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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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Leszek Balcerowicz on Poland’s success and Christensen on Balcerowicz’s success

For the past soon 15 year I have followed the economic development in Poland very closely and have visited the country very often. I have come to love the country and the Poles so I rejoice these days as Poland celebrates the 25 year anniversary of Poland’s first (partly) free election on June 4 1989. The democratic revolution opened the floodgates for free market reforms across the former communist countries in Central and Eastern Europe.

The main architect of the Polish reforms, which have led to a remarkable economic success over the past 25 years was Leszek Balcerowicz. Balcerowicz is one of my absolut biggest heroes. A great economist and a true reformer. Poles have a lot to thank Leszek Balcerowicz for. If anybody symbolizes the successful transition from communist dictatorship to free market democracy in Poland it is Leszek Balcerowicz.

Balcerowicz has a very good piece on Polish success story on FT.com.

I really feel like quoting the whole thing. But here is just a piece of it:

How does one explain these and other differences in economic performance after socialism, including the relative success of Poland? First, the quicker and more radical the improvement in the economic system – if sustained – the faster the long-term economic growth.

An early “Big Bang”, pioneered by Poland in 1990, and implemented even more radically by Estonia, has proved much better than delayed, slow or inconsistent reforms. For example, Poland introduced the convertibility of the currency as part of a large package of liberalisation and stabilisation measures less than four months from the start of its new government, while in Ukraine it took almost four years.

What kind of capitalism emerges is vital. In Poland (and most other CEE countries) the success of private groups does not depend, as a rule, on their political and bureaucratic connections, while in Russia or Ukraine this has been crucial.

Politicised or crony capitalism is not only unfair but inefficient, as it stifles economic competition and generates huge rent-seeking activity. Equal treatment is not only a matter of ethics but of efficiency.

Second, fiscal stance matters for growth. One reason for Hungary’s poor record has been the size of its government, coupled with persistent deficits, occasional fiscal crises and huge public debt. Poland’s fiscal situation has been far from ideal, but not as bad as Hungary’s.

Third, longer-term economic growth slows down when countries suffer deep recessions – a result of external shocks, boom-bust policies (Baltics, Bulgaria, Ukraine) or of the misallocation of credit by the dominant state banks (Slovenia).

Uniquely among post-socialist economies, Poland had no recession after 1989. A boom-bust pattern was avoided by relatively prudent monetary and supervisory policies while politicised misallocation of credit was avoided due to a surge in bank privatisation during 1998-2000.

Great stuff!

By the way this is what I wrote about Balcerowicz when he stepped down as central bank governor in 2007:

“Balcerowicz musi odejsc” (“Balcerowicz must go”). This was the all-too-familiar demand made by the populist Polish politician Andrzej Lepper when the outgoing Polish central bank governor Leszek Balcerowicz was Polish Finance Minister in the early 90s. Mr Lepper’s wish is to some extent now finally being fulfilled, as Mr. Balcerowicz steps down today after six successful years as central bank governor.

Mr. Balcerowicz has always been a controversial figure in Polish policymaking, but no one can dispute his enormous influence in the past 20 years – first as an economic advisor within the independent labour union Solidarność and participant in the roundtable negotiations that in 1989 led to the end of communist rule in Poland. As the first Finance Minister in post-communist Poland, from September 1989 to August 1991, Mr. Balcerowicz used what he has called a window of opportunity to implement the plan named after him – the Balcerowicz Plan – to transform Poland from an inefficient planned economy to a market economy. The Balcerowicz Plan was the first example of shock therapy being applied in the former communist countries in Central and Eastern Europe, and in our view there is no doubt that the reforms Mr. Balcerowicz engineered are one of the key reasons for Poland’s economic success over the last 18 years. Mr. Balcerowicz later continued the reform effort as Finance Minister once more from October 1997 to June 2000.

From December 2000 until today Mr. Balcerowicz has been governor of the Polish central bank (NBP). As NBP governor he has shown himself as a strong anti-inflationist central banker who has fearlessly defended the independence of the NBP from numerous unfortunate political attacks. The best measure of a central banker’s success is undoubtedly is the development in inflation, and here there is no doubt about Mr. Balcerowicz’s achievements. From December 2000 to November 2006, inflation in Poland dropped from 8.5% to 1.4% y/y – clearly something that Mr. Balcerowicz and his colleagues at the NBP can be proud of. Obviously there have also been policy mistakes over the last six years at the NBP. Some would, for example, argue that the NBP took far too long to ease monetary policy and this helped to push the Polish economy into a massive slowdown in 2001-2003. On the other hand, the NBP’s conservative approach to monetary policy during Mr. Balcerowicz’s rule has opened the door to a much more sustainable recovery in the Polish economy than would otherwise have been the case. It, of course, should also be noted that Mr. Balcerowicz’s term as NBP governor was to a minor degree tainted by fairly bad communication policies – that to some extent reflected internal disagreement at times within the NBP’s monetary policy council.

We say goodbye and thanks to Mr. Balcerowicz, but we don’t believe the charismatic liberal economist will be silenced and we expect – and hope – that Mr. Balcerowicz will continue to engage in the debate on economic policy in Poland in the coming years. Poland surely needs his input.

Luckily Leszek Balcerowicz has not been silenced and he has continued to call for further economic reforms in Poland so the success of the past 25 years can be continued.

This is Balcorwicz’s suggestions for reform in Poland – also from his FT-piece:

However, past success can be a poor predictor of performances, and Poland is not immune to this rule. Indeed, without additional reforms, Poland’s economic growth will slow considerably.

There are three reasons for this. First, the ageing population would reduce employment and increase the share of older, non-employed people. Second, Poland’s private investment ratio is the lowest in the region, along with that of Hungary. Third, the growth of overall efficiency (as measured by total factor productivity – TFP) which has been a main driver of Poland’s economic success, has slowed considerably in recent years.

These negative tendencies could be neutralised by further reforms. For example, Poland could considerably increase employment of younger and older people.

The gradual increase in the retirement age to 67 was a step in the right direction. But more has to be done – for example stopping and reversing the rise in the mandatory minimum wage.

Private investment could be raised by the elimination of various regulatory or bureaucratic barriers to investment and by increasing the savings ratio. Unfortunately, the de facto confiscation of the mandatory retirement savings enacted in 2013 was a step in the wrong direction.

I fully agree with Balcerowicz’s analysis and policy recommendations. Further deep structural reforms are certainly needed in Poland if the success of the past 25 years should be continued. But I am also hopeful that the great Polish people understands this.Congratulation to my beloved Poland with 25 years’ freedom and economic success.
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Balcerowicz book

 

 

The antics of FX intervention – the case of Turkey

I have often been puzzled by central banks’ dislike of currency flexibility. This is also the case for many central banks, which officially operating floating exchange rate regimes.

The latest example of this kind of antics is the Turkish central bank’s recent intervention to prop as the Turkish lira after it has depreciated significantly in connection with the recent political unrest. This is from cnbc.com:

“On Monday, the Turkish central bank attempted to stop the currency’s slide by selling a record amount of foreign-exchange reserves in seven back-to-back auctions. The bank sold $2.25 billion dollars, or around 5 percent of its net reserves, to shore up its currency – the most it has ever spent to do so”

A negative demand shock in response to a supply shock

I have earlier described the political unrest in Turkey as a negative supply shock and it follows naturally from currency theory that a negative supply shock is negative for the currency and in that sense it shouldn’t be a surprise that the political unrest has caused the lira to weaken. One can always discuss the scale of the weakening, but it is hard to dispute that increased ‘regime uncertainty’ should cause the lira to weaken.

It follows from ‘monetary theory 101’ that central banks should not react to supply shocks – positive or negative. However, central banks are doing that again and again nonetheless and the motivation often is that central banks see market moves as “excessive” or “irrational” and therefore something they need to “correct”. This is probably also the motivation for the Turkish central bank. But does that make any sense economically? Not in my view.

We can illustrate the actions of the Turkish central bank in a simple AS/AD framework.

AS AD SRAS shock Turkey

The political unrest has increased ‘regime uncertainty’, which has shifted the short-run aggregate supply curve (SRAS) to the left. This push up inflation to P’ and output/real GDP drops to Y’.

In the case of a nominal GDP targeting central bank that would be it. However, in the case of Turkey the central bank (TCMB) has reacted by effectively tightening monetary conditions. After all FX intervention to prop up the currency is “reverse quantitative easing” – the TCMB has effectively cut the money base by its actions. This a negative demand shock.

In the graph this mean that the AD curve shifts  to the left from AD to AD’. This will push down inflation to P” and output to Y”.

In the example the combined impact of a supply shock and the demand shock is an increase in inflation. However, that is not necessarily given and dependent the shape of the SRAS curve and the size of the demand shock.

However, more importantly there is no doubt about the impact on real GDP growth – it will contract and the FX intervention will exacerbate the negative effects of the initial supply shock.

So why would the central bank intervene? Well, if we want to give the TCMB the benefit of the doubt the simple reason is that the TCMB has an inflation target. And since the negative supply shock increases inflation one could hence argue that the TCMB is “forced” by its target to tighten monetary policy. However, if that was the case why intervene in the FX market? Why not just use the normal policy instrument – the key policy interest rates?

My view is that this is a simple case of ‘fear-of-floating’ and the TCMB is certainly not the only central bank to suffer from this irrational fear. Recently the Polish central bank has also intervened to prop up the Polish zloty despite the Polish economy is heading for deflation in the coming months and growth is extremely subdued.

The cases of Turkey and Poland in my view illustrate that central banks are often not guided by economic logic, but rather by political considerations. Mostly central banks will refuse to acknowledge currency weakness is a result of for example bad economic policies and would rather blame “evil speculators” and “irrational” behaviour by investors and FX intervention is hence a way to signal to voters and others that the currency sell-off should not be blamed on bad policies, but on the “speculators”.

In that sense the central banks are the messengers for politicians. This is what Turkish Prime Minister Erdogan recently had to say about what he called the “interest rate lobby”:

“The lobby has exploited the sweat of my people for years. You will not from now on…

…Those who attempt to sink the bourse, you will collapse. Tayyip Erdogan is not the one with money on the bourse … If we catch your speculation, we will choke you. No matter who you are, we will choke you

…I am saying the same thing to one bank, three banks, all banks that make up this lobby. You have started this fight against us, you will pay the high price for it.

..You should put the high-interest-rate lobby in their place. We should teach them a lesson. The state has banks as well, you can use state banks.”

So it is the “speculators” and the banks, which are to blame. Effectively the actions of the TCMB shows that the central banks at least party agrees with this assessment.

Finally, when a central bank intervenes in the currency market in reaction to supply shocks it is telling investors that it effectively dislikes fully floating exchange rates and therefore it will effectively reduce the scope of currency adjustments to supply shocks. This effective increases in the negative growth impact of the supply shock. In that sense FX intervention is the same as saying “we prefer volatility in economic activity to FX volatility”. You can ask yourself whether this is good policy or not. I think my readers know what my view on this is.

Update: I was just reminded of a quote from H. L. Mencken“For every problem, there’s a simple solution. And it’s wrong.”

The economics of airport security – the case of Poland

I am writing this sitting in Warsaw’s Chopin airport. Over the last decade I have spend more time in Chopin than in any other airport in the world. The airport has changed a lot over the years and the development in the airport in many ways seem to have tracked the development in the rest of the Polish economy.

In many ways one can say that airports are reflections of the countries in which they are located. Airports tell stories of economic, social and cultural development.

Today I got a very pleasant surprise when I arrived at the airport. A surprise that fundamentally makes me quite a bit more optimistic about Poland’s long-run growth perspectives.

So what have changed at Chopin airport? Well, it is simple, but in my view quite important – airport security has been changed. Until recently and as long back I can remember (more than a decade) the staff taking care of the security check at Chopin airport has been uniformed militia style people in combat style outfits armed with guns.

These people have never seemed especially concerned about seeing their jobs as a service to clients at the airport. Rather they generally never smiled and in general were quite inefficient in getting people through the airport security check.

Today, however, I was not meet by armed military style people, but instead by polite and a lot more efficient staff dressed in normal cloth – and nice orange ties. They looked like the personal in Scandinavian airports. I guess they are personel of a private company rather than government employees (remember they actually smiled…).

Friendly, well-dressed and efficient. Gone were the scary looking, but lazy militia type people. That indeed was a nice surprise.

Over the years have given a lot of thought to exactly what we can learn about airport security and I for many years have had a theory that countries that have military style airport security and where the security staff generally see passages as ‘animals’ which potentially are a threat to security rather than clients that should be served also are countries where government regulation is excessive in other areas of economic life.

Hence, my theory is that if you meet an unfriendly bureaucrat at the security check in the airport then it is also very likely it will be hard to start a business in that country. Therefore, I tend to think of airport security as an indicator of the level of government regulation of the country’s economy. This is something that makes me terribly bearish on the US’ long-term growth perspectives every time I encounter a TSA official in an US airport – and makes me terribly depressed about the prospects for Ukraine and it gives me an understanding of why the Scandinavian countries ‘works’ well despite excessively large public sectors.

It was therefore a pleasure today to meet friendly and efficient people at the security check in Chopin airport. And if my theory has any value this is an indication that Poland has “matured” and the level of regulation is luckily getting lighter. That is good news. So now I am thinking of raising my long-run growth forecasts for Poland…

I would love to hear my readers’ experience with airport security around the world and whether you see the same correlation between the “friendliness” of airport security and the ease of doing business.

PS I have for some time been looking for data on the efficiency of airport security. If any of my readers have knowledge of such data please let me know.

PPS I am less positive on the near-term outlook for Poland. Polish monetary policy has been excessively tight since early 2012. As a consequence the Polish economy is now seeing a sharp slowdown in growth. See my later forecast on the Polish economy here.

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