monetary Strangulation Mechanism (MSM).

It is of course impossible to say how the world would have looked had we had floating exchange rates instead of the MSM. However, luckily not all countries in Europe have joined the euro and the economic performance of these countries might give us a hint about how things could have been if we had never introduced the euro.

So I have looked at the growth performance of the euro countries as well as on the European countries, which have had floating (or quasi-floating) exchange rates to compare ‘peggers’ with ‘floaters’.

My sample is the euro countries and the countries with fixed exchange rates against the euro (Bulgaria and Denmark) and countries with floating exchange rates in the EU – the UK, Sweden, Poland, Hungary, the Czech Republic and Romania. Furthermore, I have included Switzerland as well as the EEA countriesNorway and Iceland (all with floating exchange rates). Finally I have included Greece’s neighbour Turkey, which also has a floating exchange rate.

In all 31 European countries – all very different. Some countries are political dysfunctional and struggling with corruption (for example Romania or Turkey), while others are normally seen as relatively efficient economies with well-functioning labour and product markets and strong external balance and sound public finances like Denmark, Finland and the Netherland.

Overall we can differentiate between two groups of countries – euro countries and euro peggers (the ‘red countries’) and the countries with more or less floating exchange rates (the ‘green countries’).

The graph below shows the growth performance for these two groups of European countries in the period from 2007 (the year prior to the crisis hit) to 2015.

floaters peggers RGDP20072015 A

The difference is striking – among the 21 euro countries (including the two euro peggers) nearly half (10) of the countries today have lower real GDP levels than in 2007, while all of the floaters today have higher real GDP levels than in 2007.

Even Iceland, which had a major banking collapse in 2008 and the always politically dysfunctionally and highly indebted Hungary (both with floating exchange rates) have outgrown the majority of euro countries (and euro peggers).

In fact these two countries – the two slowest growing floaters – have outgrown the Netherlands, Denmark and Finland – countries which are always seen as examples of reform-oriented countries with über prudent policies and strong external balances and healthy public finances.

If we look at a simple median of the growth rates of real GDP from 2007 until 2015 the floaters have significantly outgrown the euro countries by a factor of five (7.9% versus 1.5%). Even if we disregard the three fastest floaters (Turkey, Romania and Poland) the floaters still massively outperform the euro countries (6.5% versus 1.5%).

The crisis would have long been over had the euro not been introduced  

To me there can be no doubt – the massive growth outperformance for floaters relative to the euro countries is no coincidence. The euro has been a Monetary Strangulation Mechanism and had we not had the euro the crisis in Europe would likely long ago have been over. In fact the crisis is essentially over for most of the ‘floaters’.

We can debate why the euro has been such a growth killing machine – and I will look closer into that in coming posts – but there is no doubt that the crisis in Europe today has been caused by the euro itself rather than the mismanagement of individual economies.

PS I am not claiming the structural factors are not important and I do not claim that all of the floaters have had great monetary policies. The only thing I claim is the the main factor for the underperformance of the euro countries is the euro itself.

PPS one could argue that the German ‘D-mark’ is freely floating and all other euro countries essentially are pegged to the ‘D-mark’ and that this is the reason for Germany’s significant growth outperformance relative to most of the other euro countries.

Update: With this post I have tried to demonstrate that the euro does not allow nominal adjustments for individual euro countries and asymmetrical shocks therefore will have negative effects. I am not making an argument about the long-term growth outlook for individual euro countries and I am not arguing that the euro zone forever will be doomed to low growth. The focus is on how the euro area has coped with the 2008 shock and the the aftermath. However, some have asked how my graph would look if you go back to 2000. Tim Lee has done the work for me – and you will see it doesn’t make much of a difference to the overall results. See here.

Update II: The euro is not only a Monetary Strangulation Mechanism, but also a Fiscal Strangulation Mechanism.

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If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: daniel@specialistspeakers.com or roz@specialistspeakers.com.

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“The Euro: Monetary Unity To Political Disunity?”

The re-eruption of the euro crisis as sparked not only economic and financial concerns, but maybe even more important the crisis is now very clearly leading to serious political disunity exemplified by an article the Spanish newspaper El País in, which Chancellor Merkel (somewhat unjustly) was compared to Hitler. And it is pretty clear that Germans are unlikely to get the same level of service if they go on vacation in Spain, Greece or Cyprus this year.

The political disunity in Europe should hardly be a surprised to anybody who have read anything Milton Friedman ever wrote on monetary union and fixed exchange rate regime. His article “The Euro: Monetary Unity To Political Disunity?” from 1997 has turned out to have been particularly prolific.

Here is Friedman on why the euro just is a bad idea:

By contrast, Europe’s common market exemplifies a situation that is unfavorable to a common currency. It is composed of separate nations, whose residents speak different languages, have different customs, and have far greater loyalty and attachment to their own country than to the common market or to the idea of “Europe.” Despite being a free trade area, goods move less freely than in the United States, and so does capital.

The European Commission based in Brussels, indeed, spends a small fraction of the total spent by governments in the member countries. They, not the European Union’s bureaucracies, are the important political entities. Moreover, regulation of industrial and employment practices is more extensive than in the United States, and differs far more from country to country than from American state to American state. As a result, wages and prices in Europe are more rigid, and labor less mobile. In those circumstances, flexible exchange rates provide an extremely useful adjustment mechanism.

If one country is affected by negative shocks that call for, say, lower wages relative to other countries, that can be achieved by a change in one price, the exchange rate, rather than by requiring changes in thousands on thousands of separate wage rates, or the emigration of labor. The hardships imposed on France by its “franc fort” policy illustrate the cost of a politically inspired determination not to use the exchange rate to adjust to the impact of German unification. Britain’s economic growth after it abandoned the European Exchange Rate Mechanism a few years ago to refloat the pound illustrates the effectiveness of the exchange rate as an adjustment mechanism.

Note how Friedman rightly notes that downward rigidities in price and wages are likely to cause problems in the euro zone in the event of a negative shock to one or more of the euro countries.

These problems cannot be ignored and if they are ignored it will likely lead to political disunity – if not indeed political disintegration. As Friedman express it:

The drive for the Euro has been motivated by politics not economics. The aim has been to link Germany and France so closely as to make a future European war impossible, and to set the stage for a federal United States of Europe. I believe that adoption of the Euro would have the opposite effect. It would exacerbate political tensions by converting divergent shocks that could have been readily accommodated by exchange rate changes into divisive political issues. Political unity can pave the way for monetary unity. Monetary unity imposed under unfavorable conditions will prove a barrier to the achievement of political unity.

Friedman unfortunately once again has been proven right by events over the past couple of weeks.

Slovenia is not Cyprus, but Slovenia is the second ‘S’ in PIIGS(S)

We used to think that the trouble countries in the euro zone were what has been called the PIIGS (Portugal, Italy, Ireland, Greece and Spain) and then suddenly Cyprus comes along and blow up. So now everybody is looking for the ‘next Cyprus’ rather than the next Spain or Greece.

So now all eyes are turning to Slovenia as it is again and again has being mentioned as the ‘next Cyprus’. I would, however, strongly argue that Slovenia is not Cyprus. That might sound good. Unfortunately it is not Slovenia, which is the ‘outlier’ – it is Cyprus.

I think it is really simple – the countries in the euro zone which are in the biggest trouble – risk of sovereign default and potential banking crisis – are the countries that have seen the largest drop in nominal GDP since 2008. The graph below illustrates this very well. It shows the relationship between the change in NGDP from 2007 to 2012 and the change in public debt ratios (debt/NGDP) in the same period. Surprise, surprise the countries that have seen the biggest increase debt ratios happen to be the PIIGS and those are also the countries that have seen the biggest drop in NGDP during the same crisis.

DebtNGDPeurozone

But notice Cyprus. Cyprus hasn’t really seen a major drop in NGDP and the increase in the debt ratio is not alarming. Cyprus is the ‘outlier’ – despite of banking crisis and a potential sovereign debt default the economy has been holding up pretty well (so far!). Cyprus is in trouble not because of the Cypriot economy as such, but because of a few banks’ exposure to Greek sovereign debt (this is likely a result of moral hazard). That is the story Cyprus, but it is not the story of Slovenia.

It is therefore wrong to say that Slovenia is Cyprus. Unfortunately it might be worse – Slovenia is the second ‘S’ in PIIGSS.

PS For those who are unable to differentiate between Slovenia and Slovakia – you have no reason to worry about Slovakia. The country is doing remarkably well.

Ernest Hemingway and Rüdiger Dornbusch on Cyprus

Here is Ernest Hemingway:

“How did you go bankrupt? Two ways. Gradually, then suddenly.”

Or rather this is how Rüdiger Dornbusch used to discribe the ‘stages’ of a crisis:

“The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought.”

So if you want to listen to the advice of these two gentlemen then you shouldn’t expect the Cyprus crisis to hit its climax this week, but if it does it will happen very fast. Or maybe they where not talking about Cyprus, but about Spain, Italy or Greece…

HT Matt O’Brien

The Cyprus ‘deposit grab’ sparks a rally in Bitcoins

Nowhere is the fears sparked by EU’s ‘deposit grab’ in Cyprus more visible than in the price of Bitcoins. Take a look at this graph.

Cyprus Bitcoin

Chuck Norris beats Wolfgang Schäuble

So far it is has been a remarkable week in the global financial markets. The ’deposit grab’ in Cyprus undoubtedly has shocked international investors and confidence in the ability of euro zone policy makers has dropped to an all-time low.

Despite of the ‘Cyprus shock’ global stock markets continue to climb higher – yes, yes we have seen a little more volatility, but the overall picture is that of a continued global stock market rally. That is surely remarkable when one takes into account the scale of the policy blunder committed by the EU in Cyprus and the likely long-lasting damage done to the confidence in EU policy makers.

I therefore think it is fair to conclude that so far Chuck Norris has beaten German Finance Minister Wolfgang Schäuble. Or said, in another way the Chuck Norris effect has been at work all week and that has clearly been a key reason why we have not (yet?) seen global-wide or even European-wide contagion from the disaster in Cyprus.

Just to remind my readers – the Chuck Norris effect of course is the effect that monetary policy not only works through expanding the money base, but also through guiding expectations.

When I early this week expressed my worries (or rather mostly my anger) over the EU’s handling of the situation in Cyprus a fixed income trader who is a colleague of mine comforted me by saying “Lars, you have now for half a year been saying that the Fed and the Bank of Japan are more or less doing the right thing so shouldn’t we expect the Fed and BoJ to offset any shock from the euro zone?” (I am paraphrasing a little – after all we were talking on a trading floor)

The message from the trader was clear. Yes, the EU is making a mess of things, but with the Bernanke-Evans rule in place and the Bank of Japan’s newfound commitment to a 2% inflation target we should expect that any shock from the euro zone to the US and Japanese economies would be ‘offset’ by the Fed and the BoJ by stepping up quantitative easing.

The logic is basically is that if an European shock pushes up US unemployment up we should expect the Fed to do even more QE and if that same shock leads to a strengthening of the yen (that mostly happens when global risk aversion increases) then the BoJ would also do more QE to try to meet its 2% inflation target. Said in another way any increase in demand for US dollar and yen is likely to be met by an increase in the supply of dollars and yen. In that sense the money base is ‘elastic’ in a similar sense as it would be under NGDP targeting. It is less perfect, but it nonetheless seems to be working – at least for now.

The fact that markets now expect the supply of dollars and yens to be at least quasi-elastic in itself means that the markets are not starting to hoard dollars and yen despite the ‘Cyprus shock’. This is the Chuck Norris effect at work – the central banks doesn’t have to do anything else that to reaffirm their commitment to their targets. This is exactly what the Federal Reserve did yesterday and what the new governor of Bank of Japan Kuroda is expected to do later today at his first press conference.

So there is no doubt – Chuck Norris won the first round against Wolfgang Schäuble and other EU policy makers. Thank god for that.

 

Fed NGDP targeting would greatly increase global financial stability

Just when we thought that the worst was over and that the world was on the way safely out of the crisis a new shock hit. Not surprisingly it is once again a shock from the euro zone. This time the badly executed bailout (and bail-in) of Cyprus. This post, however, is not about Cyprus, but rather on importance of the US monetary policy setting on global financial stability, but the case of Cyprus provides a reminder of the present global financial fragility and what role monetary policy plays in this.

Lets look at two different hypothetical US monetary policy settings. First what we could call an ‘adaptive’ monetary policy rule and second on a strict NGDP targeting rule.

‘Adaptive’ monetary policy – a recipe for disaster 

By an adaptive monetary policy I mean a policy where the central bank will allow ‘outside’ factors to determine or at least greatly influence US monetary conditions and hence the Fed would not offset shocks to money velocity.

Hence, lets for example imagine that a sovereign default in an euro zone country shocks investors, who run for cover and starts buying ‘safe assets’. Among other things that would be the US dollar. This would obviously be similarly to what happened in the Autumn of 2008 then US monetary policy became ‘adaptive’ when interest rates effectively hit zero. As a consequence the US dollar rallied strongly. The ill-timed interest rates hikes from the ECB in 2011 had exactly the same impact – a run for safe assets caused the dollar to rally.

In that sense under an ‘adaptive’ monetary policy the Fed is effective allowing external financial shocks to become a tightening of US monetary conditions. The consequence every time that this is happening is not only a negative shock to US economic activity, but also increased financial distress – as in 2008 and 2011.

As the Fed is a ‘global monetary superpower’ a tightening of US monetary conditions by default leads to a tightening of global monetary conditions due to the dollar’s role as an international reserve currency and due to the fact that many central banks around the world are either pegging their currencies to the dollar or at least are ‘shadowing’ US monetary policy.

In that sense a negative financial shock from Europe will be ‘escalated’ as the fed conducts monetary policy in an adaptive way and fails to offset negative velocity shocks.

This also means that under an ‘adaptive’ policy regime the risk of contagion from one country’s crisis to another is greatly increased. This obviously is what we saw in 2008-9.

NGDP targeting greatly increases global financial stability

If the Fed on the other hand pursues a strict NGDP level targeting regime the story is very different.

Lets again take the case of an European sovereign default. The shock again – initially – makes investors run for safe assets. That is causing the US dollar to strengthen, which is pushing down US money velocity (money demand is increasing relative to the money supply). However, as the Fed is operating a strict NGDP targeting regime it would ‘automatically’ offset the decrease in velocity by increasing the money base (and indirectly the money supply) to keep NGDP expectations ‘on track’. Under a futures based NGDP targeting regime this would be completely automatic and ‘market determined’.

Hence, a financial shock from an euro zone sovereign default would leave no major impact on US NGDP and therefore likely not on US prices and real economic activity as Fed policy automatically would counteract the shock to US money-velocity. As a consequence there would be no reason to expect any major negative impact on for example the overall performance of US stock markets. Furthermore, as a ‘global monetary policy’ the automatic increase in the US money base would curb the strengthening of the dollar and hence curb the tightening of global monetary conditions, which great would reduce the global financial fallout from the euro zone sovereign default.

Finally and most importantly the financial markets would under a system of a credible Fed NGDP target figure all this out on their own. That would mean that investors would not necessarily run for safe assets in the event of an euro zone country defaulting – or some other major financial shock happening – as investors would know that the supply of the dollar effectively would be ‘elastic’. Any increase in dollar demand would be meet by a one-to-one increase in the dollar supply (an increase in the US money base). Hence, the likelihood of a ‘global financial panic’ (for lack of a better term) is massively reduced as investors will not be lead to fear that we will ‘run out of dollar’ – as was the case in 2008.

The Bernanke-Evans rule improves global financial stability, but is far from enough

We all know that the Fed is not operating an NGDP targeting regime today. However, since September last year the Fed clearly has moved closer to a rule based monetary policy in the form of the Bernanke-Evans rule. The BE rule effective mean that the Fed has committed itself to offset any shock that would increase US unemployment by stepping up quantitative easing. That at least partially is a commitment to offset negative shocks to money-velocity. However, the problem is that the fed policy is still unclear and there is certainly still a large element of ‘adaptive’ policy (discretionary policy) in the way the fed is conducting monetary policy.  Hence, the markets cannot be sure that the Fed will actually fully offset negative velocity-shocks due to for example an euro zone sovereign default. But at least this is much better than what we had before – when Fed policy was high discretionary.

Furthermore, I think there is reason to be happy that the Bank of Japan now also have moved decisively towards a more rule based monetary policy in the form of a 2% inflation targeting (an NGDP targeting obviously would have been better). For the past 15 year the BoJ has been the ‘model’ for adaptive monetary policy, but that hopefully is now changing and as the yen also is an international reserve currency the yen tends to strengthen when investors are looking for safe assets. With a more strict inflation target the BoJ should, however, be expected to a large extent to offset the strengthening of the yen as a stronger yen is push down Japanese inflation.

Therefore, the recent changes of monetary policy rules in the US and Japan likely is very good news for global financial stability. However, the new regimes are still untested and is still not fully trusted by the markets. That means that investors can still not be fully convinced that a sovereign default in a minor euro zone country will not cause global financial distress.

Cyprus, bailouts and NGDP targeting

Cyprus has received a bailout from the EU and the IMF. I don’t want to waste my readers’ time on my views on this issue, but I think that Ed Conway got it more or less right. This is from Ed’s blog:

Back in 1941, with the memory of the Great Depression still weighing heavy, an American wrote into the Federal Reserve with an idea. “Would it not be feasible,” the member of the public asked, “to impose a Federal tax on the deposit of funds in bank checking accounts?”

The reply from the Fed was polite but succinct: while there’s no doubt a tax on bank deposits would have “the advantage of administrative simplicity”, it is “not in accord with one of the fundamental principles of taxation in a democracy, namely, that taxes should be imposed in accordance with ability to pay”.

And that, when it comes down to it, is the most scandalous and worrying aspect of the overnight decision to impose a one-off levy on all bank deposits in Cyprus. There is no doubt the country is in big trouble: it was heading for a potential default and is in desperate need of another bail-out. However, trying to recoup some of the cash directly from bank deposits is a step across the financial Rubicon. Even in the depths of the euro crisis, none of the troubled countries had, until now, gone so far as to confiscate bank deposits. As the Fed said all those years ago, doing so involves arbitrary charges on those least equipped to afford them.

And so it will be in Cyprus. If you have anything up to €100,000 in a bank, by the time you next get access to your account on Tuesday (there’s a bank holiday on Monday) some 6.75% of your cash will have disappeared into the Government’s coffers to help keep the country afloat. That goes for everyone, from a pensioner to a small business owner to a millionaire (although Greek depositors get an exception). If you have more than €100,000 the charge is 9.9%.

In exchange, Cypriots will get a share in the relevant bank, equivalent to the value of the tax deduction – although this is unlikely to be of much consolation given the country’s current financial woes.

But why do we continue to debate the terms for bailouts in Europe? Because we got monetary policy terribly wrong. Had we instead had proper monetary policy rules in Europe then we would not have these problems. Let me quote myself on why NGDP targeting has a strict no-bailout clause:

“NGDP targeting would mean that central banks would get out of the business of messing around with credit allocation and NGDP targeting would lead to a strict separation of money and banking. Under NGDP targeting the central bank would only provide liquidity to “the market” against proper collateral and the central bank would not be in the business of saving banks (or governments). There is a strict no-bailout clause in NGDP targeting. However, NGDP targeting would significantly increase macroeconomic stability and as such sharply reduce the risk of banking crisis and sovereign debt crisis. As a result the political pressure for “bail outs” would be equally reduced. Similarly the increased macroeconomic stability will also reduce the perceived “need” for other interventionist measures such as tariffs and capital control. This of course follows the same logic as Milton Friedman’s argument against fixed exchange rates.”

I am not arguing that Cyprus would not have had problems if the ECB had targeted NGDP, but I am arguing that if the ECB had followed a proper monetary policy rule like NGDP targeting then a banking problem or a sovereign debt problem in Cyprus would never had become an issue for the entire euro area.

Update: David Beckworth and Nick Rowe also comment on the Cyprus. As do Frances Coppola  and Felix Salmon.

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