Tuesday, April 03, 2012

What Wolfson Did Next

At around 9:00am London time this morning Lord Wolfson held a press conference to announce the five finalists in his economics prize contest. I have done a podcast discussing the prize objectives and their implications with the Spain based British blogger Matthew Bennett. You can download it here.

The first thing that needs to be said about the initiative Wolfson has taken, in offering a 250,000 pounds stirling prize using his own money to anyone able to offer practical solutions to the current Euro crisis, is bravo. Someone willing to put their money where their mouth is, to try to find policies which should be applied in the common good has to be lauded.

Naturally Lord Wolfson is not looking for just any solutions, as the initial question makes clear, he is looking for a solution in which at least one member country leaves the Euro and a procedure (or template) whereby other countries who find themselves in a similar situation might leave. The question he asked is the following one.
“If member states leave the Economic and Monetary Union, what is the best way for the economic process to be managed to provide the soundest foundation for the future growth and prosperity of the current membership?”
 Unfortunately this question begs many others, some of which have no easy answer. In particular the question assumes that someone at some point will be seeking to voluntarily leave the currency union, and that this process can be managed in an orderly fashion. I doubt that either of these assumptions are realistic, on grounds which I will explain in what follows. But first, I have to declare an interest, I submitted an essay (which you can find downloadable here), although in all honesty I have to say I never expected to be shortlisted or win. I never expected this outcome since I basically wrote trying to explain some of the theoretical background to the Euro crisis which I feel is poorly understood, and suggest that, basically speaking, they had asked the wrong question. As I wrote in the letter accompanying my submission.
Hello there,

Please find attached a Word version of the essay I would like to present to your prize. I'm sure its not exactly what you are looking for, but it is what I have to say on the subject. I fear the question is looking for a technical answer to what is inevitably a political and economic/theoretical problem. On the other hand I did not feel I could let such an important event go by without submitting something.

Anyhow, I am sure I will fare rather better than Arthur Schopenhauer did with his essay “On the Foundations of Morality” (“Über die Grundlage der Moral”) which was not honored with an award by The Royal Danish Society of the Sciences in Copenhagen, even though it was the sole submission in their essay competition. On this occasion I am confident you will recieve a wide selection of excellent and appropriate responses. With my best wishes for every success in your endeavour,
Edward Hugh

So Where's The Snag?

Basically the intellectual world surrounding the Euro is divided into two (more or less fortified) camps - those who believe it can work, and those who don't. Many things could be said about the assumptions being made by those who think the project can still be rescued, but I have commented on this endlessly, and here is not the place to repeat already well known arguments. The problem and the frustration is, and this is what I imagine is getting through to Wolfson, virtually no argument presented by those who fear it can never work seems to cut any ice with those who are convinced it certainly can. Either you think the Earth goes round the Sun, or you think the Sun goes round the Earth, and that's it, there is no single empirical argument which can lead people to change their opinion. The truly worrying thing is that most participants in the debate seem unable to even identify an argument or a fact in the world which would lead them to a rethink.

But leaving aside the "Euro Too Big To Fail" camp, there is far from uniformity among those who feel the project is flawed. Certainly there is consensus on some basic core questions, such as:

a) Currency unions - like marriages - can be done and undone
b) Greece has a special problem
c) Many periphery economies have lost substantial competitiveness and need to devalue

But beyond this things get more complicated. In particular, I think the debate about why the Euro could be a problem which was held in the 1990s and the one we are in the process of having today  are very different animals. In part this is because currency unions when they divorce, just like marriages, leave offspring (in this case shared legacy debts) and what exactly to do with this offspring can and will occasion dispute between the various contracting parties. The kind of dispute which gives endless work to lawyers and makes amicable settlements very difficult. As Tim Harford put it in the FT,  "Lord Wolfson is offering a prize for turning an omelette back into its constituent parts".

The world before the fall can never be recovered, or as the novelist Thomas Wolfe put it, "You Can Look Homeward Angel....But...You Can't Go Home Again".

The fact that in historical time you can only move forwards and not backwards also raises questions about just how the world has changed in the interim, questions which pose a number of key theoretical issues which need to be addressed. In many ways this is why I sent in the piece I did, to try and call attention to just these issues. The debate about just what to do with the Euro cannot be abstracted from the particular features of the world we now live in.

In particular I would highlight two key features which often seem to get ignored.

a) the impact of financial globalisation and what Carsten Valgreen calls the global financial accelerator on currency values. Virtually no one - not the USD or the UK pound sterling, or the Swedish Krona - can manage their currency valuation as they see fit, or devalue as they want. Currency parities are determined by complex interactive process which are by their very nature non linear in character.

Just look at the current valuation of the Japanese Yen and its impact on Japanese exports. It is impossible to understand much about current German policy thinking if you don't get the fact that a principle constraint and line in the sand for Germany is not ending up being another Japan. The world of the 1990's was not like this, and the simple rote argument of devaluation as the answer (which I myself use because while not being entirely right is not entirely wrong either)  is not as straightforward as it seems, or as it once was. Hence the resistance in Brussels, Berlin and Paris to this panacea.

b) European societies are ageing rapidly, and this has implications. You will strain hard to find any reference to this phenomenon in the  majority of commentaries offered on what to do about the Euro crisis, yet arguably the phenomenon of population ageing lies at the heart of the current debt crisis in developed economies. Impending health and pension liabilities are what makes so much sovereign debt unsustainable, and this is an issue which goes beyond the boundaries of the Euro Area, affecting countries like the US, the UK and Japan. Again, "the Euro is the root of all evil" argument fails to address this issue.

This approach is typified by Nomura economist Richard Koo, who argues  “Japan had a Great Recession, and a Great Stagnation, but it never had a Great Depression,” while adding “But recession in some eurozone countries could become a depression, just like the 1930s. This is a view which spectacularly seems to miss the point that people in Spain are not envious of where Japan finds itself now, with sovereign debt somewhere over 225% of GDP and in danger of spiralling upwards out of control. It is evident that Japan's fight against excessively rapid population ageing and the consequent deflation has simply bought the country time, but the problem has yet to be resolved. Having your own currency and the ability to print money is all well and good, but when offered as a universal panace it merely becomes a simplistic solution to what is a very complex problem. A modern version of fools gold.

c) Finally we now have more than a decade's experience of labour mobility from one European country to another, and in particular of migration patterns from periphery countries to the core. Among young qualified workers there is more mobility than many seem to imagine. I was in Latvia recently, which is a country not in the Euro but which is suffering population loss in such a way as to make its very continuity unsustainable in the longer run (you can find and download my presentation here). What I became convinced of during my visit there is that the fiscal union question is not only a Euro currency one. Simply having a single labour market in the context of generalised population ageing means that even non Euro countries will eventually need to participate in a common treasury due to the health and pension liabilities they are going to face.

Having said all this, let me return to my initial argument. For reasons I explain in the essay (or in this post here) it seems unlikely anyone would willingly want to leave the common currency.

a) Greece might like to leave if its debts to the IMF, the EU and the ECB could be restructured in an orderly and amicable way, but this seems unlikely, especially since others would rapidly seek similar treatment. On the other hand, if Greece left without agreement on official sector restructuring their debts to the official sector would become unpayable, so Greece is unlikely to want to leave.

b) So let's look at another possibility - a German exit. Germany, as I argue in my essay,  has been a great beneficiary of the Euro since it has effectively had the advantage  of having an extremely undervalued currency.  Germany will not easily surrender this competitive advantage.

c) One solution could be to divide the Euro in two, as I argue in this piece I wrote last summer, but this proposal has generated little real interest, and Europe's leaders have not demonstrated they have the political mettle to carry such a complex initiative through. Hence, despite the good intentions of Lord Wolfson and his prize participants, it seems a rationally designed solution is highly improbable, and it would be more realistic to start to prepare for the worst.

What Next Then?

So if the Euro is, as Gideon Rachman put it "the time bomb no one can defuse" (I captured some of the essence of this idea in my CNN blog post, "Dr Strangelove and the Euro Doomsday"), what is now likely to happen?

Well, the LTROs have temporarily stabilised things, and made deposit movements from one country to another a much more containable evil. But this only offers some short term relief. Credit is still gridlocked all along the periphery, where the various countries are essentially entering long term depressions, with very high levels of unemployment, low economic growth and rising non performing loans in the financial sector. This is all unsustainable, but still, what could possibly be the trigger for disorderly break up?

Well, in the short term  Greece could find itself unable to comply with the terms of its Troika programme, and as a consequence not receive its ongoing funding. This could happen at the time of the first review (roughly three months from now) or at the time of the second one (towards the end of the year). Given that the Greeks themselves are likely to be unwilling to leave, they could decide to print their own Euros using a facility known as Emergency Liquidity Assistance (ELA) whereby the local central bank effectively monetises government debt and enables civil servants to be paid (or even recieve a pay rise). It is important to remember that in the Argentina case all sorts of scrip money schemes (Patacos, Lecops) were resorted to, before finally the peg was surrendered. Even Argentina wasn't in any rush to leave its disastrous peg. But then Argentina couldn't print dollars. The novelty in the present case is that Greece (in theory) can print Euros.

Up to now use of ELA (in Ireland, in Greece) has only been possible with the agreement of the ECB, but desparate circumstances can produce desparate solutions. Certainly this issue is being discussed in Greece. In article entitled "Is ELA the key to keeping the Drachma at bay?" journalist Nick Malkoutzis argued:

"Greek banks have turned to ELA several times over the past couple of years. It’s not clear exactly how much they’ve borrowed in this way but some estimates put it in excess of 30 billion euros. The difference with the past few days is that Greece has essentially been in default and, despite that, the roof did not cave in on its financial system and the need for it to exit the eurozone did not come up once in the European debate. Could it be that the last few days have given us undeniable proof that Greece can default and remain in the euro?"

 "Athens University economics professor Yiannis Varoufakis is one of the experts who argue that it is up to the ECB whether Greece can default on its debt but not need to return to the drachma. “All that it would take to allow Greece to stay in the eurozone, in a better state than it is today (and less austerity for that matter), is the continuation of the present ECB policy toward Greek banks,” he wrote in a blog post last month. “As for those who argue that the ECB will take an aggressive stance, think again: The ECB will not knowingly take steps which will destroy the eurozone.”"

If Greece did make this move it would effectively be initiating what Buiter has termed the "Euro as the new rouble zone". The Euro Group (or even the entire EU) would then be faced with the much more general problem of whether or not to expel the country, risking initiating a cascade effect of contagion of totally unknown dimesions.

In the longer term, given the ongoing economic depression, we will almost certainly see growing political destabilisation along the periphery, leading to a steady process of weakening in Europe's  democratic institutions. This is my greatest fear, and here Hungary seems to offer us an example of what might happen. Hungary it will be remembered was the first country to embark on austerity measures back in 2006, and these measures have still to yield the gains claimed for them in terms of economic growth.

The Euro was created as means of drawing Europe together politically, it would be a tremendous tragedy if instead it ended up tearing the continent apart and effectively destroying democracy in one country after another all along Europe's periphery. I repeat what I said in my letter of submission to wolfson,  the problems with what to do about  the Euro are not by-and-large legal and technical (how to reclassify debt), they are inevitably political and economic/theoretical. The issue has shifted from that of what to do to manage an orderly exit, to one of how does the rest of the world prepare itself for a disordely one. As Lord Wolfson himself said in his recent Telegraph article:
"What seems likely to happen is that, as their public finances deteriorate, one of these countries will again be unable to refinance its debts. At this point the tsunami hits and the danger of financial contagion may dictate an urgent re-think of the euro"...."If that moment comes, the world must be prepared – with an understanding of the challenges and a plan. We will need an economic fire drill that minimises the damage caused by the euro’s disintegration and gives Europe the best chance to return to prosperity".
 Lord Wolfson is a practical man, I am sure he will know how to appreciate the importance of the tasks and challenges that now face all of us. Those responsible for managing current Euro Area policy have the right to let the thing explode, but do they have the right to sweep the better part of the known financial world away with them in the Tsunami that will surely follow.

This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".