Category Archives: 101

Understanding Eurozone Imbalances II: Talking TARGET

Posted on March 11, 2012 | 3 comments

More time is only good if it’s used for something. The success of the Greek debt swap this week staved off chaos but is not a solution to Europe’s problems or a signal that an end to the crisis is in sight.  Recent weeks have seen a growing awareness of the accumulation of imbalances in Europe’s central payment system, TARGET. These imbalances are yet another reflection of the fundamental asymmetries at heart of Eurozone crisis and are analogous to build ups that destroyed the Bretton Woods system.

The commentary and debate on TARGET is currently overly technical. This post explains and analyses the nature and origin of these imbalances, and asks what they mean for the Eurozone (for some background on the link between budget and current account deficits see here and the crisis in general here, here and here!).

What are TARGET imbalances?

TARGET is an acronym standing for Trans-European Automated Real-Time Gross Settlement Express Transfer. Fog lifted?! It’s basically a system through which commercial (‘normal’) banks in one Eurozone country make payments to commercial banks in other Eurozone countries. Importantly, TARGET balances can be interpreted as a measure of the accumulated deficits and surpluses in each Eurozone country’s balance of payments with other Eurozone countries, reflecting the amount of ‘extra’ money circulating in a country over that created inside the country by it’s own national central bank.

Until mid 2007, TARGET balances netted out at zero; there were no deep asymmetries in financial flows within the Eurozone. This is no longer the case.  Prompted by the financial crisis, imbalances in the TARGET system have ballooned. This is shown in the graph below, taken from Sinn and Wollmershaeuser (2011) (GIPS refers to Greece, Ireland, Portugal and Spain).

TARGET imbalances have gone under the radar because they do not show up on the ECB’s balance sheet. However, this is not to say they are inconsequential.  Researchers have commented on the similarities in the imbalances captured by the TARGET balances and those that destroyed the Bretton Woods system. Therefore, understanding what these balances reflect, how they have arisen and how to fix them is of crucial importance.

Something for Nothing

Let’s build up how these imbalances have arisen in stages.  To understand the full story, we need to look at how payments are made between banks. When customers make transfers between commercial banks, in effect, it is actually central bank money, or ‘base money’, that actually flows between them.

Consider a Greek factory owner wanting to buy a new machine. If she buys from a vendor within Greece, funds need to be transferred between bank accounts within the same country. To affect the transfer, base money is taken out of the central bank account of the purchaser’s bank and put on the central bank account of the vendor’s bank. The purchaser’s bank then charges the checking account of our factory owner, and the vendor’s bank credits the vendor’s account with the payment amount.

If our factory owner instead buys from a machine vendor in another country, say Germany, a similar procedure occurs but payments now flow via the Target system of the European Central Bank (ECB). When the Greek National Central Bank (NCB) debits the account of the commercial bank of our Greek factory owner, it takes money out of the Greek economy and sends a payment order to the Bundesbank. In so doing, it acquires a liability to the ECB. On the other side, the Bundesbank creates new money and transfers it to the German producer’s commercial bank, acquiring a claim on the ECB.

Target balances reflect these liabilities and claims on the ECB. Until 2007, payments between countries cancelled out as they flowed in both directions. This is despite the huge asymmetries in intra-Eurozone trade because importing countries paid for their imports with foreign money received from asset sales to exporting countries. Thus, private capital flows financed trade flows. Target imbalances have arisen because trade and asset flows no longer net out at zero, causing a build up in claims and liabilities. A Target deficit represents a net outflow of money to pay for an inflow of goods, and a Target surplus can be thought of as an accumulation in a stock of ‘outside money’ within a country.

Look like loans….

Target balances are best thought of as loans given that they reflect the fact that economic goods are moving between countries without movements of goods or other assets in return. They represent real claims and liabilities on the ECB. To affect our machine payment transfer, the Greek NCB destroyed money without its assets becoming any smaller and in so doing acquired a liability to the ECB. This Greek Target liability can thus be thought of as a public debt provided to the country by the Eurozone. On the other hand, the Bundesbank created money without actually receiving any tangible assets from commercial banks. The Target claim it acquires compensates for that and thus can be thought of as a public credit given to the Eurozone, allowing recipients to buy foreign goods.

The Rescue facility before THE Rescue facility

To get at the full picture, we need to add another level of complexity. As described above, Target balances shift money from Greece to Germany. The Greek NCB destroys money when a payment request to buy the German machine comes in, and the Bundesbank creates money to wire to the vendor’s commercial bank in return. If this was the end of the story, there should be no money left at all in Greece. Their coffers should have been emptied long ago. Yet, the monetary base of periphery countries has actually grown slightly since the start of the crisis. What is going on?!

The money flowing out of the periphery countries via international transactions has been fully offset by the creation of new money by their NCBs. In effect, these NCBs have been issuing new money as a form of credit to finance the purchase of foreign goods, taking the place of the private credit that was free flowing before the financial crisis.

Likewise, in Germany, we should have seen an explosion in the monetary base given that the payment process demands the Bundesbank creates new money and this new money has not been used to purchase foreign assets. No such explosion has occurred. German commercial banks have not needed all the additional money flowing into them and thus have either reduced the amount they tend to borrow from the Bundesbank or have placed the unneeded liquidity at the ECB to earn interest.

Therefore, we have witnessed a huge shift in refinancing credit from Germany to Greece without any change occurring in the monetary base of these countries. This credit reallocation represents a capital export from Germany to Greece, a loan given by the Bundesbank to periphery countries, enabling them to buy more German goods than would otherwise be the case.

This public credit provision can be thought of as a hidden rescue facility, propping up the economies of the periphery countries long before the creation of official rescue provision. Sinn and Wollmershaeuser (2011) argue these flows are analogous to Eurobonds, the only difference being that Eurobonds imply transfers of existing money, while the Target credits imply a reallocation of money creation activity. Target credits thus also involve liabilities. If the periphery states go bankrupt, all Euro countries are liable for losses in proportion to their capital shares in the ECB. No wonder the Bundesbank has started to worry about Target imbalances…

We’ll take the Parthenon (and everything else)

In theory, given sufficient appetite, peripheral and core countries could go on swapping Target claims for real goods indefinitely, with imbalances becoming more entrenched over time. However, this is unsustainable. These imbalances reduce the ability of the ECB to influence the Eurozone economy and preserve and perpetuate the structural asymmetries at the heart of the crisis.

Given that Eurozone countries, by definition, operate within a single currency union, there are no automatic mechanisms to force the system back into balance. If we want adjustment, explicit policy action to tackle the heart of the problem is called for, i.e. credible steps to harmonise structural policy and reduce the asymmetries in productivity and demand across the Eurozone. We are yet to see believable policies to this effect, especially those that would challenge German dominance.

Rather, what we have seen in the last few weeks are moves by the Bundesbank to insure the €500bn Target claims it has built up against the Euro system. Given that these claims represent public loans to the periphery, they stand to loose a lot if the Euro was to suddenly collapse, some 20% of GDP in fact. The head of the Bundesbank has proposed that these claims be securitized, or in other words, he demands access to the Periphery property and asset markets to cover losses in the event of a Euro collapse. Wow. Shame we’ve already snatched the Elgin Marbles. Finally, the fact that this proposal has even been raised signals that the Bundesbank is deeply worried about the death of the Euro. For them to seek this kind of insurance, demise is still most definitely on the cards.

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Budget and Trade Deficits 101: Two Sides of the Same Coin

Posted on January 8, 2012 | 1 comment

The economics behind trade and budget imbalances applied to the Eurozone crisis. 

In my last post I argued that fiscal profligacy is too highly stressed as an underlying cause to the Eurozone crisis. Rather, deep rooted differences in  productivity and competitiveness have resulted in divergent trade balances and public finance disaster zones. Why have trade imbalances contributed to a government debt crisis? What does a single currency have to do with it? Let’s see….

Setting the scene

Many Eurozone countries’ budget deficits are astronomical, incomprehensibly large. Despite all the hype, they aren’t necessarily shrinking. The Greek budget deficit continued to widen throughout 2011, growing to €20.52bn in the first 11 months of 2011 (a 5.5% year-on-year increase), as did Ireland’s, widening to €24.9bn in 2011 from €18.7bn in 2010. Further, it’s not just the problematic PIGS creating trouble: Belgium, Malta, Cyprus, Hungary and Poland are all waiting to hear if they face EU financial penalties to punish for the poor state of their public finances.

Trade figures highlight significant imbalances between Eurozone countries in the run up to the crisis. To talk of a common European trade experience is grossly misleading. The pattern of imbalances across the Eurozone in the period running up to the crisis was dominated by a few outlier countries: Ireland, Italy and Greece on the ‘negative’ front and Germany and the Netherlands on the ‘positive’ (see a relevant IMF paper here). Helping to convey the power of German export machine, the WTO estimated the value of German exports at $1.334tn in 2010, placing them second in the world behind China. This is more than double the value of UK exports and 60 times larger than those of Greeks. (See the following graph from this FT article and this IMF analysis for more data and graphs).

Trade imbalances correctly identify the countries at the heart of the Eurozone crisis. Estonia, Portugal, Greece, Spain, Ireland and Italy had the largest trade deficits over the period 1999-2007. High trade deficits going along with dreadful public finances. A coincidence? No. Exploring the economics behind trade and budget imbalances highlights that the two are intimately related.

Talkin’ the talk: trade terminology

In the global economy, countries interact via trade in goods and saving/borrowing. The “current account” records the net effect of a country’s international trade, constituted of goods and transfer payments. More often than not, commentators simply refer to ‘trade balances’, which don’t incorporate transfer payments. Exports feature as positives, and imports as negatives in these accounts. Thus, a trade deficit denotes a situation where the value of a country’s imports exceeds that of its exports.

The “capital account” records the net effect of international financial flows. Foreign investment, purchases of domestic assets and foreign loans to a country all feature as positives; they represent flows of money into the national economy. Conversely, domestic investment into foreign markets and loans made by domestic institutions abroad features as negatives, representing flows of money out of a country. Thus, a capital account surplus refers to a situation where there is a net flow of funds into a country.

By definition, the balances of the two accounts are inversely related. Given a particular level of total output, any trade deficit must be reflected in inflows of money from outside the country (borrowing basically) to fund that deficit. This is shown most easily by exploring the national accounting framework in a bit of detail. It involves a few equations but there’ll be no more after this, promise!

Total spending in the economy (Y) is made up of what we, consumers, spend (C), investment (I), government spending (G), foreign spending on our goods, i.e. exports (X) minus what is spent on foreign goods, i.e. imports (M).

Y = C + I + G + X – M

rearranging….

Y – C = I + G + X – M

The difference between total income and what households spend, can instead be thought of as what gets taken away in tax (T) and what we choose to save (S). Thus,

S + T = I + G + X – M

or….

X – M = (S – I)  + (T – G)

so….

Current Account Balance = – (Capital Account Balance)

Thus, imagine we have a current account deficit, then the capital account balance must be positive, i.e. foreign funds must be flowing into the economy to fund that deficit.

How does the exchange rate fit into all this?

Take a step back from the Eurozone, to a country like the UK, which has its own currency. The current and capital account balances measure, respectively, the demand for, and supply of, domestic currency.

Take a current account surplus. Foreigners must acquire £s to pay for all the UK exports they are buying. The current account balance is therefore negatively related to the exchange rate. The exchange rate gives the relative ‘price’ of currencies. A depreciated currency (think cheap) boosts exports and limits imports, making for a more positive current account balance.

The negative of the capital account gives the supply of a currency. A capital account deficit represents a situation where money is leaving a country to be invested abroad. To be invested abroad, these funds need to be transferred into the relevant foreign currency. Thus, domestic currency must be supplied to the market in exchange for foreign currency.

So, for a country with its own currency, the net balances of the current and capital accounts determine the net demand and supply of currency and therefore the exchange rate at which its currency trades.

Budget and trade deficits: Two sides of the same coin

How can the build up of large trade deficits cause government finances to go awry? Imagine some country, getting along pretty well by today’s standards, without a government or trade deficit: taxes are just sufficient to cover government spending, and the value of imports equals that of exports. Oh, imagine such a country!

Then, the world changes. Other countries fall into recession, reducing their demand for our country’s exports. Assuming our demand for imports is unchanged, this would cause a trade deficit to develop: exports are now lower than imports. (Alternatively, one could think of imports rising relative to exports if, for example, another country starts producing higher quality goods or invents a new products highly demanded by our own citizens). Unless something changes, this widening of the trade balance will hit total demand in the economy resulting in lower national output and higher unemployment. To prevent this, or at last cushion the blow, the government could prop the economy up by running a budget deficit, pumping money into the economy to make up for the loss of exports, borrowing from abroad to fund this build up of debt (capital account surplus). Thus, a trade deficit can prompt a budget deficit, financed by borrowing from abroad.

If a country has its own currency, exchange rate movements can also occur to stabilize the economy, reducing the extent to which a government has to get embroiled in the situation. A trade deficit implies a fall in demand for domestic currency and thus one would expect an exchange rate depreciation to follow. This depreciation makes exports cheaper, boosting their demand, helping to close the trade gap and support domestic demand and employment.

Applying to the crisis

As stated above, it’s those Eurozone countries that ran sizable trade deficits in the years running up to the crisis who have seen their government debt explode.

Building up imbalances….

There are significant asymmetries in productivity growth across the Eurozone. German real wage growth (wage growth adjusted for inflation) has been much lower than the Eurozone average. In fact, it fell by approximately 20% relative to the Eurozone average in the period 1994-2009. As a result, the labour cost of output rose by a much less in Germany, 5.8% for the period 2000-09, than in its trading partners (equivalent labour costs in Ireland, Spain, Greece and Italy rose by roughly 30% in the same period). Production costs in ultra-efficient Germany are, therefore, much lower than those of its peers.

The Euro accentuated Germany’s competitive advantage. All Eurozone countries trade in the same currency but German goods are cheaper to produce, hurting domestic industries in the other countries that cannot hope to compete with these cheap exports. The trade balances of Eurozone countries have thus been following divergent trajectories: the German trade balance shooting up to the stars, while those of the Club Med descended further into the murky depths of the underworld.

…and funding them

As explained above, trade deficits imply that foreign funds must be flowing into a country and this is what we have observed. The majority of Eurozone governments’ debt is held by nonresidents. In fact, banks and financial institutions in the advanced European economies financed a large part of the build up of debt in the periphery as noted by Blanchard and Giavazzi (2002). BusinessWeek notes that German banks are on the hook for at least $250bn in troubled Eurozone nations’ bonds.

If each country had its own currency, trade deficits and excessive foreign borrowing witnessed would have put pressure on the exchange rate, helping to restore the export-import and borrow-lend balances between European states. For example, we would have expected to see the Greek drachma fall in value relative to the German Deutsche Mark, effectively raising the cost of German goods and helping to rebalance the European economy. This has not happened, allowing imbalances to get out of control and the single currency has also eliminated stabilization mechanisms which would have provided additional routes, other than higher government spending, to prop up the economy.

Missing the heart

Thus, although financial mismanagement and recklessness have had parts to play in the Eurozone crisis, fundamental structural imbalances between Eurozone economies lie at the center of the mess. The singular prescription of harsh fiscal discipline thus does not hit at the heart of the matter. Not even the stomach. Adjustment on the part of creditor nations is also required. At present there is nothing to temper the onset of austerity across Europe. All adjustment is being forced through by depression and default. This is far from efficient. Germany has benefited enormously from Euro membership, taking advantage of an undervalued currency and low trade costs. Others have not been so fortunate, shackled with an over-valued currency and the withering of domestic industries.

Can such adjustment and rebalancing be achieved? Can the Euro be sustained in the long run given the imbalances and limited mobility within its domain? Oh I wonder, I wonder….

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Banking Reform: The Principles & Proposals

Posted on September 14, 2011 | Leave a comment

On Monday, a 358 page tome on financial sector reform was delivered to UK politicians and public, the outcome of an investigation into UK banks by the Independent Commission on Banking (ICB). What were the central recommendations and their motivations? Do they go far enough?

The ICB was set up by the Treasury in the aftermath of the financial crisis and is headed by Sir John Vickers, former boss of the Office of Fair Trading and Warden of All Souls College, Oxford. Achieving a stable banking sector is more important to the UK than many other countries. Britain is hugely exposed to turmoil in the financial sector. The balance sheet of banks is £6trillion. To put this in perspective, this is 4 times larger than the total value of our economic output. Incomprehensively huge. This is not the case in all Western countries. In the US banking liabilities are equivalent to ‘only’ 50% of GDP. It is thus of upmost importance that we get the structure of our banking industry right.

Some banking basics

There is a lot of jargon in this field. To help get to grips with what the reforms target, let’s briefly review the basics on the banking system.

In a simple world, one can think of banks as absorbing savings deposits and certain types of debt and transforming them into longer term investments, such as mortgages and corporate & government loans. This means that our savings do not just ‘sit in the bank’, they are re-lent out to generate profits. Banks suffer from a ‘maturity mismatch’; their liabilities are short term (we can demand our savings back right now), while their assets pay back in the long term (the flow of profits from mortgages and bonds might go far into the future).

But what happens if lots of people suddenly want their savings back? In ‘normal’ times banks satisfy the demands of their depositors by lending to each other in overnight inter-bank reserve markets. If you’ve heard the term LIBOR, this is the London Interbank Offer Rate, the interest rate charged in the London overnight reserve market. Banks short on liquidity (i.e. those that don’t have enough free cash to satisfy deposit demand) borrow from those with excess reserves. In this way, it doesn’t matter most of the time that savings don’t just stay in the vaults at the bank.

So what happens when loans go bad? When loans go bad, losses must be absorbed by past profits generated by good loans or depositors, i.e. savers, will take a hit and the bank will be judged insolvent. Thus, it is important that banks carefully monitor the loans that they make and set interest rates to properly reflect the risk they face. Regulators also require that a portion of loans are funded from equity capital. This is the stock of past profits accumulated by a bank. Then if a loan goes bad it is the bank shareholders that shoulder the loss. This is fair. They oversee the management who allowed the bad loan to be made.

Equity capital is thus a lovely safety cushion on banks’ balance sheets. The higher the equity capital relative to the total size of the bank, the safer it is. The Vickers’ report and the Basel III agreement are both concerned with increasing equity capital ratios. What they actually do is specify a minima for:

Equity capital/Loans*risk weighting

where the ‘risk weighting’ figure reflects the quality of the loans made. So, it will be high if all the loans you made were to unemployed teenagers for multi-million pound houses.

In brief, during the financial crisis banks made, or were at least expected to make, losses far in excess of their equity capital. This led to a run on savings deposits, a freeze in interbank lending (banks couldn’t tell if each other were solvent and so wouldn’t lend to one another to help meet high deposit demand), a credit crunch and severe recession. Nice.

The recommendations

The Treasury set up in ICB to help prevent a similar financial crisis from arising again in the future. One can group the ICB’s proposals under three main headings:

1. Ring fencing retail operations

This is the proposal that has gobbled up the most column inches. The ICB argues that we need to separate the retail operations of banks from investment banking. Retail operations are those which ‘normal’ people think of when you say “bank”, i.e. savings, current accounts and mortgages, while investment banking activities include things like the more exotic sounding derivative trading. Ring fencing effectively builds a sort of firewall around the crucial activities which we really care about and will result in our own savings funding the flow of domestic loans.

 2. Promote greater competition

The UK banking industry is dominated by a small number of very big players. To create greater effective competition in the sector, Vickers recommends that the Lloyds banking group be broken up in a way that creates a strong new challenger. Further, measures to make it easier for individuals to switch their accounts between institutions are outlined and the need for a greater amount of clear pricing information is pressed.

3. Raise banks’ ability to absorb losses

This proposal relates to the amount of equity capital banks hold. From above, this is key in determining how safe a bank is as it sets the degree of loss it can sustain. The ICB feels that the proposals achieved by Basel III do not go far enough and want higher equity capital ratios for retail operations.

Intended effect

Lots of our problems in the financial crisis stemmed from two main things: 1) Banks made bad loans and 2) Banks weren’t holding enough equity capital to cover the bad loans. So ideally the reforms will:

1)       Reduce the likelihood that bad loans will get made

Ring-fencing retail services should work to discourage reckless risk taking and promote more sensible lending. The ‘too big to fail’ problem is often mentioned in this context. During the financial crisis, it was felt that the government had no option but to intervene to bail out the banks. The costs of not doing so were unfathomable. However, this created a “moral hazard” problem. Banks knew that, when push came to shove, the taxpayer had little choice but to bail them out and cover their losses. This reduced their incentive to make good loans and monitor the amount of risk they took on, encouraging the dodgy lending and trading practices at the heart of the crisis. If the government could have credibly promised to stand back and watch banks fail, it is likely that many of the bad loans would never have been made.

The reforms should make it easier for the government to do just this. Stand back and allow banks, or certain parts of banks, to fail, reducing this moral hazard problem. Ring fencing allows for better targeted bailout policies making it easier to force the creditors of failing investment banks bear the consequences of their investment decisions. Not just the good ones. The government can choose if it wants to support the investment banking arms of banks rather than being compelled to do so because of the risk to the retail services it really cares about.

2)       Make banks better able to cope with losses

Raising the capital requirements of banks enhances their ability to shoulder losses and ring fencing should also help insulate the banking of the layman from international troubles as much of the complex international exposures of UK banks relate to their investment banking divisions.

Answering some criticisms

There have been noises made on the cost that these reforms will impose on the already fragile banking industry. Critics also mention that the proposals will damage the global competitiveness of the UK banking industry. Neither criticism is particularly strong.

Vickers estimates that banks will face costs in the region of £4-7billion per year as a result of the proposals. So, actually, given the total size of the industry these costs are relatively trivial. Also, these costs are nothing compared to the bill the government is footing: The New Economics Foundation argues that the 5 biggest UK banks received a £46bn government subsidy in 2010 alone. Furthermore, these costs are the result of returning risk bearing to where it should be, i.e. with investors rather than taxpayers, and so are not wholly bad. One can argue that the cost of capital has been artificially low for banks because of the implicit government bailout promise outlined above. Banks have been able to borrow at lower cost than they should have been able to because lenders have known that it is highly unlikely that they won’t get paid back. In the past it was known that the government would step in if things got bad. Therefore, interbank interest rates and borrowing costs have been lower than those which actually reflect the social risks.

On the issue of global competitiveness, the proposed regulations largely apply to high street business. By definition, the high street has to stay where it is (!), reducing the international ramifications of reform. The ICB estimates that only a relatively small portion of investment banking activity will be affected and all operations outside the ring-fence will continue to be regulated according to international standards. The enhanced equity capital ratios also only apply to the retail operations of banks. Operations outside the ringfence will continue to be policed by international standards.

Is it enough? Short answer: No. 

This is where I’m sceptical. Yes, the proposals are relatively wide reaching but they are also moderate. Meek even. The fact that there has been relatively little fuss and bother in the aftermath of the report is strong evidence that nothing really challenging has been put forward. Furthermore, implementation is far on the horizon. 2019 to be precise. That is a long time in the future. Who knows what issues will have arisen by then and this also gives the banks a long time to work out every way to minimise the impact of the proposals on their activities.

What Britain can achieve on its own is limited with respect to banking reform. Sadly, an international solution is needed. This is I think why Vickers’ proposals are not going to bring the radical change we need. The ‘sadly’ qualification is because the terms international, agreement and radical are not often found together in this environment.

I want more sensible debate and research on an international financial transaction tax. Such a tax would bring in revenue, which could then be directed to helping those in need at home and round the world, and would help to curb certain types of destabilising financial activities. For example, the growth of ‘High Frequency Trading’ (HFT), identified by the Bank of England as a serious systemic risk, could be reduced by a minimal tax on each transaction as these trades all rely on minuscule margins. However, such a tax does need to be international. The UK could not implement this on its own.

In summary, the Vickers’ report outlines sensible but mild reforms to the UK banking industry which certainly won’t make anything worse. However, they are not enough and their implementation is too far on the horizon. Creative, serious thinking on a challenging international solution is required. Sadly, I’m sceptical about what will be achieved.

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The PIGS Problem: Surprisingly Difficult to Cure

Posted on August 14, 2011 | 2 comments

Damned with austerity, damned if they don’t. What lies ahead is unclear… except a shortage of bacon. 

Despite the insane number of crazy news stories that 2011 has thrown at us, the column inches devoted to the Eurozone Crisis have proven surprisingly resilient over the course of the year. How has the mess developed and why is it going to be so difficult to resolve? (I should note here that I am heavily indebted to Dr. Christopher Bowdler, a tutor at Oxford University, for his absolutely brilliant lecture notes on this topic which have provided me with most of the theory outlined here).

What’s the story so far?

Let’s start at the beginning. The Euro officially came into existence on 1st January 1999, with Greece joining the single currency in 2001. Concern over the size of certain member countries’ budget deficits started to develop in April 2009, with France, Greece, Ireland and Spain all ordered by the EU to reduce the size of their budget deficits. However, by December 2009 the Greek debt burden had risen to 113% of GDP. Not even a near miss of the Eurozone limit of a debt-to-GDP ratio of 60%. This led the ratings agencies, who give assets a grade depending on how ‘safe’ they are perceived to be, to start downgrading Greek debt.

Things were only to get worse. At the start of 2010, Greek accounting (ahem) “irregularities” were discovered, resulting in the size of their budget deficit being substantially upward revised, from 3.7% of GDP to 12.1%. This was almost four times the maximum allowed by EU rules. The market started to get really worried about the country’s ability to pay its debt. It wasn’t so confident about the other countries mentioned above either. This led to rising interest rates on these countries’ government debt as the perceived likelihood of their default grew (see my first post for more on the mechanism). The Eurozone and IMF intervened offering financial support and loans to Greece and Ireland, and also Portugal by May 2011, conditional on the implementation of austerity measures.

However, for Greece, it’s May 2010 110bn-euro package was still not sufficient to quell investor fears. This may have been due to the difficulty/slow speed at which Greece was implementing it’s announced fiscal tightening. Further speculation surrounding the long term viability of Greek membership of the Euro (or lack of it to be more precise) led to the need for further financial aid. In July 2011, a further 109bn-euro package was unveiled which was designed to (hopefully) resolve the Greek debt debacle and prevent the crisis from intensifying and spreading to other countries. This package included measures to increase the amount of time Greece would have to repay it’s debts, reduce the overall amount that it would have to pay back (a selective default…. the phrase “a rose by any other name would smell as sweet” comes to mind….maybe the language is too beautiful for this context though) and created a role for private sector involvement in the bailout.

Despite initial rejoicing at the package, the storm quickly started to brew again with the EU President Jose Manuel Barroso admitting a few weeks ago that measures had not stopped the crisis from spreading. Italy, in addition to the PIGS, is now also the object of intense scrutiny and concern and the European Central Bank (ECB) has now agreed to buy Spanish and Italian bonds in an effort to reduce the interest rates that the market now demands. Last week, there were also rumours that France was the next to go under, with speculation over the possibility of a downgrade in it’s debt rating. Time to cue “Another One Bites The Dust”?

So to sum up, a sizable portion of the Eurozone countries are in financial difficulty. A lot. Bailout packages have not yet been deemed sufficient to quell investor fears and speculation about the future of the single currency. Interest rates on EU government debt remain high, making the whole situation worse and potentially making an even more severe crisis self-fulfilling. Its not yet clear what the outcome of all of this will be. Everything just seems to be all over the place at the moment.

So there’s the timeline. Now we can ask how this mess developed and why the Euro exists in the first place.

Why would you want to join the Euro anyway?

I mean, poor Estonia. Surely there must have been some pretty big plus points to joining for them to finally adopt the Euro this year. Talk about bad timing.

The main arguments for joining the Euro concern the lowering of trade costs and reducing exchange rate uncertainty. The elimination of these costs could, in theory, allow faster growth and greater prosperity among European nations. The advantages of membership were seen as especially relevant to Greece and other southern European nations. Growth via exporting to high income nations in northern Europe was thought to be more easily achieved within the single currency and there was a belief that the exchange rate stability bought about by conversion to the Euro would help these countries achieve inflation and macroeconomic stability.

Some thoughts on why things got Totally Out Of Control. 

We can break this down into two parts. First, what factors contributed to the huge growth in debt to GDP ratios among certain Eurozone countries. Second, how did membership of the Euro make stabilisation harder?

A. The growth in debt-to-GDP ratios

Government debt in the countries in trouble is high. Very high. However, this was  generally true even before they joined the Euro, partly because strong trade unions and political myopia in these countries contributed to sizable deficit bias. Global imbalances (more on this issue in the future) and the perception of Western macroeconomic stability resulted in very low borrowing costs prior to the financial crisis resulting in it being easy and cheap for governments to raise debt in line with GDP.

However, membership of the Euro has been cited as an underlying cause of high debt levels. Euro membership was thought to have raised southern countries’ growth rates permanently through the advantages above, implying a higher sustainable debt level, and also prevents currency devaluation facilitating cheaper borrowing. The second reason makes investing in these countries ‘safer’ as the value of one’s assets are more protected. Imagine I decided to invest all my money in Greece. Previously, the Greek government could have allowed the drachma to loose value relative to the pound, meaning that what I what I stood to get back from my investment would have been worth less in £ terms. I’d have been worse off and would have want some insurance, in the form of higher interest rates, to protect me from this. With only one currency, the control of which is largely beyond smaller countries, the risk of this currency devaluation is smaller, allowing borrowing rates to fall.

Some have also pointed to the moral hazard arising in currency unions. This is a term you might have heard in connection to the banking crisis. Moral hazard refers to a situation where my incentives to act change after we put our names to some contract. Note that this contract could be implicit– it doesn’t need to be written down, just implied. Membership of a single currency creates an incentive to, or at least removes a disincentive to not, relax about the whole fiscal responsibility thing. Membership creates a presumption (an implicit contract) that a country will be bailed out if they run into trouble with their finances because there is a strong common interest in action which preserves the viability of the Euro. This implicit promise reduced the incentive for Greece to take action to reduce its budget deficit and also lowered the risk to investors, as they knew they would get their money back, making borrowing cheap and easy for countries for whom it really shouldn’t have been.

B. Constraints imposed by the Euro

There are some significant constraints imposed by being a member of a single currency. These constraints have played a role in the current mess as European government’s have been less able to buffer their economies against the financial crisis. So how did Euro membership hinder stabilisation?

(1) Countries have lost the ability to change interest rates to manipulate their economies. They have no individual control over their monetary policy. Thus any stabilisation must be done via changes in tax and government spending BUT at the moment there is no way that investors would accept these countries initiating a widening of their budget deficits. So, there is little the government can do to help ease the pain.

In fact, all the countries in trouble are having to implement harsh austerity measures to get their borrowing costs under control. The Irish Republic passed the toughest budget in the country’s history and the Greek Parliament has also passed severe austerity measures. On Friday, Italy announced further tightening in an attempt to balance the government budget by 2013. Bailout finance has also been made conditional on promises to get debt positions under control. So, what we’re seeing are huge fiscal tightening’s across large swaths of Europe.

(2) With only one currency, nominal exchange rate movements between member countries have not occurred to help rebalance things. Other things equal, one would expect austerity measures and low demand in one country to result in a depreciation of their nominal exchange rate. This acts to makes exports cheaper, boosting their demand and helping to buffer the fall in government spending. Nominal exchange rate depreciation has been an important buffering influence in the UK. Sterling has depreciated by around 20% against the Euro over the last 3 years. The fact that these movements cannot occur quickly means that these countries are hit especially hard, probably harder than the UK, by the onset of austerity measures.

Given the above I’d be pretty nervous as an investor. All the signs suggest that growth among the PIGS is going to be slow…. for some time to come. Therefore, market participants are unlikely to get fully repaid. This has seen the interest rate that these countries can borrow at shoot up making the problem a whole lot worse as this makes the debt financing issue even harder (again, touched upon in post number 1)

What’s next? Oh, if only someone knew!

The outlook is not looking good to say the least. It remains uncertain whether the current bailout packages will be sufficient to impart just a degree of calmness in the markets or will even achieve the desired aims. Greece does appear to be fundamentally insolvent. It is unclear that the state will be able to implement the austerity measures required by the IMF and EU given the widespread social unrest and their sheer scale appears unachievable to me. Further, considering the importance of intracontinental aspects adds some more issues to ponder over. Harsh austerity policy in one country has impacts on others through the trade (export markets dry up) and the financial system (banks and institutions in other European countries will be exposed to their neighbours’ private and government debt and thus defaults in one country directly impose losses on banks in other countries), acting to intensify the slowdown in growth across the region. Thus, it seems to me that the degree of austerity required to quell market fears may actually end up bringing down other countries and thus not get us anywhere closer to a better place.

Basically, I have no idea what the hell is the best way forward. The PIGS are damned with austerity, damned if they don’t. Whatever happens, there will be a transfer of wealth within European countries towards the slower growing, heavily indebted nations either through explicit bailout packages or through the consequences of their default as banks in other countries hold PIGS government debt.

In my opinion, the Euro will not survive in the long term. I have no idea how an exit from the Euro will occur, or what its ultimate impact will be. I just can’t see how the union can stay a union without integration of EU fiscal policy and I don’t think there’s a strong enough European identity for people to be ready to do that. The Economist looked at the states in America which corresponded to the PIGS in Europe. There, huge internal transfers of wealth take place between states and this is possible because of a common fiscal framework and popular support which I take to be grounded in the commonality of values and national identity. Neither of these things are forthcoming in the Eurozone. Also, I don’t think that only ‘a few’ of those in trouble could exit as once outside the union their currencies could devalue, making them more competitive and making it worse for those troubled nations who stuck with the Euro. All or nothing?

There’s the background. No bloody idea what’s going to happen with this one to be honest. Hopefully though this has helped you to understand the background behind the news stories! Let’s see what happens this week……..

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Deficit Bias: Why We Need to Tie Politicians’ Hands….. Loosely

Posted on August 11, 2011 | 3 comments

A couple of people contacted me about the problem of the (lack of) credibility of government promises to cut the debt in the future. I didn’t give this issue enough space. This post should rectify that.

There are good reasons for a government to intervene in the economy during hard times to play a stabilising role. In fact, I don’t know of a theory in which one can cut government spending and raise taxes during a recession and leave output and employment unaffected. Keynes argued that market economies find it difficult to escape deep recessions and that monetary policy could only provide limited push in helping get the economy back on track. For Keynesian economists, a fiscal stimulus in the form of either higher government spending or lower taxes is a good idea during a bad recession. Actually, they’d probably say it was more than just a good idea. In fact, until the whole ‘Greek debacle’ the US and UK governments and even the IMF at times suggested that governments should play a role in recovery.

So lets just accept for the moment that there are good reasons for the government to run a budget deficit during a recession to help smooth out the dip. Then why is it that all we’re hearing at the moment is ‘Cut Cut Cut’? Why the switch from the presumption in favour of fiscal stabilisation to ‘austerity is the ONLY way’? Especially when we hear institutions like the Office for Budget Responsibility (OBR) saying that the austerity measures in the emergency budget last year would increase the risk of a double dip recession. To understand this we need to explore the concept of deficit bias. This discussion will also illuminate the motivation for creating the Office for Budget Responsibility and why both Gordon Brown and the coalition set themselves some rules over fiscal policy.

Deficit bias is basically the idea that it is difficult and painful for the government to reduce debt levels but very easy for them to say that they will in the future. In a recession a government should want to run a budget deficit to help buffer the economy against the storm. Then when times are ‘good’, the government should act to reduce the deficit. The stabilising has been done then. However, in these good times, tax rises and spending cuts are going to remain unpopular. Politicians don’t want to turn round with a smile to their voters and say “Right now everyone, its time for those taxes rises!”. Much easier to just ignore the whole debt problem. This leads to rising debt to GDP ratios. We observe this in reality. For example, among OECD countries levels of debt relative to GDP roughly doubled in the 30 years leading up to the recession for no good reason.

From my first post, you should (hopefully!) know that very high debt levels are to be avoided. There are costs. Investors start getting hot under the collar. This is why there are calls for austerity measures now. If the government could promise to put in place measures to bring debt levels down once the economy is out of the woods then we wouldn’t see the same budget as was presented earlier this year. The government faces a commitment problem. It would be best for everyone if Os-terity Osborne committed to reducing the deficit in the future. But this commitment isn’t deemed credible. So, they say, we must reduce the deficit now. In the middle of the deepest recession since the 1930s. Brilliant. We need someway of tying the government’s hands so they do actually cut the debt in the future, thereby allowing them to help us out now.

Luckily for us there are ways to mitigate this commitment problem, allowing for less cut throat austerity measures right now. I believe that the UK government needs to slow down in its mission to reduce the deficit. I am basically calling for the government to put its hands up and say ‘look guys, I’m going to mainly cut later….only a bit now’. Setting up the OBR and putting in place the new fiscal rules helps the UK government solve its commitment problem, making a promise to get the debt under control when things get less crazy more believable.

The OBR is an independent forecasting body, giving predictions of future growth and employment, assessing the plausibility of the figures which lie behind the government’s plans and evaluating the likelihood of the government meeting its self-imposed targets. Although not under its mandate at the moment, there have been calls for the OBR to also comment on the desirability of plans for deficit reduction and the like. Setting the OBR up in itself sends quite a clear message to investors that the government is serious about fiscal discipline. I mean, its called the Office for Budget Responsibility! The government could use the fact that the OBR forecasts and figures are independently calculated to build a bit of wiggle room into policy. Austerity measures could be staggered and implemented conditional on the speed of recovery and there could be no worry that figures were cooked to let the government off the hook.

Further, the government set itself two fiscal targets when it came into power: (1) to balance the budget 5 years ahead and (2) to have net debt falling by 2015-16. As we saw with the last Labour government, the fact that rules are stated doesn’t mean that they will be followed (that credibility problem again) but the fact that the OBR independently assesses the likelihood of these targets being reached reduces that risk.

Therefore, it seems to me a little odd that we are following the ‘Only-Way-Is-Austerity’ strategy at the same time as setting up an independent body that should allow us to slow the pace of cuts.

Let me ask you now, have I missed something?!

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Gallery

UK Deficit 101: Explaining the Malady and Medicine

Posted on August 10, 2011

Oh hearing those fateful words: “Wait, you’re an economist! So what’s the deal on…..”.  I shudder at the memories. This blog is in response to a couple of people who’ve recently asked me to explain the background to some of … Continue reading →

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