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Friday, May 25, 2012

The Need for More Monetary Expansion in the Eurozone

In the previous posts, we’ve talked about the costs and benefits of a Greek exit. This post will argue that if the eurozone is to continue, more aggressive policies by the the European Central Bank (ECB) are desperately needed.

Germanys Recession and Recovery in the Early 2000s 

Even if Greece exits the euro and the ensuing financial contagion is limited, the euro area still faces a lot of tricky problems. For the eurozone to survive, the ECB needs to stop its obsession with inflation and focus more on growth. Monetary expansion is needed to counteract the contractionary impact of fiscal austerity, though Germany seems unwilling to accept this fact.

As Paul Krugman argues, when Germany was in a recession in the early 2000s, its recovery was aided by a current account surplus against the peripheral countries that are in deep financial trouble now. In the early 2000s, Greece, Ireland and Spain enjoyed strong economic growth. The low interest rates set by the ECB were optimal for Germany but too low for these 3 countries.

On one hand, the low interest rates helped Germany recover. On the other hand, the low interest rates led to high inflation and even higher growth (to the point of overheating) in the PIIGS. In economic boom, the PIIGS bought more exports from Germany, adding an extra boost to Germany’s recovery. 

Expansionary Policies to Pull the PIIGS out of Recession 

Now the monetary policy is again optimal for Germany, but not expansionary enough for the PIIGS countries. Last time the PIIGS helped Germany return to growth, and now is the time for the reverse to happen. 

Under monetary expansion, Germany and the Netherlands will experience relatively high inflation. While this may be unpleasant internally, wages and prices in the South will be cheaper in relative terms as a result. This is exactly what Europe needs to solve its key problem – the large productivity gap between Germany and the troubled economies in the South. With cheaper, more attractive exports, the PIIGS can sell more to Germany and the rest of the world, getting out of recession.

Though deflation and wage cuts in the South can narrow the gap too, deflation is contractionary while wages are sticky in the short run. Hence, it’s much better to have inflation in the North instead of deflation in the South.

Indeed, the ECB should help narrow the productivity gap with more aggressive policies. Easing measures can restore cost competitiveness of the PIIGS, which is the first step to less unemployment and economic recovery. In turn, recovery will help governments control the public debt and achieve balanced budgets.

Liquidity Injection to Support Banks

Signs show that the ECB is moving in the right direction. The long-term refinancing operations (LTRO) in December and February injected liquidity in the markets by offering banks unlimited short-term loans at interest rates as low as 1%. Many commentators think of the LTRO as the European version of quantitative easing.

In addition to boosting the economy, injecting liquidity is also a measure to strengthen the firewall and prevent contagion. The ECB can inject liquidity by, for example, guaranteeing to buy unlimited amounts of sovereign bonds in the event of a Greek exit.

In this way, the ECB can ensure that banks won’t collapse because of sour sovereign debt. This is important because credit freezes if banks fail, which will result in a further economic slump in Europe and probably the rest of the world.

The real question is who should take the responsibility to bail out troubled banks, and the answer is the ECB is in a better position to do so than the euro countries. Government bailouts will add to the public debt and risk increasing borrowing costs for the state. Obviously, this isn’t helpful and will only aggravate the sovereign debt crisis.

(Entry 3 of 4 in the Update on the Euro Debt Crisis series) 

Tuesday, May 22, 2012

Grexit: Hard Choices and Inevitable Tradeoffs

Last time, we talked about why a Greek exit has become more likely and how policymakers are preparing for it. However, whether to exit or not won’t be an easy decision. A Grexit entails costs and risks, or else it’d have occurred a year ago. In this post, well discuss these costs and risks, first for Greece and then for other euro members. 

The Costs for Greece

Given that recent polls show about 80% of Greeks want to stay in the eurozone, it seems they’re aware of the costs, which are listed below.

(1) An exit destroys Greek savings. A Grexit means euro deposits in Greece will have to be redenominated in Greece’s new currency. Given Greeces high trade deficits and weak public finances, its new currency will be worth a lot less than the euro (with some estimates of a 60% depreciation). Such a depreciation will incur a huge loss for the Greeks.

(2) Contracts will have to be redenominated under the new exchange rate, which will result in a chaotic transition. Under a large, sudden depreciation, the cost of inventories and the loan burden to external creditors will shoot up. Many business will face bankruptcies.

(3) Though devaluation can restore competitiveness in the long run, rapid inflation makes lives difficult in the short run. Nevertheless, some commentators argue the economic contraction after default and devaluation, though severe, won’t last long. They often point to Iceland as an example. The country, which suffered from a credit crisis and a collapse of the financial sector back in 2008, is now on a steady path of recovery.

(4) Anticipation of an exit causes an outflow of Greek deposits to foreign countries. To protect their savings, Greek depositors prefer to save in a German bank (where savings will still be denominated in euro with purchasing power intact) rather than to save domestically (where savings will be redenominated and depreciate by a great deal). This is why Greeces deposits have fallen from $236 billion last December to $214 billion now. If the situation continues, banks will collapse and Greeces financial system will be wrecked.
The Costs for the Rest of Eurozone
A Greek exit will be tough for other euro members as well because of the following reasons.

(1) It may cause bank runs in other peripheral economies. Worried that their countries will ultimately follow the same path of Greece, Spaniards and Italians may take deposits out of domestic banks and put them in foreign banks. Again, this will severely damage the banking system of the respective countries, making the breakup of the euro area more likely.
(2) The risk of contagion is a serious threat to the European economy. Since many European banks have exposure to Greek debt, Greeces default and exit may spark a confidence crisis and cause a credit crunch. Though European finance ministers are working hard to build a firewall to deter the spread of contagion, and European banks have been offloading Greek assets in the past few months, these efforts may not be enough. The slump in stock markets around the world in the past two weeks suggests businesses and investors arent that confident in the effectiveness of the firewall.

(3) Grexit means the eurozone wasted lots of money to bail out Greece. In the last two months alone, the eurozone lent $140 billion to Greece in its bailout efforts. European leaders may not want to give up right after such large-scale bailout efforts, especially when Grexit means the rescue loans wont be paid back. However, one can argue that its time to stop the bailout and cut loss before its too late.

(P.S. Interestingly, some have proposed a conspiracy theory on why Germany doesn’t want Greece to exit. The fear is Greece’s exit will turn out to be a success and help the country return to growth. Observing Greece’s successful experiment, Spain, Portugal, and other distressed countries will want to follow suit and exit the euro. This will lead to the collapse of the euro.) 

Time to Make Hard Choices 

Given these costs, whether Greece stays in or leaves the euro isn’t an easy decision. However, after months of procrastination, Europe is finally at the critical stage where it must face inevitable tradeoffs and make hard choices. And a Greek exit is definitely an option to consider.

To me, Grexit is the only way out for Europe, because there is no way economies as diverse as Germany and Greece can stay in the same monetary union for long. It simply isnt sustainable. Greece cant restore competitiveness and will die a slow economic death if it remains in the euro. Other euro members cant prop up Greece and its financial sector forever, especially when Greece most likely wont be able to afford to pay back its loans. A Grexit is necessary despite its short-term pain, and what is important is to have an orderly exit and contain contagion to other countries.

(Entry 2 of 4 in the Update on the Euro Debt Crisis series) 

Sunday, May 20, 2012

A Potential Greek Exit from the Euro

This post, first in the series, will discuss the possibility of a Greek exit from the euro. Given the results of the Greek general election, an exit has become an increasingly likely outcome.
Greece’s Legislative Election 
Many Greeks are fed up with contractionary austerity measures imposed by eurozone leaders. Thats why, in the election on May 6, many voters turned to support the Coalition of the Radical Left (known as the Syriza party). The Syriza party, which opposes austerity, tells voters that Greece can stay in the euro even if they reject the bailout package. This strategy won the Syriza party a lot of support and a lot more seats compared to the last election. On the other hand, the PASOK, a pro-bailout party which was previously the largest party in the Parliament, suffered a heavy defeat

But the May election didnt produce a clear winner. After failed attempts to form a coalition government, Greece is heading to a second-round election on June 17. Polls show that pro-bailout parties is likely to lose the election again in June.
Potential Exit from the Euro

Following the election results, a Greek exit (or Grexit, as some now call) has become a lot more likely. If the anti-austerity parties win the second-round election and they reject the bailout package, Greece will probably be kicked out of the eurozone. Even if the Syriza party doesnt win and the election results in another stalemate, Greece wont be able to put together a coalition in time. The terms of the bailout package will surely be breached, and a Greek exit will still be likely.

Despite what the Syriza party says, talks of forgiving Greek debt are fantasy. The party is only making promises they cant deliver in order to win votes. Debt forgiveness will send a perverse message to Spain, Ireland and Portugal that the eurozone rewards defiance by writing off a countrys debt. To ensure these countries will comply with the austerity programs previously agreed upon, Germany and other euro members won’t allow the moral hazard of forgiving Greek debt.

But maybe an exit is in Greeces interest. A commentary on Der Spiegel, a German news magazine, persuasively argues that leaving the euro is the only effective way for Greece to regain competitiveness in the long term. The article points out that default can help reduce Greece’s debt burden, while devaluation can restore cost competitiveness and boost net exports. The eurozone benefits as well since it doesn’t need to spend more money on Greece’s bailout.

Preparation for the Grexit

Greece is a small economy (in terms of GDP) in the euro area. Grexit doesn’t have to be catastrophic as long as the aftermath doesn’t spread to bigger economies. The policymakers are starting to manage expectations and prepare financial markets for a potential Greek exit.

Christine Lagarde, Managing Director of the International Monetary Fund, told the press that the IMF must be “technically prepared for anything.” In the past few months, Europe’s economic and regulatory institutions have been building firewalls and recapitalizing banks. They hope this can prevent contagion to Spain and Italy if Greece exits the euro.

(Entry 1 of 4 in the Update on the Euro Debt Crisis series) 

Friday, May 18, 2012

Update on the Euro Debt Crisis

In view of the new developments in the past 2 weeks, I’d like to update on the eurozone debt crisis.

This 4-part series will first discuss the benefits and the costs of a Greek exit from the euro. Then it’ll argue why the eurozone needs more aggressive monetary expansion if it’s to survive. 
Finally, this series will discuss the future of the euro area. If the euro countries lack a commitment to closer European integration, then the exit of some countries or even a breakup of the eurozone is probably the best outcome in the long run.

Part 1  A Potential Greek Exit from the Euro
Part 2  Grexit: Hard Choices and Inevitable Tradeoffs
Part 3  The Need for More Monetary Expansion in the Eurozone
Part 4  The Future of the Euro Area: Falling Apart or Growing Closer?
Hopefully, these posts will shed some light on how the crisis will unfold in the coming weeks and months. Thank you and please feel free to leave a comment.