Tuesday, May 29, 2012

Old-fashioned remedy for the euro disease

The economic situation in Spain worsens by the hour. Today we learn that retail sales dropped by 10% in April, compared to same month last year. Banks are virtually bankrupt, unemployment reaches 25%. The Spanish economy risks a complete collapse.
Spain may of course hope for external help from Brussels and the ECB, but there are chances that such help will amount to too little, too late. Spain needs to do something, although the range of actions it can take seems rather limited.
One thing it could do, as aearlier post advocated, is take liberties with the euro. This post gets back to the subject and examines a concrete example of how it could proceed.


Spain would emit promissory notes (IOUs) in order to relieve its economy in two ways:
  • Inject liquidity in an economy paralyzed by a credit-crunch.
  • Help finance a budget deficit that amounted to 8.9% in 2011, and that Spain would be supposed to reduce to 5.9% in 2012. If it tries to do so, additional austerity measures will aggravate the recession (and possibly trigger the collapse), if it does not, it will face prohibitive rates and won't be able to get the money from the markets.
One thing those notes would not achieve however is restore Spanish competitiveness through devaluation (which would happen with an overnight switch to the peseta).
There are certainly many ways in which a promissory note scheme may be designed. Let's see what it could look like:

  • The Spanish government discloses in advance all details of its scheme (because promissory notes, just like money, require confidence, and thus transparency).
  • Notes (IOUs) entitle the holder to receive a payment in euros on June 1st, 2015.
  • Each month, the government emits notes for a maximum nominal amount of 4 billion euros, for a limited period of two years. That's roughly half the deficit, and 10% of the budget.
  • IOUs are issued in notes of 1, 10, 100 or more euros and printed on paper. They are directly used to pay for the domestic expenses of the state, according to a given ratio (a civil-servant making 1,600 euros a month would receive 1,400 euros and 200 "notes" to be withdrawn at a post-office). 
  • The notes bear no interest. Technically, this means that the beneficiary of the note offers a discount to the Spanish government. With 3-year market rates at 5%, notes are worth about 86% of their face value at the moment of emission.
  • One the face of it, not much different from money
  • Banks are allowed to open current accounts for notes. They can offer short-term loans in notes, and exchange euros for notes, or conversely, at market rate.
  • In addition to the scheme, the government implements reforms for improving competitiveness (and having a more flexible labor market). 
Several questions must be positively answered for the system to work:
  • Would civil servants accept to be partially paid in notes ? This is highly likely. In the example above, the civil-servant would abandon 1.75% of its salary, a decrease that would remain mostly virtual if the the civil servant is able to buy things with the notes.
  • Would merchants then accept the notes ? This is again quite likely. In the depressed state of the Spanish economy, they would rather be glad to sell anything at all. In which proportion they accept notes, or whether they accept them at face value, may in fact soon become key selling points.
  • How would react the international financial markets ? This is a more debatable question, but it not unreasonable to think that markets would welcome the scheme, and that the rates on Spanish Government Bonds would return to affordable levels. What we've seen in the crisis so far is that the markets are wary of Brussels inaction, but react favorably to anything that looks like a solution, even a partial or temporary one (markets have been quite keynesian so far, in showing some distrust of austerity - dig Krugman's blog for evidence).
More liquidity, less fiscal pressure. Would that be enough to restore growth? Maybe, maybe not, but at least it would help. And apart from growth, it should also have a positive side effect on banks.
People won't exchange their notes for euros. They will as much as possible do the opposite, spend notes and save euros (Gresham's law: bad money chases out good), lowering the pressure on the balance sheet of banks.

The scheme displays additional tactical advantages:
  • It puts pressure on Brussels and the ECB. As they might not like the scheme, they will have more incentives in coming with their own solution.
  • It provides Banca de España with the possibility of becoming lender of last resort for commercial banks (in notes). Although such a possibility should be clearly announced at the start of the scheme.
  • Should the events turn nasty elsewhere in Europe (and that can happen any day), Spain could make its scheme more aggressive.
Suppose now that after a couple of years growth returns (thanks to the scheme or for whatever reason). Spain would balance its budget, and rates would reflect the confidence of the markets. Spain would be in position of repaying its notes as intended and ending the scheme.
Or it could renew it and use it as a monetary tool to place in the hands of Banca de España rather than those of the ECB. Since such a tool would work both ways, it would help prevent the next housing bubble.
And if growth does not return, Spain could more easily decide to exit the euro and switch to the peseta, since the transition would have been facilitated by the existence of the notes. By the way, that's a reason why notes should not be called pesetas in the first place (although they are technically not much different). If the initial intent is not an euro-exit, people should not be made to believe it.

It must be noted that such a scheme is more promising if the debt level is low, the government credible, and the economy structurally healthy. Spain displays all three conditions, Greece none of them. It is however quite likely, and most unfortunate, that Greece will have to experiment IOUs first.



Such a dual currency system is neither odd, nor creative one. It is old-fashioned. We now increasingly hear that the euro replicates the gold standard. But the euro rather replicates gold itself. Under the gold standard, national economies had national currencies pegged to gold. In the eurozone, national economies use a common currency, in the same way as they did with gold before the 20th century. When those economies progressively issued bank notes (with a promise to repay in gold) in the 18th and 19th centuries, they created their own currencies. Gold (and other metals) remained in use until the gold standard was abandoned in the 30's. The difference between the euro and gold is that the ECB can increase the supply of euros at will, while no one ever had the power to create gold out of nothing. But if the ECB does not make enough use of its power, that difference is of little use for troubled European economies.

Saturday, May 26, 2012

Greek wrestling

Showing the way in or the way out?
Simon Wren-Lewis believes Greece might stay in the euro. His analysis is quite convincing, because it looks at the intricacies of European politics rather than at the reality of economic figures. In Europe, politics prevails over economics (that's why there is the euro in the first place). According to his analysis,
  • The Germans will give ground,
  • The Greeks will be able to renegotiate their loans,
  • The ECB will provide the Greeks with the liquidity they need.
All this sounds reasonable, since there is no obvious alternative. But it does not say whether it will happen at once or gradually. Gradually seems more likely for three reasons:
  • European politics is slow, and Europeans are notoriously unable to reach conclusive agreements.
  • Even if they were, they would not want to relax too much the pressure on Greece (that still needs to implement lots of structural reforms).
  • They would fear that being too soft on Greece might give ideas to other south Europeans countries.
In a sense, that's what's already been happening since Mr Draghi replaced Mr Trichet at the head of the ECB.  And that's what could go on for a while. There are however three problems:
  • It might be conditional to the outcome of elections in Europe, starting with Ireland next week and Greece two weeks later.
  • It would not resist the bank run that might be imminent.
  • It might help the Greeks, but it would not improve the situation in Spain or Portugal that would continue to fall down the recession slope (unless, against all evidence so far, reforms and austerity work magic and restore growth on their own).
Simon Wren-Lewis is probably right about what Germany and the ECB will do, but it's not obvious that it will be enough to keep the eurozone together. If Europe wants to change the course of events, it must come with better than an uncertain and temporary solution.

Tuesday, May 15, 2012

Poker and central banking

The perfect replacement for Mario Draghi
Central banking has a great deal in common with playing poker:

  • You may play tight or loose,
  • You need to make decisions under uncertainty,
  • You're facing random events,
  • You're facing human beings (who try to anticipate your moves and take advantage of them),
  • Your main objective is to remain credible,
  • Scandinavians excel at both.

Both poker and the economy are competitions, but poker is a zero-sum game while the economy is not. That's a big difference, but it does not affect the strategic lessons that central bankers could learn from poker.
In poker, a tight strategy looks safe, while a loose one seems to deliver better returns. The optimal strategy is to mix both styles, and keep adapting to opponents and circumstances. This is a direct consequence of the human and the random factors, and it is something that economic models have much trouble with (but something that Walter Bagehot was already aware of).

Saturday, May 12, 2012

They won't get fooled again

Picture yourself in Greece. Not on a sunny beach as a tourist, but as a middle-aged Greek citizen who modestly participated in the economic and political life of its country in the past decade. You never were a militant, but you voted at each election. You never dreamed of extravagant riches, you simply worked in earnest. How do you feel now? Do you feel any share of responsibility, or do you consider you've been fooled?

  • First, there's been the euro. This idealistic political project was enthusiastically carried by the European Union, and the Greek government (Papandreou) was eager to join in. Like in most of Europe, there had been virtually no warning of the dangers and drawbacks of a single currency.
  • Because of insufficient awareness, the following government (Karamanlis) failed to take measures that could have in part prevented such dangers (measures such as tax or pensions reforms admittedly come at a political cost). When the worldwide financial crisis hit in 2008, irresponsibility turned to fraud as the government cooked the books (with the technical support of Goldman Sachs). The 2009 budget deficit was budgeted at 3.75%, then revised to 6%, and finally turned out to reach 12.7% (data borrowed from this article of Jean-Pierre Lehmann).
  • Here, the European Union totally misunderstood the economic situation and imposed some severe short-term austerity measures. This did little to improve the budget gap, but seriously aggravated the crisis. Europe did try to offer some support (bail-out), but so little and so late that it was possibly worse than nothing at all.

So, the Greeks can reasonably say they've been fooled three times, either by the European Union, or by the Greek government, or by a joint effort of both of them. They did not vote on the euro, they certainly did not support creative national accounting, and when their government finally considered submitting austerity to referendum, they were denied that right following European pressure. As for Greek government politics themselves, it is maybe telling to note that Mr Karamanlis and Mr Papandreou are respectively the nephew and the son of former prime ministers that served in succession since democracy was reestablished in Greece in 1974.
In ancient Greek, in ancient Greek, krisis means turning point in a disease. Before being economic, the Greek crisis is democratic, and time has come for both Greece and Europe to fix their institutions. The Greeks don't want to get fooled again, that's the lesson of last week elections.

Monday, May 7, 2012

If you can't divorce, take a lover

South European know-how
for fixing divorce obstacles
The founders of the euro thought they were forging a rival to the American dollar. Instead they recreated a version of the gold standard (The Economist, Charlemagne column, April 7, 2012).
Gold or euro, if the problem is the same, so should be the solution... In two words: paper money.
The previous post argued that the euro was a mistake, and that time has come to talk about it. But such a discussion can only happen if it is based on the prospect of a solution. As the Economist points out: one reason the euro holds together is fear of financial and economic chaos on an unprecedented scale.
Such a fear may be widely exaggerated. A euro exit will not necessarily trigger chaos, but might instead reduce the risk of chaos. It does not have to be economically painful, and it does not even have to be a real exit, let alone a complete break-up.


First, let's look at the political implications of a euro break-up:
  • In theory, members of the Eurozone are not allowed to exit the euro, or they would have to quit the European Union. This is unlikely. After the mandatory screaming and warnings, Brussels will accept whatever it takes to avoid a European implosion.
  • A euro break-up would sanction the failure of the biggest European project so far. Obviously, it won't look good for the European construction. But it was an ill-conceived project from the start, and nothing threatens more the European Union right now than the current crisis. Politically, a euro break-up would be less damaging than further deterioration of the economic situation.
Economists tend to think of a break-up in the same fashion: the lesser of two evils. That may not be imaginative enough.
The standard view is that a country (call it Spain, for the sake of the example) could quit the euro by switching overnight to the peseta, possibly forcing the conversion of bank accounts and  internal debts, which would most likely result in a bank-run and further economic collapse (chaos). But it does not need to happen that way. That's the kind of things that happen when an economy is bankrupt and the currency must be sharply devalued (like in Argentina in 2001). Spain is in a very very different situation.
  • Spain is not a failed economy. It experienced a housing bubble, its banks are over-indebted, and its labor regulations are notoriously rigid. But it's got schools, infrastructure and institutions. Its budget was balanced before the crisis, and it just experienced twenty years of robust growth (arguably a bit inflated by the euro in the early 00's).
  • Spain needs to eventually restore its competitiveness, but more urgently, it needs a bit of cash.
  • The euro is not a failed currency at all. In fact, it is rather strong and (on average, for the Eurozone as a whole) correctly valued.
So, it does indeed look like an old-fashion crisis, when gold was the standard. And the remedy might be the same as in the 19th century.
  • Spain may well keep the euro as its main currency. But on top of that, it might print a few pesetas for the daily expenses its government is not able to finance through taxes.
  • The peseta will be seen as a weak currency, but in a cash-strapped economy, that's better than no cash at all. Spaniards will rather receive their allowances in pesetas than see them cut. And they should have no problem spending them, as in a depressed economy merchants will prefer to get paid in pesetas than miss a trade.
  • If the peseta needs a bit of help, there are ways to encourage its use, for example through a lower VAT rate for transactions held in peseta.
  • Banks (especially near bankrupt Spanish ones) will have no choice than to accept pesetas in repayment of their loans.
  • This should restore confidence in Spanish banks and put an end to austerity and its death-spiral effect. As Spain would be back on the growth track, the Spanish government would even increase its tax intake of euros. It could then slow down its printing of pesetas  (and possibly even withdraw some from the market).
Too good and too simple to be true? Let's look at three issues: conversion, inflation and competitiveness.
  • Conversion is a good question. It would probably have to be restricted and kept at a par with the euro. As long as the euro remains the main currency, this should work.
  • Inflation is more of a worry. A budget deficit in the area of 7% of GDP, entirely financed with money printing, would mean a significant increase of the monetary base in Spain. But until the economy reaches its equilibrium growth path again, inflation should remain moderate (authorized opinions would be welcome in this respect). In the worst case, only part of the deficit should be financed that way.
  • Such a solution would not restore competitiveness by itself and structural reforms might still be necessary. At least, it would provide the breathing space for Spain to engage in such reforms.
Maybe I'm missing something. Maybe there is a serious flaw in this reasoning. But as John Kenneth Galbraith illustrated in Money, whence it came, where it went, the history of money is filled with innovative solutions that were first deemed too good to be true. And as Brad DeLong recently showed, there was a better understanding of monetary policy in the 19th century than today.


This said, it is clear that the introduction of a parallel currency requires some caution and credibility from the authorities that will conduct it. It is necessary that governmental debt is not already out of control, and that the economy is not structurally too weak. For those reasons, such a scheme has far better chances to succeed in Spain than in Greece.


Finally, unless the crisis is solved in some other providential way, this is something that is likely to happen, because there's no need of a deliberate political will to apply it. Read again the article, and replace peseta with IOU. The mechanism won't be too different.
When there is no money at all, IOU is the only way for the public authorities to keep functioning. In some areas of the USA or Europe, that time is near.

Saturday, May 5, 2012

We need to talk about the euro

Graph borrowed from Krugman's blog, who addressed
such issue in numerous recommended posts 
It is an increasingly mainstream opinion among economists that austerity is worsening the crisis rather than solving it. And nowhere is it more obvious than in Southern Europe, that is in Greece, Ireland, Portugal, Spain, Italy (Ireland doesn't share the latitude or the climate, but it shares the woes). But for Southern Europe, austerity is only part of the story. It is the euro that initiated the crisis, and it the euro that now makes things worse, and prevents any way out.
  • The exchange rate is the major problem. Not that the euro is globally over or under-valued: the trade balance of the Eurozone has been fluctuating in a narrow margin around the equilibrium ever since the creation of the currency. But what's true for the zone as whole is very different for individual countries. Trade balances (or current account balances, as it's not very different in Europe) plunged into deficits in the south, while recording heavy surpluses in the north (see graph).
  • It means that the German euro is overvalued and that the Spanish or Portuguese euro should depreciate (which is of course not possible, as euro is the one and only currency). Such imbalance is nothing abnormal in itself. It happens all the time in all integrated economies, i.e. in economies with a single currency, a unified fiscal system, harmonized labour laws, a single social benefits system, and substantial money transfers across regions. Apart from the currency, there's no such thing in Europe (which is not a country), and that's why regional exchange rate discrepancies matter a lot.
  • Monetary policy did not help. Interests rates and money supply are monitored by the ECB for the Eurozone as a whole. For the south, whose economic weight is lighter than that of the North, those rates were too low in the first half of the 00's, allowing for housing bubbles in Spain and Ireland, for public over-borrowing in Greece (in Greece only!).
  • In many crisis, exchange rate adaptation is the only way out. The concerned country needs to restore the equilibrium of its trade balance, which can happen only through an adjustment of its terms of trade (i.e. cost reduction with respect to international markets). In theory (that is, in the neoclassical theory), it could happen through prices and wages decreases. But there is mechanism that neoclassical theory is at odds to explain: price and wage stickiness. Prices and wages can only go up, not down (and it's typical of neoclassical economists of pretending that a mechanism that doesn't fit into their theory does not exist rather than trying to explain it).
  • Without exchange rate depreciation, the only adjustment could then come from inflation in the north. But that's very theoretical again, as there's little chance the ECB or the Germans might agree to pursue such monetary policy (although the ECB has been much more flexible since Mr Draghi took function).
  • And because they no longer have their own currency, southern countries are no longer able to print currency in order to finance their temporary budget deficits (remember they had on average balanced budgets before the beginning of the crisis!). Instead, they increase taxes and cut spending, which, in confirmation of old keynesian thinking, turns out to worsen the crisis.
So, because of the euro, Southern Europe is trapped in a downward spiral with no end in sight. The life of many people is already seriously affected, with record unemployment rates, bankruptcies, suicides, poverty and rise of extremist movements. The situation is only getting worse, and then there's the question of the long-run. In Spain and Greece, one young person out of two has no job. If they don't acquire the skills now, what are they going to do in 10 or 20 years? Certainly not working their countries out of a prolonged deep recession (there's a word for that, it's called hysteresis).


But if the euro is such a big problem, how come is it not more debated, especially in the Eurozone itself where mainstream opinion is a long way from discussing such issue? Well, for a variety of bad reasons:
  • First of all, the continental European establishment is economically illiterate. Maybe I shouldn't generalize, but for France at least, it's true. You just need to read the proposals of the candidates to the presidential election to get convinced (that was either austerity, social benefits, subsidies or protectionism, or a mix of all that!). Economists don't speak out much (just as they did not at the time of the creation of the euro), and there's not much of economic blogging either (or in English, which does not help much). As far as politicians are concerned, they never admit they've been wrong, no matter what.
  • Secondly, it does not help that the euro is contested by extremes (far-left and far-right in France, Geert Wilders in the Netherlands), that is the sort of people either with a low economic credibility or one should not want to associate with. Besides, such extremes may aim their attacks at the euro, but they make little mystery their real target is Europe.
  • More significantly, the euro is the big and only symbol of European integration. Despite all the civil servants in Brussels, and all of the good or less good European policies, apart from the euro, Europe looks like nothing more than a mere trade agreement. Europe so far has been unable to develop a real common defense or foreign policy. Touching the euro would leave a scarf, for sure. But the question is whether the economic health of Europe requires surgery.
  • In the 90's the euro had been strongly promoted not only by politicians, but also by business people who were looking for simplified trade and easy accounting at the end of the fiscal year. Such motivations may look marginal, but they remain nevertheless true, and business people (big or small) still like the euro.
Maybe there is a reason more fundamental than all of the above that explains why so few people want to talk about the euro. Everyone seems to be convinced that a euro break-up would be hugely complicated and hurt more than the alternatives (prolonged depression and substantial money transfers from north to south). It does not necessarily have to be that way, and that will be the object of the next post.