Tag Archives: euro crisis

On the merits of Option #2

From his perch, Torrens reckons that Mr Tspiras should listen to the the advice of Marx (Groucho, that is) and choose not to belong to a club that would have Greece as a member. Particularly when that club is the euro zone, and the conditions of membership are those laid out by Mr. Schäuble (his Option #1, which Greece agreed to). Instead, Greece should take Mr Schauble up on his alternative offer (his Option # 2) for a “time out” from the euro as he put it.

Although the second option was most likely intended as a belittling negotiation tactic to force Greece to capitulate (had he been serious,  Mr. Schäuble would surely have put it on the table months before), there may be some merit to the option, and one should think it through before dismissing it.

In many respects, Mr Schauble’s Option 2 harks back to the Bretton Woods system in roughly 20 years before 1971 when most of the world had fixed, but adjustable exchange rates. Under the system, if a country’s exchange rate had become misaligned (typically over-valued and uncompetitive) leaving the county short of the money it needed to meet its import needs, it could have gone to the IMF for short term financing to cover the import bill while at the same time it took remedial measures to address its external imbalance. The adjustments typically included a devaluation of its exchange rate and reforms to reduce spending.

In addition, like the Bretton Woods system before it, Mr. Schäuble’s second option would also allow Greece to write down its debts. Right now, Greece cannot do this because doing so would force the ECB to withdraw its emergency lending assistance (this is what allows Greece to stay in the euro and ensures that its banks remain functional, albeit barely).

But if Greece exited the eurozone and had its own currency, Greece would be able to announce a standstill on its debt payments. It could use that time to renegotiate with creditors. This would put Greece in a fairly good bargaining position because it could conceivably threaten not to pay back anything.

Given that nearly all the debt is held by official creditors, writing off most of that debt would allow Greece to access private markets again. Moreover, if it also implemented many of the proposed structural reforms, Greece could also become a favourable investment destination.

Torrens reckons that it’s time to take Mr. Schäuble’s second option seriously.  To paraphrase Einstein, is it not insane to keep repeating the same mistakes over and over in the hope that the outcomes will change?

Some worry that the Greek currency would fall by 50%. But to put that into perspective the Australian dollar has fallen about 30% in the last year and no one has battered an eyelid (the RBA is even calling for more)!

Don’t get me wrong, eventually Greece will overcome the negative consequences of the bailout program and economic conditions in Greece will improve. Markets do work, even in the face of huge debt over-hang and excessive austerity. But that could take a long time and progress will be slow.  An exit and substantial debt write down would be better.

Last, is it just me, or is Varoufakis another incarnation Peter Garret, the leftist lead singer of Midnight Oil, and Australian Labor Party MP?

Can local currencies do what the ECB can’t?

Since writing the post advocating local currencies in the euro periphery, Torrens has discovered that quite a few of these are popping up in the periphery – apparently there are 325 of them in Spain alone! They were popular in pre-crisis Germany too. So, it seemed like an opportunity to think about the circumstances in which these currencies would appear and whether they are really as useful as originally hoped. Can local communities (residents and businesses) partially take over the role of the ECB?

In a nut shell, local currencies:

  • are a temporary monetary solution that coulld reduce slack in the local economy
  • can provide monetary stimulus when the usual (national) monetary transmission mechanism isn’t functioning properly (or possibly when national interest rates are higher than required to maintain local price stability) and hence boost output and reduce unemployment
  • can also introduce a distortion into the economy that, under some circumstances, could act as a “tax” on purchases of non-local goods (most likely when the local dollars are paid to unemployed workers or cash constrained individuals). This tax might also cause too many local services to be produced and consumed.
  • Because the tax discourages imports, it also means that the monetary stimulus generated by the local currency is less likely to leak out of the region or cause increase indebtedness in the region.

The rest of this post is a bit long and academic in nature, for which TH makes no apology.

What is a local currency?
Local currency is what economists call scrip. It is typically a money issued by a local retailers association or a local council, but there are electronic (purely private) forms of it on the web too (often to avoid taxes). Typically, it is 100% backed by a national currency on deposit at a bank (local dollar for national dollar) and can be spent at local businesses that choose to accept it. Because money relies on a network effect (I am more likely to accept it if I know you are prepared to accept it) it is unlikely that the money will be usable outside of the local region and is more likely to be successful the more local retailers are prepared to use it. There is nearly always a fee for conversion back into the national currency and sometimes local currencies lose value over time (called demurrage — the Albertan prosperity certificate had this trait), which makes them circulate faster.

If the local chamber of commerce wanted to start a local currency, it would need to get as many members to participate as possible. Depending on the set up, these will tend to be retailers of locally produced goods and services that will find it easier to get rid of their local money by paying wages, giving it away in change or paying suppliers, than say wholesalers of goods imported into the region or easily exported out of the region (traded goods). To get started, the retailers would have to raise $20,000 of national dollars and deposit it at a bank. This deposit would then be used as backing for $20,000 local dollars that the retailers would have to get printed. The 100% backing ensures that there can never be a run on the local currency – every dollar can always get converted back into the national currency. That being said, the chamber of commerce typically charges a fee to anyone who wishes to convert local dollars back into national dollars, say about 10%. Sometimes the chamber of commerce will require that the local currency get “stamped” periodically for a small fee (say 2% of its face value) in order to remain valid. This means that the currency is depreciating over time so people will want to spend it faster. It is reasonable to assume that the local chamber of commerce will incur some administrative costs (the cost of printing and storing the money as well as organising their members etc., which can be high).

Assuming some degree of success (a decent network effect), local residents will be willing to use the local dollars to buy locally made goods and services (e.g. to buy a nice loaf of bakery bread) and sometimes for their novelty value. They probably won’t keep them as a store of value and will not use them as a unit of account – that is what the national currency is for (amongst other things).

So here are the key questions:
1) When is it beneficial to the local chamber of commerce to issue a local currency?
2) When is it beneficial to the local community?
3) When is it beneficial to the country as a whole?

When is it beneficial to the local chamber of commerce to issue a local currency?
The local currency will prove to be beneficial when the extra revenues (if any) to the local retailers exceeds the administrative costs. Let’s ignore the costs and assume that prices don’t change because of the local currency (at least initially). The cases when nothing happens are easy to figure out. First, nothing happens if you have enough national currency to make all your planned purchases of both local and traded goods. Nothing will happen either if the amount of national currency in your pocket just happens to be sufficient to buy the amount of traded goods you need, and the amount of local currency sufficient to buy the local goods.

In the cases when nothing happens, the chamber of commerce can still benefit, some of the local currency might get lost, or held on to as a souvenir, and so the chamber of commerce will never have to redeem those. But this revenue is likely to be small, so let’s ignore it.

Things get interesting when you haven’t got enough national currency to buy the traded goods but more than enough local dollars to buy the local goods. Because then you have a problem, you have to decide whether to exchange local dollars for additional national currency at an exchange rate of 90cents per dollar of local currency, or buy more non-traded goods. In this case each additional traded good you plan to buy now costs you 10% more. The fee for converting the currency is just a tax on consumption of traded goods, so you will tend to buy less of them and more of the local good. In this way it is like the local currency exchange rate has been devalued (at least on the consumption side). And it is this mechanism that will drive an increase in revenues for the non-traded sector.

A good example of someone who might open their wallet and find a mix of local and national currencies such as this is an unemployed worker who gets hired by the local bakery to deliver bread. If they don’t have a lot of national currency savings to draw on then they will find that their weekly cash budget has more local currency than they would prefer. A not so obvious example is the person who is accumulating more local cash than they plan to spend in the future. These people will try to get rid of excess local currency by spending it (just like if you were travelling overseas and ended up with too much foreign currency in your pocket at the end of the trip and didn’t want to hold on to it or pay the penalty to exchange it). This effect is enhanced if the local currency depreciates over time. Another possibility is that a person may simply misjudge their (national) currency needs because of unexpected events.

Thus, it is possible that the distorting convertibility tax can boost the revenues of the chamber of commerce, but it does so at the expense of whoever has to hold it. So it may be beneficial for the chamber of commerce but not necessarily the residents of the local community.

When is it beneficial to the local community?
Despite the negative consequences for the holders of the cash, the introduction of the local currency could still be beneficial to the local community by acting as monetary stimulus. Monetary policy is set at the national level, and is not perfectly tailored to local conditions. If the local economy was in a sufficiently bad slump, then having the local community issue currency – especially if it can get it into the hands of people who are short of cash and will spend it – can be quite beneficial. It might even be the local council using the cash to fund local projects.

You might argue that there are, in a way, already local monies that circulate alongside the national one in the form of bank deposits. Bank deposits are private money (or inside money as monetary economists call it) and the creation/destruction of inside money is a key channel through which monetary policy is transmitted to regions such as those that we have in mind. Private banks create bank deposits by making loans and depositing the money into people’s bank accounts. Under a system where there are no reserve requirements and when all is going well, banks can freely expand the supply of deposits at an interest rate similar to the central bank’s policy rate. So in principle, if the local economy was in a bit of a slump, people could just go to the bank and borrow money and spend it to make up for the shortfall in demand. No need for anyone to set up a Spanish Spud.

But suppose local borrowers used the bank loan to buy traded goods (i.e to buy imports). Then instead of being deposited back at a local branch, the local bank’s cheque gets spent on TV that was made in some faraway place, and the cheque gets deposited in another bank there The region thus has a trade deficit, and the local bank potentially has a problem. Because it made a loan and didn’t get the deposit back, it now owes the far away bank money and will have to ask it for a loan to balance its books. This would be OK in normal times, but if the local bank is stressed (because of slack in the local economy), the faraway bank won’t be forthcoming with the loan.

In such a situation, the local bank would be OK if it could be sure that the loan would get re-deposited back at one of its branches. Suppose the bank lent the money to the local chamber of commerce, who promised to leave the loan on deposit in the bank and used the money to back its issuance of a local currency (dollar for local dollar). If the local dollars are going to the cash strapped, who spend it all on local goods, then this scheme could boost local demand and reduce unemployment without causing increased indebtedness. These benefits would have to be weighed against the costs of excessive consumption of local goods. When the increase in local currency just encourages people to use national currency to buy more imports, then there would be no difference between creating local currency and relying on the usual bank channel.

So creation of local currencies could be beneficial, but it would require that the local community be experiencing an economic slump, and that there wasn’t sufficient money to fully meet people’s demand for money already.

Is it beneficial to the country?
The answer might be yes, to the extent that it simply boosts local demand without detracting from demand in the rest of the country. But the problem is when local currencies start to be used to steal market from other communities. You can imagine two local regions using local currencies to try and dissuade local residents from shopping in neighbouring towns. This can happen because of the network effect – money is only useful if there is someone else that is willing to accept it as payment. So if you have a local currency in your pocket you tend to shop locally rather than in the other town. Surely everyone would be better off if the two communities decided to simply use one common currency and not two. By induction you get to a point where it seems sensible to abandon local currencies altogether in favour of one national currency. Which makes TH wonder, perhaps a “Spanish spud” would be better than a “Barcelona Bit”. But that said, he rather likes the idea of people not politicians solving the crisis in their economies.

The euro area currency crisis – time for local currency solutions … and a serving of wedges

Brixton has one, Toronto has one and now Bristol does too (hat tip JH). They all have local currencies. These currencies are really scrip, and like the Austrian “worgl”, which has been discussed numerous times in this blog, they circulate in parallel to the official currency and are designed to boost demand in the local economies in which they circulate.

Just a thought, isn’t it also time to boost local demand in Greece, Portugal and Spain too? There are no other policy tools left that can directly boost demand in these economies (wage restraint is assigned to boosting supply, fiscal policy to reducing demand and achieving external balance, but nothing is assigned aiding the process by boosting demand see earlier post here).

The arguments for local currencies in the euro periphery are straightforward. First, ECB policy is set to maintain euro area price stability. By design it is currently too tight for the periphery. Engaging in additional quantitative easing in the periphery is just sensible monetary policy. And local currencies essentially do just that.*

Second, local currencies are mercantilistic. Normally mercantilism is a bad thing. But when you are stuck with a way over-valued local currency and an unsustainable trade deficit, mercantilism is really just what you need. Local monies work like this: they are currencies that are accepted by local merchants and trades people (places like bakeries and so on), but they are not widely accepted to by goods that are traded across jurisdictions. The reason is that although you can freely convert the official currency (say the euro) into a local currency (say the Spanish spud) at a rate of one euro for one spud, when you convert back, you only get 0.9 euros per spud. This convertibility “wedge” does two things. First, it makes the local currency a bit of, well … a hot potato. People who want to get euros to buy TVs will tend to try and spend their spuds as fast as they can and save any euros that they happen to already have or get in change. That spending will tend to go on locally made services rather than imported goods. Secondly, the convertibility wedge makes buying goods from outside the local jurisdiction more expensive for those who receive spuds. In popular macroeconomic parlance, the convertibility wedge helps to rotate demand away from imports towards local goods, which in turn reduces the trade deficit.**

Third, if it is successful, the Spanish spud could be expanded to the whole economy and eventually, but not necessarily, be used to smooth an exit from the euro.

Let’s face it, Spain is already in the fryer. They need to try something new. The youth unemployment is over 50% (likewise for Greece), paying the unemployed in Spuds to deliver local services, which have been heavily cuts due to austerity measures, can’t really hurt can it? Even if it is a ridiculous idea, how much worse could it be? OK the project would need to be managed by someone sensible, but there is no shortage of smart Spaniards around (except maybe in Spain – apparently a lot are emigrating). The idea shouldn’t be limited to just Spain. Perhaps the Athens argo, the Dublin Dubliner, Milano Money … . TH reckons it’s an idea whose time has come. And here’s the other thing, they don’t have to wait for national politicians (though they should be considering them) but can be implemented in small towns or big cities too. Go on Madrid, now is the time to try.

* This is really just an extension of an old argument by Paul Krugman .

** As Nick Rowe explains, people are always itching to get rid of the cash in their pocket, but in this case they are particularly keen to get rid of spuds. The rate at which they spend could also be increased by making the currency a depreciating currency — see earlier posts on “the worgl”.

The Assignment Problem and European Adjustment: aligning policy with outcomes.

For policy to be successful, it has to be properly aligned with outcomes. People have to know why tough economic decisions are being made and how it benefits them; it also has to make sense. You can’t just tell someone that something will be good for them and expect them to do it if it doesn’t make sense and isn’t in their interests.

It occurred to TH after writing the last piece that the Assignment Problem for the euro area was particularly interesting. Correct him if he’s wrong, but it seems that what you would probably take away from a quick review of the literature on euro crisis adjustment (from the news, blogs, analysis, etc.) is that countries in the periphery, such as Spain, or Portugal or Greece are undertaking internal devaluations as a means of regaining external balance. This leaves open the question of what fiscal policy is being used for. Most people would probably argue that fiscal policy is being adjusted to maintain government debt sustainability. But it certainly isn’t clear that it is being assigned to maintain internal balance.

Such a view of fiscal policy while not necessarily wrong – but it is probably not completely right either and might be a bit confusing too. In TH’s mind the idea that fiscal policy can be adjusted to achieve a non-macroeconomic objective (i.e. not associated with key macro variables such as growth, employment, inflation and so on) is more consistent with the new macro orthodoxy for countries on flexible exchange rates, rather than those on fixed exchange rates. It is the assumption that fiscal policy is an extra policy lever that is largely unassigned to macro policy (recall that under flexible exchange rates, the exchange rate adjusts to maintain external balance, leaving monetary policy to maintain internal balance and fiscal policy free to meet non-macroeconomic social objectives such as roads, education and health). And before you stop reading, don’t think that TH doesn’t think improving fiscal sustainability is not important, it is but the problem might be more about national solvency than fiscal. Anyway, we digress.

Likewise the idea that an internal devaluation – cuts to wages to deflate the economy – to restore competitiveness and external balance is borrowed from theories about flexible (or at least adjustable) exchange rates. It is the idea that a depreciation is what is required keep the balance of payments in balance when faced with a situation where a trade deficit suddenly becomes unsustainable for some reason. But when in a common currency area, it is not quite as obvious that the real exchange rate (i.e. relative prices) is what adjusts – other things do too including labour, capital and income flows. This adjustment process is complex and not so well understood as we like to think.

TH wonders whether perhaps the better way of thinking about the euro periphery Assignment Problem for countries such as Spain might be this: Assign structural policies to achieve internal balance, leaving fiscal policy to be adjusted to generate external balance (assuming that you can adjust exchange rates or create an independent monetary policy – see the earlier rant on this here http://www.specie-flow.net/2012/02/22/its-twins/).
It might just be semantics, but TH reckons that looking at how adjustment occurs and the policy tools that are required from this alternative perspective could help. For example, suppose that the Portuguese or Spanish governments target labour market reforms and wage cuts with the explicit objective of creating jobs. This would be more palatable to workers than being told that they needed to adjust to maintain competitiveness vis-a-vis Germany (not to mention other periphery countries in the same boat that are all going about a competitive internal devaluation at the same time).

Using fiscal policy to target external balance is not a bad idea either given that for most of the periphery fiscal solvency is directly linked to the solvency of the banking systems that financed the external imbalances. Thus targeting fiscal policy to achieve external balance helps to break the feedback between banks and sovereigns.

The basic message here is fairly simple. The euro area cannot go on ignoring internal balance at the expense of actions to restore external balance and fiscal sustainability (especially when the link between the policy instruments and objective is not well-defined nor aligns well with those having to make the adjustments). Saying that wages need to be lowered to reduce unemployment to a reasonable level is hard for workers, but it is straight forward, logical and justifiable, so is saying that government savings will be increased to boost national savings.

Government Debt Sustainability – a simple equation

The distinction between insolvency and illiquidity is an important one. It usually comes up when thinking about banks that are in financial trouble and suffering a drain on deposits. Before a central bank will intervene with a lender of last resort loan, it normally asks “is it the drain on deposits that is causing the financial problems for the bank, or is the drain on deposits because the bank has made bad lending decisions and got itself into trouble?”

The issue is just as important for governments, but it has not one that has gotten a lot of attention until the euro crisis came along. In future posts, we’ll look at whether governments can suffer a run like a bank (we thinks they can) and if lender of last resort lending could solve it (again, he thinks it could). But before going around advocating lots of LOLR lending (which TH is not 100% convinced about just yet), he wants to discuss a more fundamental problem – what determines whether a government is solvent or not and the relationship between solvency and credibility.

long run debt to GDP ratio*= (primary deficit*)/(nominal growth rate of GDP*-nominal interest rate on government debt*)

Where a * denotes the expected long-run equilibrium value and the primary deficit is the government’s budget deficit excluding interest payments.

The formula is easy to use. Suppose, for example, that the primary deficit was 2% of GDP, the nominal growth rate was 6% and the nominal yield was 5%, then the long-run debt to GDP ratio would be (2/1=) 200% of GDP.

To determine whether this is sustainable or not, one thing you need to think about the tax burden that this stock of debt implies. Based on our calculations, just paying the interest would amount to (0.05×200=) 10% of GDP. That is high, but a country with this level of debt could quite plausibly be solvent. It seems reasonable to think that a government could easily collect, say, thirty percent of a nation’s GDP in taxes and that one third of that could be used to pay bond holders, leaving 22 percent of the nation’s GDP for government provided goods and services (such as roads, schools, hospitals and TV –like the ABC in Australia, BBC in the UK or CBC in Canada).

The ability to service a high debt seems even more likely if the debt is held by domestic residents. Then the debt payments are just a transfer from those in the country who earn income and pay taxes to those who earn an income from holding the government’s bonds (quite often those who have retired and are living on pension income). In this regard, domestically held debt represents a redistribution of income of sorts and doesn’t necessarily cause a significant reduction in the resources available for the economy as a whole to spend on consumption or investment.

Nevertheless, raising taxes to redistribute income can still be a challenge for governments, and there are limits to how much and how effectively governments can tax, which might make high debt levels unsustainable. And of course, if all this debt was foreign owned, then there is much more of an issue – domestic voters might not like seeing their taxes redistributed to foreign bond holders. This is one reason why periphery countries like Spain and Greece face problems – substantial amounts of their government debt is held by foreigners (Germans and other European current account surplus countries). So while Europe owes money to itself as a whole, individual country governments are heavily indebted to residents in others.

It is also important to note that the expected debt level that the formula generates can be quite sensitive to the assumptions (i.e. what people expect the country’s growth rate, interest rate and primary deficit to be). Every time the primary deficit doubles, so does the long term debt and the tax burden required to service it. So, if the primary deficit was 4% of GDP instead of 2% (assuming other assumptions stay the same), then the equilibrium stock of debt would end up at 400% of GDP and the tax bill for interest alone would be 20% of GDP. And, if the interest rate rose to something over 6% or the nominal long-run nominal growth rate dropped to below 5%, then the debt would never stabilise – it, along with the tax burden required to service it, would eventually go to infinity.

That is not to say that residents of this economy, which we assumed would  achieve nominal growth rates of 6% and pay a nominal yield of 5% over the long term, could not tolerate primary deficits that were temporarily much higher than 6% of GDP, just that they would have to be temporary. But it does suggest that the expected long-run solvency of a country can be very sensitive to what assumptions people make.

This sensitivity to the assumptions problem has also affected the Euro area periphery countries – markets have substantially changed their assumptions about these countries fundamentals. For the periphery in general, markets have lowered growth expectations as the previous assumptions about the growth benefits from being a member of a common currency union have proven to be wrong. And that, in turn, has raised the risk premium on government debt.

On top of that there are concerns about the ability of governments to adhere to budget commitments. In Greece for example, markets doubt the credibility of government commitments to budget targets (after all the Greek repeatedly deceived the public about its true budget position); and Europe as a whole has a track record of violating its own treaty on avoiding excessive budget deficits. Last, Europe already has a very high level of taxation – governments in the Euro area collect almost 50% of GDP in taxes – it’s hard to see how they could increase that further without it damaging the capacity of their economies to grow.

So where does that leave us: On the whole Europe, is OK – the debts of some countries are simply a mechanism to redistribute taxes to residents elsewhere in Europe. But Europe doesn’t have a pan-European federal fiscal policy to redistribute funds back to heavily indebted governments, whose debts are held by residents elsewhere in Europe. So periphery governments must tax their residents to pay the residents of the core surplus countries like Germany. This in turn raises discussions about fairness and makes the political commitment to avoid default more challenging to sell to voters. The heavily indebted governments are also part of a monetary union that has proven to be a constraint on rather than a source of growth for the periphery, which has also reduced the capacity of these governments to sustain and service their debts. Furthermore, a poor track record in Europe to meet budget targets despite a high level of taxation, combined with the failure of policy makers to decisively deal with the crisis has reduced government credibility. As a result, markets doubt the ability of governments to meet budget targets.

Thus, while in principle, periphery governments (such as Spain and Greece) could potentially be solvent and able to cut spending and raise taxes required to stabilise debts at reasonable levels; in practice, it seems unlikely that markets would consider these commitments to be credible. Unfortunately for the  European periphery, unless something changes to bolster credibility or growth potential, market expectations are unlikely to be consistent with what is required to make debts sustainable.

Targeting a euro breakup — the role of the ECB

Here’s a thought experiment for you. Greece and Spain are bleeding deposits right now. Presumably depositors prefer core country banks (such as German banks) to Greek and Spanish banks. These deposits have been made up for by money from the ECB via the target system. So here’s the experiment: what would happen if, in the extreme, the Greek banks lost all of their deposits to a bank in, say, France and the ECB just kept on doing what it is doing now and made up for the lost deposits at Greek banks through the TARGET system?

As far as Torrnes is concerned, such a run would amount to complete capital flight from the Greek banking system. Greek depositors would now have insulated themselves from the negative monetary effects of a euro exit or a collapse of the Greek banking system.  The ECB now bears toe risk that depositors held. Effectively the ECB would have paid out on an implicit deposit insurance scheme. Of course the Greek banks would still have to worry about their loan portfolios, but they don’t have to worry about deposits – effectively the ECB is the sole depositor at Greek banks.
Suppose that the Greek government also announced that it would introduce a new drachma in one year’s time to completely replace the euro as a means of payment and unit of account, and that it would freely float at a greatly depreciated rate. Lenders would now have a big incentive to renegotiate their loans and shorten them down to one year; otherwise when the loan becomes due, the borrower would have to pay the bank back twice as much in drachma. It follows that in one years time Greek banks could simultaneously rollover the old loans into Greek drachma and use the euros that have been repaid to settle their position with the ECB. These loans would in turn form the basis for the new Greek monetary system.

Torrens reckons that the effect on Greece wouldn’t be so bad. The average Greek household both gains and loses – they gain because after one year the drachma value of their euro deposits doubles and they lose because after one year their real wage (measured in euro terms) halves. Moreover, achieving this outcome doesn’t seem so nightmarish either. All it requires is that the ECB plays a supportive role in the transition.

It all seems a bit too easy. So what do you reckon? Has TH lost it?

A euro fable

TH  was a fan of Bill and Ben the Flower Pot Men when he was a kid (link at end of post). And just as he was way back then he is lost for words over the Spanish banking situation.  It is all so predictable and has been for a long time.  He wonders what happens if you have a broke friend (Bill) who in turn has a broke friend (Ben), and you lend Bill money to lend to his mate. Does the loan solve the problem, or make it worse?  Perhaps Ben could get lucky by using the cash to short Bill’s bonds or, perhaps, the euro.  You never know.

Anyway, trying to just reflect on the “how we got here” story. So here is a story about the euro system. Torrens is sure that there is a moral at the end, but he’s not sure what it is. Once upon a time, there was a new Europe. It introduced a new currency, set to rival the US dollar. It combined the rich, mostly central and northern nations stretching from France, through Germany and Austria, with the poorer periphery countries from Ireland through Greece in the South with a common currency. The masters of the euro promised the latter vast riches as their living standards converged to those of the North. A common currency would increase trade and European integration. The poorer periphery would soon become like the richer core.
To aid this process, the new euro system was constructed in such a way to effectively cross-subsidise the borrowing costs for the Southern periphery by effectively giving their governments access to funding on the same terms as the northern counter-parts (essentially the euro system made it much more effective for European banks to buy cheap periphery debt to meet their regulatory requirements than to buy expensive northern debt). And borrow the periphery did; whether it was the government of Greece or the private sectors in Ireland and Spain.

Of course, the borrowing had to be financed from somewhere – mostly, but not entirely, from Germany via the banking system. The European banking system was a cobbled together set of national banking systems, which meant that it was difficult for banks in Spain, say, to borrow directly from German households or for German banks to lend directly to Spanish firms and households; the transactions generally involved two banks – one from each jurisdiction.

Anyway, so when the periphery borrowed it involved both periphery banks that originated the lending and German (and other core country banks) banks who raised the cash from German depositors. Some of the smaller German landesbank, which were inexperienced in international markets and willing to absorb the additional risks, were quite involved in this process. They were not overly worried about these risks, because the loans were being made against the higher levels of income (and hence capacity to repay) that these countries were expected to have when the debts came due.

The trouble was that the promised convergence in productivity levels was not occurring. While Irish banks were using their easy access to German savings to finance domestic investment and expansion, they were also lending to English home buyers. Spanish banks were using those savings to finance huge Spanish housing bubble.
Alas, when the US sub-prime crisis hit, which many European banks also had large exposures to, it became clear that the cross subsidisation had also led to a gross misallocation of capital in Europe. There were huge losses in the banking system that would have to be dealt with; but by whom? Would it be the periphery banks that originated the lending or the German banks that provided the financing?

Of course it is the periphery banks, which originated the lending, that bear the burden. They have the maturity mismatch – they lent long term to finance a construction boom, while German banks lent to these banks short term. The banks that were providing the financing simply chose not to roll over their loans, and Germany’s money went two places: into German bonds and to the ECB.

The latter happened because there was now also a mismatch between loans and deposits across jurisdictions – German banks with plenty of deposits and periphery banks with plenty of loans – in such a situation the ECB act as a clearing house must correct the imbalance if the system was not to completely breakdown. Through the target 2 system, the banks in the periphery received loans from the ECB (an ECB asset), while German banks received deposits at the ECB (an ECB liability). Suddenly the German banks had gone from bearing quite incredible risks to having some of the safest assets possible (German bunds and ECB deposits).

As a consequence of the set up of the system, all the risks from the periphery bank lending was crammed down on the periphery banks – there was no risk sharing. Instead there was an intensification of risks in the periphery and drastic removal of risks in the German core. The Irish banks were thus forced to seek a bailout or go bust. And now Spanish banks have been forced to do the same.

Banks are a national responsibility in Europe, and so the ultimate costs of the European banking crisis has become the burden of periphery tax payers. In a bizarre twist of fate, the euro system, which promised them so much, has now impoverished them. At the same time, because German savings have started to return home, the costs of borrowing in Germany have been driven to next to nothing and the those largely government owned banks in Germany that lent so freely (partly because of the government ownership that allowed them to take excessive risks) have ample funds while there periphery counterparts have been locked out by markets.

Oh and did TH ever mention that banks in other Euro system countries other than Spain and Ireland are also at risk?

And for the video junkies — a short video of Bill and Ben.

Is the ECB on target?

Central banks typically do two things. They issue currency and, as a banker to the banking system, they effectively run the banking system’s clearing house. Thus, a central bank will issue notes (liabilities of the central bank that are matched on its balance sheet by government bonds of the same value – central bank assets) and it will also accept deposits from banks (the deposit is a liability to the central bank and an asset to the bank) that can be transferred from one bank to another as a way of settling (or clearing) banks’ positions. So for example, if you are in Australia, and you write a cheque for $100 drawn on the ANZ bank that gets deposited at the Commonwealth Bank, then, at the end of the day, the ANZ will owe the Commonwealth $100. This outstanding debt can be settled by transferring $100 from the ANZ’s account at the Reserve Bank of Australia to the Commonwealth’s account. Typically, at the end of an average day, the two banks’ positions will more or less net out given the huge volume of transactions in both directions. So there is not much need to literally transfer central bank deposits, and even when there is an outstanding position, banks will often simply lend other banks the any cash they owe, so long as the bank that is lending them has good collateral (such as a deposit at the central bank). Thus, in practice, the central bank is rarely called upon to transfer large sums from one bank to another and the size of banks’ deposits with the central bank is typically only a small fraction of the total value of all the banks’ deposits.
As the runner of the clearing house and issuer of currency, the central bank is also well positioned to go beyond its clearing house role and lend money directly to a bank that may come up a bit short of what is needed to meet its obligations with other banks. In such circumstances the central bank may have to act as a lender of last resort to the bank in difficulty. So when the Queensland Metropolitain Building Society experienced a rumour-driven run and a rapid loss of deposits to other banks, it was forced to borrow from the Reserve Bank of Australia (via a trading bank) to settle its positions with the rest of the banking system. Typically, this is just a temporary intervention by the central bank.
The ECB is not much different from other central banks except the ECB also acts as banker to the various euro area central banks (which in turn act as banker to the banks in their own jurisdictions). TH admits that he doesn’t understand this particularly well at all – part of the point of this post is to figure this out – but think of the euro area as consisting of a central bank that clears the positions of 17 euro area central banks (the country-level central banks such as the Bank of Greece), each central bank having an account with the ECB and the clearing process between the euro area central banks being the Target 2 system. Typically, the accounts of these banks with the ECB would not be large and would be just enough to settle payments between the banking systems of various countries that could not be facilitated through the usual system of interbank borrowing and lending. But when one country’s banking system experiences a large loss of deposits that it cannot replaced by, say, issuing paper to other banks, then it will need to make up the difference by borrowing from its own central bank, which in turn must borrow from the ECB. If the central bank didn’t go to the ECB, then it would be forced to let its banks go bankrupt. This is what happened in Greece.
There is another way of looking at this. Imagine that the Bank of Greece had a typical fixed exchange rate system when the banking system suffered a loss of deposits to the rest of the world, then to maintain the fixed exchange rate, the central bank would have to have run down its foreign reserves, or if it could borrow them from another central bank (via a swap line) or borrow then from the IMF.

Chart 1 shows that between March 2010 and March 2011, euro area monetary and financial institutions (MFIs or, in this case, the ECB) transferred 20 billion euro to the Bank of Greece and another 20 billion since. This is roughly equivalent to 10% of Greek GDP per year! In turn, the ECB lent about one quarter of this money to Greek commercial banks. It has not been sufficient to make up for the 30% loss of deposits since March 2010.

 Now we said that, as a clearing house for financial transaction, central banks were well placed to make these last resort loans. The problem here is that what this lending is doing is financing a run down in deposits. Although the data is not as clear cut, Greek lending to the non-bank private sector has remained pretty much stagnant over the last two years, but deposits at Greek banks have fallen. The difference has been made up by the lender of last resort loans. This essentially means that the ECB has been lending money to the Bank of Greece, which keeps some and lends some to Greece banks. The depositors at Greek banks have, in turn, withdrawn the money (about 11 billion euro, see Chart 2) and deposited it elsewhere (other euro area and Swiss banks). This could be a pure run, but should Greece exit the euro by suddenly converting all banking system amounts into new drachma, then these depositors will make a tidy sum and the losers will be the central banks of Greece and the ECB.

Losing it

Looking at the most recent European data you can’t help but wonder whether the Euro crisis is beginning to develop into something more akin to a plain vanilla recession – manufacturing deteriorating and firms responding by cutting jobs, and Spain is further down the path of no return than had been hoped. Worse this is starting to happen in the core – France seems to be increasingly affected, but it seems likely that exports dependant Germany will lose its lustre. The problem is that, as we all know and have discussed before, there are no standard policy levers left to pull – it seems to me that the worries that we had a year or two ago could now materialise in Europe.
It is also the 100th anniversary of the sinking of the Titanic, and yes the movie has been re-released. All this along with the reports that, and TH found himself losing it — thinking about his own version of a Titanic movie. A Monty Python version, where the main characters are the great economists Hayek, Keynes and Fisher, and the crew is the Euro group finance ministers (played by Monty Python, I leave it to you to figure out who is who). The titanic is the Euro area – its unsinkable, so long as the Euro group can just keep going, sticking to the original course.
It looks like a tragedy in three parts, set on a commemorative sailing of a super liner to remember the Titanic. The first part — the response to the US Subprime crisis (hurricane winds soon after ship sails) – two characters Hayek and Keynes debate the policy response. Hayek says do nothing, Keynes says do everything – the crew side with Keynes and increase spending and start quantitative easing to maintain the ship’s speed. The conclusion to the first part, “We are all Keynesian now” sung by John Cleeese dressed in drag as Celine Dione and trumpeted by the chorus (the ship’s captain and crew form the bow) of the ship’s crew.
Second act, concern arises about series of ice bergs that appear on the horizon. Keynes advocates maintaining speed, but changing course, Hayek advocates a slowdown while staying the course – he points out that the ship has no fuel left to change course anyways. Enter Fisher, who points out that icebergs are 6 times larger than they appear on the surface. He mentions something cryptic about “a downward spiral.” Enter Monty Python, playing Euro Group leaders, singing “Always look on the bright side of life.” Announcement from the captain to passengers that the ship was built to sail through ice flows, and the passengers should stand on the deck to observe the spectacular natural event. Part two ends with captain laying off crew as a cost cutting measure. They abandon ship.

Part three: A giant cartoon hand, reaches down beneath the sea and pulls out a plug – Fisher advocates that they can all be saved if they would just believe that there is no problem he asks them to imagine a world where prices are rising and the crew get their jobs back – he suggests that to the captain to tell everyone that the ship has a secret fuel and will use it in a big bazooka to destroy the hand. Alas, the hand is burned, but it is too late the downward spiral has begun. Giant sucking sound. Final credits roll.

It’s Twins!

As the ink dries on a new deal to provide Greece with a Euro130 billion loan, TH is struck by how many people misunderstand the euro crisis and the solutions available. He is also struck by how quickly most people jump to the conclusion that euro exit means sovereign and banking default default. What people forget is that Europe is facing two crises not one, and that two tools are needed to resolve the situation in an orderly way. TH reckons a depreciating parallel currency is one of those tools (financing – i.e. official lending — is the other).

To most people, the euro area is suffering a fiscal crisis and that is more or less it. As such, they frame the policy debate in terms of whether any proposed solution solves the fiscal crisis. This is in most part what the haggling in Brussels has been all about. When you think about it from that perspective, talk of euro exit almost certainly implies that a country would redenominate and monetise its government debt. No wonder they think that TH is a bit of a delusional crackpot (well not quite) when he talks about introducing parallel depreciating currencies as a solution for the euro periphery. TH reckons that had they thought about the euro area crisis as a primarily current account crisis, they would think differently.

One reason for forgetting that the euro periphery is experiencing a current account crisis is because Greece et al. don’t have their own currencies. But, as FT columnist, Martin Wolf, recently explained at length, a country can have a current account crisis even if it has no currency to call its own.

Indeed, international macroeconomists understand that most international crises, like that affecting the periphery, are twin crises (see Kaminsky and Reinhart, for example). That is, when these crises happen they not only represent a shortage of export receipts to pay for imports (a current account crisis), but also a shortage of financing to pay for the imports (typically due to a fiscal or banking crisis).

As the great Dutch economist Jan Tinbergen  pointed out, an economic policy maker with twin crises to resolve will need two tools. For peripheral Europe, as with most twin crises, those two tools are financing and adjustment judiciously balanced: financing to solve the fiscal crisis and adjustment to solve the current account problem.

So far, Brussels has worried about the financing side of the equation (i.e. the fiscal or banking problems). For two years policy makers and bankers have haggled over how to provide Greece (and other euro periphery economies) with the money it needs to finance the fiscal deficits that countries in deep prolonged recessions with unemployment over 20% generally need to prevent complete collapse. But few have seriously discussed how the adjustment to overcome the current account problem will occur. Instead policy makers think that the natural adjustment process, known as the specie flow adjustment process (after which this blog is named) will work as elegantly as David Hume proposed over two centuries ago. That is, as money flows out of current account deficit countries such as Greece, Portugal and Spain, the corresponding fall in aggregate demand will cause wages and prices to fall and return the periphery to a competitive position vis-à-vis their euro area counterparts. Oh, it’s so simple … not.

There is no doubt in TH’s mind that the advocates of the classical adjustment process would work, … eventually. But only after severe economic and political turmoil like that which we are witnessing in Europe today. Surely the objective is to do better.

In Torrens Hume’s mind, doing better means coming to terms with the fact that Greece, Portugal and Spain need a better adjustment mechanism (in addition to financing like that just negotiated with Greece) and that mechanism is a parallel depreciating currency.

Here is a restatement of the plan to deal with competitiveness:
1) introduce a new currency (the worgl) in parallel with the euro and let the central bank supply whatever is demanded (which may not be much);
2) require that wages be paid in the new currency;
3) set a pace of devaluation for the new currency over the course of 1 to 2 years.

This would do two things. First, with wages paid in the depreciating currency, competitiveness would be regained, unemployment would fall and the economy will stop contracting. Second, on the demand side, the depreciating currency will stimulate demand as people seek to spend it rather than hoard it. It would effectively be a Gessellian currency.

It’s also worth noting that while those with loans in euro that receive payment in the worgl will find it more costly to service their debts, those with euro deposits will enjoy an increase in their wealth in terms of worgl.

Some people would argue that introducing a new currency would cause a banking crisis due to currency mis-match, but surely the internal devaluation would do the same thing. In the best case scenario, if wages and prices adjusted quickly down by say 30%, would not a firm’s ability to service its nominally fixed debts be just as impaired as they would have if the adjustment was due to a currency devaluation? And if they didn’t adjust, I am sure that firms suffering from 4 years of negative growth operating in an economy with 20% unemployment, are almost equally likely to default on their loans as firms facing a currency mis-match.

There may be alternative ways to restore competitiveness — some argue that it is structural reforms, which would some how make Greeks and Euro periphery countries change their labour leisure preferences, and suddenly become more prodcutive by working more.  But, at the end of the day, these do nothing to help get the periphery out of a currnecy union to which they should never have belonged.

And, something for the video junkies:

 Note: this  post was updated on February 25th .