Posted by: Dirk | October 20, 2011

Back to the Future II: Revisiting the European Crisis

I freely admit that I stole the title from Paolo Pesenti at the NY Fed’s Liberty Streets Economics blog. Nevertheless, a sequel is always a good idea if the first feature was successful. I think that Pesenti’s description of the European Crisis 92-93 are correct. However, the conclusion is partly open to debate:

From the summer of 1993 on, building domestic credibility meant, in addition to fiscal rectitude, a reform of monetary policy to signal some radical break with the past. For instance, the Bank of England and the Bank of Sweden adopted inflation targeting as a new comprehensive strategy to stabilize prices. For other countries, the credibility-building strategy was to develop a stronger domestic political consensus to participate in EMU, and therefore to fulfill all the formal prerequisites established in the Maastricht Treaty in terms of inflation, fiscal stance, and interest rates.

In 1993, national commitments to fiscal discipline and price stability under the systemic umbrella of the nascent Eurosystem were credible enough to convince markets and halt the long wave of speculative frenzy. In retrospect, this was far from the definitive solution to the problems of financial and economic cohabitation in Europe. While exchange rate volatility disappeared forever from the list of policy concerns in Europe, fiscal spillovers and cross-country financial vulnerabilities remained at the very top. But the attempt to find systemic solutions to systemic problems was an important step in the right direction. Twenty years later, current market events seem to be calling for a renewed, and deeper, assimilation of this key lesson from the 1992-93 events.

While I agree with the last sentence – that systemic problems call for systemic solutions – I am much in doubt where the crisis of 92-93 can be of much help today. The main reason as I see it is that the ECB is a completely different kind of animal than European national central banks back in the 1990s.

In the pre-ECB days, European central banks were able to issue debt in their own currency. Therefore, foreign debt stocks had been quite low. Borrowing at cheaper rates from Germany in Deutschmarks might seem like a good idea at first sight, but then the frequent devaluations of the, say, lira made repayment more difficult for Italian firms. Borrowing abroad was like a forbidden fruit.

The introduction of the euro changed this. Now, there was no more difference between borrowing at home and borrowing from abroad, at least not inside the euro zone (currencies). Essentially, everybody had to borrow in foreign currency: the euro. Euros could not be printed on demand in case of emergencies, like looking public debt default. Also, the government could not supply the private sector (including the banking system) with new funds in case of emergency. The amount of foreign debt holdings in the euro zone exploded because there was no domestic currency anymore.

Following is a look at statistics of the stocks of international debt securities in some countries of the European periphery (billions of $, source: World Bank). The term is defined as following:

International debt securities cover all foreign currency issues by residents and non-residents in a given market, including in the borrower’s own currency, and foreign bonds (domestic currency bonds issued by non-residents in a given market). [..] The international securities statistics thus exclude all domestic currency issues by residents targeted to their own national market, whether purchased by residents or non-residents.

It shows clearly that with the introduction of the euro international debt securities have increased manifold. This is a major difference from the pre-euro era.

Re-alignment of real price levels are the lesson that has to be learned again, you might think. Since exchange rates are fixed now, only variations in price levels can do the trick. However, there is a complication. While the amount of foreign debt was low in the early 1990s (there is no data before 1996 in the World Bank database, sadly) it much higher now. Repayment of foreign debts issued in a foreign currency might become a major problem. Falling wages make repayment more difficult. Like that of public debt.

This is why the lessons of 92-93 should not be applied to today. Attempting to solve our systemic problem by looking at a solution from a much different system for a problem that is not identical to today’s will not be helpful. The ongoing attempts to suppress the price level through wage cuts via austerity programs in countries like Greece show that learning the wrong lesson can do a lot of harm.

The problem of today is the gold standard system in the euro zone. Governments must turn to bond markets for refinancing, they cannot print their own money. The ECB rules do not allow it to buy government bonds of its member states. Still, it has done so in the past and by breaking the rules probably unmade a euro zone breakup. This, perhaps, is the true legacy of Mr Trichet. If the ECB would be allowed to buy government bonds, the financial crisis as we know it would be over. Alternatively, a truly big EFSF – like a couple of gazillions at least plus lots of leverage – would also stop the crisis.

Of course, that does not mean that all is well. However, it would take the financial sector out of crisis resolution and put the discussions – how can growth return and unemployment be fought, who takes on the losses and risks, which government is allowed to borrow how much – back in the political arena. That would be a step forward.


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