Posted by: Dirk | May 25, 2010

The eurozone – issues

Let me quickly sketch out the new workings of the euro zone as it stands. Before we go there, just a quick reminder what caused this crisis. This is an image from the SPIEGEL:

What is says is: government debt did not cause the crisis. This is important, since many politicians now try to blame the crisis on government debt and speculators – wolf packs of speculators.

This being said, we can move back in time and see how the EU countries went about their business before the introduction of the euro. I will be short on details and simplify the story because this is not a history book.

In the pre-euro days, countries had their own currencies and used them as a policy instrument – mainly for one thing: to adjust their competitiveness. Whenever Germany competitiveness was rising relative to her neighbors, there came a point when these used depreciation or devaluation of the currency to regain competitiveness. That way, countries with different combinations of wage growth and productivity growth had a policy instrument that would lead to adjustment of the external position. If a country experienced prolonged net imports while its competitiveness declined, then foreign debt went up and pressure build up to use the exchange rate to correct the situation. When that happened, foreign capital in that country was worth less in the country of origin (since the exchange rate went down).

On the domestic side, inflation was responsibility of the national central banks. Some fought inflation with almost religious zest (Bundesbank), others were more sloppy. Each nation could choose the policy it preferred, both on the internal (domestic demand/ domestic inflation) and external (foreign trade/ imported inflation) dimension.

With the euro, things have changed. There is only one monetary policy for all members of the euro zone, and of course, only once currency. Domestic demand and inflation is the responsibility of the ECB, while the allocation of capital was left to the financial market. There was no instrument left to fix potential external disequilibria, apart from nominal wages. However, that is not a good instrument. Wages can be influenced by things like wages in the public sector, but apart from that it is not easy for a government to influence wages. In Germany, the government by law is not allowed to interfere in the wage setting process.

So, what happened? German productivity outgrew German wages, increasing the competitiveness of German exporters, while keeping domestic demand low. Germany increased its exports, while other countries mirrored this by increasing imports. Euros were flowing from the periphery to German exporters, from there to German banks. These invested the money in the periphery, since they perceived good investment opportunities. Spanish banks were eager to get money in order to lend it to Spanish households, which used it to build and buy houses at historically low real interest rates.

Companies also borrowed, not only in Spain but elsewhere as well. These investments turned out to turn bad. However, instead of letting the market fix things by valuing these assets at a lower price, governments interfered and guaranteed for the asset prices. This brought us the increase in government debt, first directly and second indirectly by causing the negative growth in 2008, which has let tax incomes of European governments go down.

Now to solve the euro zone problem for the long-run, competitiveness in the periphery has to adjust. The question is, how can this be done? The Baltic countries are undergoing deflation to achieve that, but it seems to go very slow. The political costs are high: unemployment and negative growth rates for years. A hair cut on existing debt might help, on both private and public debt. However, this will be a political problem, with countries bickering over how much everyone gets to lose.

The way things are going, adjustment will take place through capital depreciation. The ECB will guarantee for all assets from the periphery, and as the euro zone countries are paying the price they will have to cut public expenditures somewhere. This will surely create a political backlash, leading to a decision on how to distribute the losses from the crisis between everybody (through the creation of money) and the holders of financial assets (through depreciation of asset prices). It is unclear whether the creation of money will lead to inflation, given the economic outlook.

The total amount of debt in the euro zone, M3, is decreasing at the moment. Less debt and positive growth rates mean that there is potentially less money to buy more goods. However, it is unclear whether this will work out that way. M3 contains illiquid forms of money, which cannot be used to buy stuff. Since M1 – mainly cash and short-term deposits – has been rising over 2009 without creating inflation, it can be doubted whether inflation will result if the ECB would directly finance governments.

After all, there is much capital looking for save havens, and one of them is government bonds, as Bloomberg reports:

German 10-year government bonds rose, pushing the yield to the lowest since at least 1989, as stocks fell amid concern that Europe’s debt crisis will hinder the economic recovery. The yield on France’s 10-year security also declined to a record as investors sought the region’s safest assets. The rate banks say they pay for three-month loans in dollars climbed to the highest level since July as concern mounted that the crisis will widen and cause banks to doubt each other’s creditworthiness.

To conclude, the final decision will be left for voters to decide. It seems that politically it is not possible to face the losses incurred through the malfunctioning European financial system. When governments cut expenditure in order to bail out the holders of financial assets, it is ultimately the voters that will have to decide. One thing should be clear, though: an economy can either be capitalist, with firms maximizing profits given some institutions, or it can be depressed, with firms (and households) repaying debt as fast as they can. While the former should bring some positive growth, the latter will quite certainly not.

After taking that decision, the next one is about the long-term prospects of the euro zone. How will adjustment happen in the future, which are the instruments and tools available to which institutions, and how is all this coordinated? Interesting issues for the future …

UPDATE 26/05/2010: Oh, I forgot: you could also raise taxes in order to make up for the shortfall of government revenue. This is what Luis Zapatero, president of Spain, has announced today (to do in some “weeks”). Given the size of the troubles, it is a complementary option that could help to bring down the deficit.

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