Posted by: Dirk | March 9, 2010

€MF – the European Monetary Fund

The NY Times reports on the European Monetary Fund (EMF) proposal:

Impetus for a European Monetary Fund initially came from the German finance minister, Wolfgang Schäuble, who told the German newspaper Welt am Sonntag, in an interview published Sunday, that the countries that use the euro needed an institution with “similar powers to intervene” as the International Monetary Fund.

Mr. Schäuble did not provide details of how the fund would work, saying he would present a plan soon.

Mr. Schäuble, who came out a Keynesian during the crisis, seems to have some knowledge in his ministry of finance. Let me explain what the solution EMF is about and what the problem underneath is. Naturally, I start with the latter point.

The eurozone was founded in order to establish a monetary union. A common currency would eliminate exchange rate risk, facilitate intra-European payments and insecurity and provide a European symbol of unity. Would there be any risks to this? According to Mundell’s theory of optimum currency areas (OCA), there are five points that matter:

  1. labour mobility
  2. capital mobility
  3. wage and price flexibility
  4. a risk-sharing mechanism for fiscal transfers
  5. synchronized business cycles

Clearly, points 1. and 4. were not fulfilled from the beginning. The likeliness of these shortcomings to lead to troubles was discussed under the headline of asymmetric shocks. It was concluded that these were unlikely. The major source of trouble was thought to be the government. If some government went on a borrowing binge and then could not repay its debt, an asymmetric shock would occur. Business cycles would no longer be synchronized, and this matters because slumps were fought by monetary policy. This is a one-size-fits-all, with the European Central Bank located at Frankfurt/M. (we have two Frankfurts in Germany, the other being smaller and located in the eastern part at the river Oder. This one is on the Main.).

To make sure that government spending causes no problems (remember, this was the intellectual state of the world of the 1980s and 90s) the stability and growth pact was created. It put limits on the relative amount of government debt, both total and marginal. The borders were 60% of GDP for total debt and 3% of GDP. A blue letter was to be send to finance ministers that broke the rules, with rules to punish countries if they behaved irresponsibly. The rules were softened after Germany and France broke the rules repeatedly in the early 2000s.

As we all know by now, the stability and growth pact has failed. It was flawed from the beginning, with its focus on the governments as ‘disturbers of the peace’. It should have watched capital flows in the private sector as well, when the introduction of the euro pushed interest rates down everywhere. The European periphery, now infamously known as the PIIGS, went on a boom since their higher inflation rates translated into relatively low real interest rates, both historically and in comparison with the European core. What determined the size of this boom?

Internationally, you can only lend out what you either have been borrowing from abroad or what you have gained through your net exports. Since German economic policy favoured low wages with the rising productivity her exports soared. The current account was very positive, rising from €60 to 120 billion from 2004-07. The gains from trade had to be left somewhere. Since people wanted to save, exchanging the export earnings for euros was out of the question. Banks apparently found no worthy investment opportunities inside Germany neither, so the money was to be lend out to foreign countries.

Banks lent the money to places like Spain, Ireland and Greece, where banks used the money to fuel real estate booms (mostly Spain and Ireland). The inflowing money created jobs and pushed up wages, inflating the price level. Since productivity growth in the PIIGS has been traditionally lower than in Germany, the competitiveness of the PIIGS declined. This fuelled German exports, which again created export earnings which were lent abroad and so on. This virtuous circle quickly turned into a vicious circle. Apparently, German bankers did not understand the implications of what they were doing. At the center of this is the transfer problem, made famous by the Keynes-Ohlin debates in the 1920s.

Keynes argued that “If one pound is taken from you and given to me and I choose to increase my consumption of precisely the same goods as those of which you are compelled to diminish yours, there is no Transfer Problem.” (Keynes 1929, p.2) Keynes argued that Germany (this was all about the reparations, economics comparable to the problem of Icesave) would need to produce more exports, and that the resulting increase in supply would make total export earnings come down. If the price elasticity is less than one then a lower price reduces the total value of exports. Ohlin (1929) replied that “one very important point” would be missing: the income of the rest of the world would be determining the demand and therefore the value of German exports. In simple terms: if Germany transfers capital abroad, the price level will rise relative to hers (which should be falling since she receives less capital inflows from abroad), which makes her goods relatively cheaper but does not change the nominal price of German exports. Therefore, the adjustment necessary to facilitate the transfer would be made through the change in incomes rather than the change in nominal prices. Ohlin admitted that a combination of both is likely to happen.

So, when capital flows to the PIIGS finally turn around, will there be a transfer problem? The answer is very likely to be “yes”. A lot of capital has flown into real estate in the PIIGS. Real estate is the notorious example for non-tradable goods. Its price depends much on expectations, and these are bad for the future. As it stands, the PIIGS will be forced to undergo a bout of deflation in order to regain competitiveness. This has high social costs as unemployment rises and wages fall. Not exactly the best conditions for real estate prices to stabilize. Since Germany seems to continue a policy of suppressed wage growth the deflation will be even deeper and longer for the rest of the eurozone.

Coming back to the European Monetary Fund, the overborrowing of some actors in the PIIGS has led to unsustainable levels of debts for some governments and many banks. In this situation we have self-fulfilling prophecies: if everybody believes in repayment and interest rates are low, it can be done – if nobody does, rising interest rates raise the total burden of debt and it can’t be done. What is a liquidity crisis can easily turn into a solvency crisis, and then it’s throwing good money after bad. That is why speculators are a threat once more – they really have the power to bring some governments and banking systems down by turning illiquid actors into insolvent actors.

Now, one possible solution is providing cheap loans to the indebted. This is a traditional domain of the International Monetary Fund (IMF), which is also known to impose hard and socially costly restraints on governments which tap its funds. It has mishandled the Asian Crisis, and it actively contributed to the crisis in Argentina which ended in default. This is why countries that can avoid the ‘money doctor’ do so: this map shows the countries that have been borrowing from the IMF.

How would the EMF work? It would collect money from eurozone members and then loan it out to those in need – right now, the PIIGS. The EMF would provide cheap capital and improve the fiscal outlook for governments that have over-borrowed. It could impose conditions on these loans, like the IMF does, which would mean that countries would undergo structural adjustment programmes in order to reassure investors that they are able to repay. This mostly translated into cutting expenditures for governments – like in Latvia.

The political calculation is to keep the IMF out of the eurozone because it is influenced by the US and China. Also, its skills are at best disputed. The IMF has recently turned around a bit by advocating fiscal policies, but its involvement in Latvia shows that it still does not understand the ‘transfer problem’ (Latvia should devalue in order to increase its competitiveness and create employment, but the IMF does not allow it.). The recent thoughts of Olivier Blanchard on higher inflation seem to me like a PhD thesis presentation gone horribly wrong. Be that as it may, the eurozone should be able to solve its own problems, and a European Monetary Fund is a way to do it. There is just one catch. What if this is a matter of insolvency and not illiquidity?

The problem here is that the PIIGS could be put into a maelstrom of falling wages, rising unemployment and falling prices. This will lead to a rising debt burden. Since German wages are not rising, the PIIGS would need to increase productivity more than Germany over a stretch of years. This won’t happen, since productivity is something of a long-run thing and history tells us that this hasn’t happened for a long time. Now if economic adjustment in the eurozone plays out just as outlined above, then ‘default’ will become the only option available safe for quitting the euro. If this happens, then all the money borrowed from the EMF in the mean time will be lost as well.

European policy-makers should think really hard about this one. They clearly haven’t given a lot of thought on monetary issues, trusting in markets to deliver and focussing on banning misbehavior by governments. Questions of stability have been disregarded in the near past, also questions of adjustment. Inflation in Germany would improve the economic outlook a lot. Maybe this comes automatically if Germany stops lending abroad, but then a EMF could lead to stop this automatic adjustment.

Sloppy thinking in combination with overly precise mathematical models has led the eurozone into the abyss, and new thinking – and by new thinking, I mean old thinking, as that of the Keynes-Ohlin debates – is needed. A fiat currency is backed up by confidence, and confidence comes from knowledge. The eurozone policy-makers have to tap that knowledge now. (Personally, I would have like to see Willem Buiter at the center of this, but he’s probably busy at Citi. How about Jean-Paul Fitoussi?)


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