Baking Banking Instability into the European Cake

Apologies for the long absence. The past few weeks have been extraordinarily busy on several fronts. I think I'll be able to get this place back into fighting shape pretty quickly.

The decision of S&P to downgrade more or less the whole of Europe has made a lot of headlines, but I'm not sure how much it matters. The plan for Europe before that happened isn't much affected by the downgrade: the ECB prints money and gives it to the banks, accepting EMU sovereign debt as collateral. The banks use the funds to buy sovereign debt. The banks get financing for sure, and if all goes well so do the governments. As far as I can tell, for regulatory purposes all OECD sovereign debt still counts as "risk-less" -- meaning that banks are not forced to hold any capital against it -- under the Basel accords, so there is a regulatory incentive for banks to buy some of this stuff.

There's something absurd about all of this... every step in the chain is an attempt to hear no evil by sticking fingers in one's ear. But if the eurozone is going to survive the European banking system has to stand upright and be able to finance governments. That requires ECB support.

JP MorganChase CEO Jamie Dimon, who often says things in public that are more revealing than he perhaps realizes, recently claimed to believe that there is no banking problem in Europe:

“It eliminates bank liquidity or funding problems for at least the next year, that’s a pretty powerful statement,” Dimon said today after his company reported a drop in fourth-quarter net income. “That was the biggest single risk of an uncontrollable surprise right there, so if that’s taken off the table, that’s a good thing.” ... 

“Europe is trying mightily to solve its problems. I still think the likely outcome is they will muddle through,” Dimon said. “The longer you wait, the higher you run the risk of something disorderly that you can’t really control. I think the ECB took off the worst outcome, i.e. a bank failure.”

Dimon might be right about Europe being able to muddle through, although I still have my doubts. He might even be right that a bank failure is the "worst outcome" in Europe, although I can think of some worse outcomes. But what he doesn't say, indeed what no one has much talked about, are the negative effects this will likely have in the European banking sector if the plan works.

The problem that the new ECB policy is supposed to resolve is this: banks won't lend to needy European governments except at punitive rates. Why? Because those governments are highly likely to default. This is exactly what we want a responsible, healthy banking sector to do.* What we don't want is what we're now hoping to get, which is to say that we don't want a banking sector whose investment behavior is skewed by political institutions pursuing dubious policy goals. We don't want a banking sector that has an expectation of future support if their investments go bad, and we don't want a banking sector that cannot discipline either itself or those to whom it lends.**

We don't, in short, want a situation in which government interventions make Jamie Dimon smile. (Or interventions that make him rich.)

Is this road less bad than the one Europe was on previously? In short run, surely. In the medium-to-long run it's hard to say. Perhaps we think that once the crisis is resolved the ECB can make a credible future commitment to be more standoffish towards the European banking sector. Perhaps we think that we can rein in banks and national governments in other ways, via strict capital standards for the banks and "Hard Keynesianism" for the governments. But I have little confidence that those things are likely. They cut against almost every identifiable political current.

The only way it works is if this crisis really scares everybody so much that a significant (and durable) shift is made in the regulatory and fiscal infrastructure of Europe. While not impossible, I remain highly skeptical that that will happen. I believe it's more likely that policymakers will conclude that the institutions in place are pretty resilient already -- "How else could we have pulled through this crisis?" -- particularly when coupled with a more activist ECB that will support the banking sector when needed.  I believe the banks will conclude that the ECB is their friend, and will therefore count on support when needed, particularly if the cause of the trouble are the member nations of the EMU. That is a recipe for a lot of future financial instability.

The ECB cannot, and should not, be in the business of resolving Europe's political problems. Forcing it into that role is likely to make things worse in the long run.

*The "we" here being an imagined societal consensus in possession of the general will, which reflects more-or-less center-left neoliberal technocratic principles. Yes, I know this "we" does not exist in nature.

**I have a paper, currently R&R, that argues that when banks expect preferential policies from governments they act less prudently. Simple argument, I know, but it's not in the literature yet. I find statistical support. I'll post it if/when it gets accepted somewhere; if someone wants it sooner e-mail me.

There Is No Technocracy QOTD

Felix Salmon nails it in a post titled "All bank regulators are captured":

The fact of the matter, however, is that all regulators are captured by banks. Or, to be a little more precise, all legislatures are captured by banks, and all regulators do what the government tells them to do. 

In countries like Canada and India, there’s a very small number of strong, well-capitalized banks with a vested interest in maximizing barriers to entry. So they’re happy with very tough standards. In Europe, national banking systems are also concentrated, so in theory they could go the same way. But European banks are more likely to have cross-border and global ambitions, and in any case as a matter of contingent fact they’re not very well capitalized. So they get the regulation they want — which allows them to grow fast without having to raise lots of expensive new equity capital.

And then there’s the US, which is pretty much unique among major economies in having thousands of pretty vibrant small banks. Those small banks have a lot of political clout in Congress, and they hated Basel II, because they’re not nearly sophisticated enough to take advantage of it. So they essentially bullied Congress into keeping the old Basel I standards, for fear that otherwise they would be at a massive competitive disadvantage with respect to the big US banks like JP Morgan Chase. Congress obliged, and used the FDIC as its chosen mechanism for blocking the adoption of Basel II in the US.  

Does that make the FDIC particularly virtuous? No: it makes the FDIC just as beholden to the banks as any European regulator. Look at the banks’ contributions to the FDIC insurance fund, for instance: they fell to zero, for no good reason, just because the banks didn’t like making those payments.

Cross-national differences in regulations are not due to one country's regulators being somehow wiser than the rest. It has to do with different organizations of domestic interests within (and across) countries. These lead to different policy outcomes.

Paul Krugman does not in a post titled "Crats, Maybe, But Not Much Techno":

But it’s more than that: these alleged technocrats have in fact systematically ignored both textbook macroeconomics and the lessons of history in favor of fantasies. The European Central Bank has placed its faith in the confidence fairy, while imagining that it can run policy in a way that has never worked in several centuries of central bank experience. Meanwhile, the European policy elite has simply wished away the clear evidence that the euro zone needs to make an adjustment that is virtually impossible unless inflation targets are raised.

The point is that I know technocrats, and these people aren’t — they’re faith healers who are making stuff up to suit their prejudices.

I contend that Paul Krugman does not know technocrats. He knows people who have different priorities than those he dislikes in the government and punditocracy. He claims that his side are the true technocrats -- untainted by avarice or bias -- because that gives them a moral authority that they would not otherwise have. But Krugman's preferred "technocrats" are just those who prioritize labor over capital, to use a short-hand, while those he decries have the opposite preference. As Salmon notes, capital generally wins, but in varying ways that reflect their varying preferences in disparate places.

"Textbook macroeconomics" presupposes a political system that is dedicated to the pursuit of utilitarian aims, a "socially optimal" mix of outcomes. But there is no universally agreed upon social optimum. There are only different, competing interest groups with different, competing preferences. Rousseau was wrong about this. There is no General Will, only the Sum of Private Wills. Some interests are narrower than others, as OWS has figured out, but that's really the only difference.

Craziest Thing I Read Today

Matt Yglesias, who usually is not crazy:

Ben Bernanke isn’t the most important central banker in the world. Jean-Claude Trichet is. 

That's... crazy. Europe is certainly important, but the dollar is still the world's reserve currency, and Bernanke manages it. Plus, the Fed is responsible for overseeing the US financial system, which is central to the global financial system in a way no European countries are, separately or taken together. Additionally, the ECB isn't (technically, legally) supposed to have all that much to do with the European financial system; regulatory authority still resides with national governments. Trichet faces constraints that Bernanke doesn't face, which limits his influence, but even if that weren't true he'd be less important.

To illustrate: During the crisis, the Fed routinely provided liquidity support for foreign firms, most of which were in Europe. Has the ECB done anything similar for US firms? During the crisis the Fed opened up swap lines with every major central bank in the world. Did the ECB do anything similar? Not outside of the eurozone, as far as I can tell.

(Side note: Yglesias notes that the EU is a larger economy than the US. Which is true. But Trichet only controls monetary policy in the eurozone, not the entire EU, and eurozone GDP is roughly 75% of US GDP.)

Who Gets Optimized?

Ryan Avent reports on some research from the SanFran Fed that includes the above figure:

[I]t's clear what was going on; the ECB stood idly by while the periphery overheated because it was making policy with an eye toward the core nations. Now that the peripheral booms over which the ECB presided have collapsed, the central bank is...continuing to pursue a policy that's most appropriate for the core economies.

Now perhaps the ECB thinks it isn't responsible for managing divergent economic cycles within the euro zone. Indeed, the ECB may well be trying to force core nations to take on this responsibility and move toward closer fiscal union. If the ECB is unsuccessful in winning such progress from core governments, however, we shouldn't be surprised if peripheral economies find euro-zone policy intolerable and—eventually—drop out of the system entirely.

For those in the dark, the Taylor Rule is one simple device for determining what monetary policy should be. Krugman makes the appropriate caveat:

So here’s the thing: if you use the output gap Taylor rule that, for the US, corresponds to the unemployment version of the rule used in the SF Fed letter, it surely implies a negative interest rate. In short, the ECB has no business raising rates.

What is true, however, is that the rule might still point to a rate rise for Germany.

So the point is that while the ECB could suffer from a one-size-fits-all problem, the fact is that it isn’t even doing that; it’s tightening when only Germany even arguably needs it.

The deal underlying the foundation of the Euro was that peripheral countries would get a reduction in currency risk and therefore lowered borrowing costs. They would also get access to Europe's biggest markets at a fixed exchange rate. In exchange, they would lose monetary policy autonomy. That worked as long as their economies were growing, but obviously creates problems when the economy contracts. This is classic trilemma politics: fixed exchange rates are fine while there's growth, but monetary policy autonomy becomes more pressing during contractions. It's a lot like the Asian crises in the late 1990s.

Meanwhile, I see that Trichet is defending the eurozone by saying that the US is not an optimal currency area either. This gets said a lot, certainly more often than any definition of which currency area is "optimal" or even what that means, and there is certainly some truth to it. But my definition of what size zone is "optimal" would be something like: "As large as is politically feasible, as long as there is a fiscal adjustment mechanism included". In other words, I don't think size of area is the real problem. It's about the political organization of the area, and what other institutions come along with the currency.

The Politics of Stealth Bailouts and Plausible Deniability in the Eurozone

My post yesterday on how the German banking sector can likely withstand a restructuring of Greek debt touched on, but did not dwell on, another important aspect of the Euro crisis: it's not just the banks in the Eurocore that own debt in the periphery, but also the governments. I wrote "The taxpayers have already loaned Greece a lot of money, either directly or via the ECB" and quoted a Der Spiegel report that said:

Taxpayers might need to step in, as might the savings banks that are owned by municipalities.

In addition, the European Central Bank (ECB) has bought up tens of billions of euros of Greek sovereign bonds. Because the Bundesbank, Germany's central bank, holds more than a quarter of the ECB's capital, it would have to take its share of losses accordingly.

This latter point is the subject of this Martin Wolf column that has made the rounds of the blogosphere (Salmon, McArdle, Krugman) and yielded the above graphs. Wolf's column is provocative -- he begins with "The eurozone, as designed, has failed." -- but makes a very important point about the centrality of the European banking system to the broader regional economy:

The role of banks is central. Almost all of the money in a contemporary economy consists of the liabilities of financial institutions. In the eurozone, for example, currency in circulation is just 9 per cent of broad money (M3). If this is a true currency union, a deposit in any eurozone bank must be the equivalent of a deposit in any other bank. But what happens if the banks in a given country are on the verge of collapse? The answer is that this presumption of equal value no longer holds. A euro in a Greek bank is today no longer the same as a euro in a German bank. In this situation, there is not only the risk of a run on a bank but also the risk of a run on a national banking system. This is, of course, what the federal government has prevented in the US.

The ECB doesn't technically have legal authority as a lender of last resort (although it's taken on part of that function since 2007), so domestic central banks as well as the US Federal Reserve have had to fill that role. The upshot? Central banks in the Eurocore, such as the German Bundesbank, are now heavily exposed to debt from the periphery. At current rates of lending they're likely to run out of cash by 2013, and unlike the US Fed, they can't just print more. This is becoming a slow-moving liquidity crisis, in other words, and as London Banker wrote a few days ago, liquidity crises (such as occurred in the Fall of 2008) are really nasty. As Wolf notes, this is serious business:

Government insolvencies would now also threaten the solvency of debtor country central banks. This would then impose large losses on creditor country central banks, which national taxpayers would have to make good. This would be a fiscal transfer by the back door.

In a sense this is already a fiscal transfer, since debtor countries are spending the funds on financing the state, and the creditor central banks don't have a printing press. So why, given that a fiscal transfer was needed, was it done in a way that risks the solvency and credibility of Eurocore central banks? Because they are unelected. Such a large transfer plan on top of the EFSF is unlikely to have been approved by voters in the Eurocore, as my post from yesterday indicates. And as Hans-Warner Sinn notes (via Henry Farrell's Twitter), the size of these hidden transfers "dwarfs the parliament-approved bailouts extended to Greece, Ireland and Portugal." It's easy to see why European leaders would opt for a bailout mechanism that was less transparent, and that involved non-elected actors pulling the strings: it allows bailout financing to continue, but with plausible deniability.

Sinn draws an analogy between the situation in the Europeriphery and Britain in 1992, when Soros sank the pound by selling it off. Eventually, the British Treasury ran out of marks and francs to exchange for pounds, and was forced to devalue. Soon, writes Sinn, there won't be enough funds in Bundesbank to cover the borrowing in the periphery. At that point, the Euro will collapse like the pound. If Sinn is right, then the Euro has two years. I've been saying for awhile now that 2013 was key to the Euro's future. 2013 is officially when haircuts begin, and when new bailout lending ends. It's also when the "stealth bailout", through the central banking system in the EU, can no longer sustain itself. At that point, either the peripheral economies have righted the ship by balancing the budget and/or regaining access to private credit markets, or they exit the Euro.

So right now it's a waiting game. The Eurocore doesn't want a restructuring, which would cost taxpayers (and banks) billions, if it can avoid it. The Europeriphery doesn't want the economic collapse that would accompany a Euro-exit. But both of them want the other to pick up more of the tab. But there's not much more the periphery can pick up, with unemployment above 11% in Portugal, 14% in each of Greece and Ireland, and 20% in Spain. And there's not much more the core can pick up without risky the solvency of their domestic central banks. More direct fiscal funding mechanisms look to be politically impossible. Maybe one of those things changes by 2013, but I wouldn't bet on it.

Euro Developments

First, the ECB is quarreling with Berlin:

The cold war between Berlin and Frankfurt reached a new high last week. Should Germany implement its plans, the ECB would have to cut off funding for Greece, the monetary watchdogs warned. The consequences for Europe's banks and the Greek economy would be devastating.

The mere suggestion of what the Financial Times called the " central bank equivalent of nuclear deterrence" was enough to prompt German Finance Minister Wolfgang Schäuble to withdraw the German proposal immediately. A debt restructuring, Schäuble admitted sheepishly, could lead to a repeat of the events triggered by the bankruptcy of Lehman Brothers in September 2008.

In addition to revealing how serious the euro's problems are, the slugfest proves how much of its reputation the Frankfurt-based ECB has lost in the euro zone's strongest economy.

In the past, the central bank was seen as the undisputed economic authority in Germany. Anyone who opposed the monetary policy experts was quickly marginalized. Today, however, the central bank must threaten with the most drastic of measures just to force the German government to toe the line. A majority of German economic politicians and economists see the ECB's crisis strategy as unrealistic and contradictory.

But would a Greek restructuring really be so devastating for Germany? It would have some costs, but at this point these would be manageable:

A debt reduction -- known as a "haircut" -- of as much as 50 percent would be an expensive proposition for Greece's creditors. With around €330 billion ($467 billion) in loans, that would mean cutting as much as €165 billion. Most of Greece's debt is with foreign creditors, and so foreign banks and governments would have to take massive hits over the loans Athens is unable to repay in full.

But what would this mean in reality for Germany? ...

The answer to all of these questions is reassuring -- at least at first glance. The consequences of a debt write-off against the government in Athens would be manageable for Germany. At the moment, some €25 billion in Greek debt is held by Germany's commercial banks and the so-called "bad banks" set up to take on toxic assets. This debt takes the form of either Greek sovereign bonds in their portfolios or loans made to the Greek government. ...

With a 50-percent haircut, the two bad [government-backed] banks would lose around €4.4 billion in total. Taxpayers would end up indirectly footing the bill. ...

Of mild comfort is the fact that the state would probably not have to come to the rescue of any private institutions. Commerzbank, Deutsche Bank and the DZ Bank, which acts as the central bank for Germany's roughly 1,200 partly state-owned co-operative banks, are (once again) in a position to be able to cope with possible shortfalls by themselves.

But that's just the banks. The taxpayers have already loaned Greece a lot of money, either directly or via the ECB:

But the situation looks different for the German government and the federal states. At the very least, the large exposure of KfW and the bad banks of Hypo Real Estate and WestLB could end up being expensive. Taxpayers might need to step in, as might the savings banks that are owned by municipalities.

In addition, the European Central Bank (ECB) has bought up tens of billions of euros of Greek sovereign bonds. Because the Bundesbank, Germany's central bank, holds more than a quarter of the ECB's capital, it would have to take its share of losses accordingly.

However the Irish and Portuguese banking sectors are still exposed to Greece, and are much weaker than Germany's banking sector. Still, the fact that the Germany financial system has largely healed since 2008, and has already taken many steps to lessen their exposure to Greece, gives Germany a lot of negotiating leverage in the EU. And, as EU Monetary Affairs Commissioner Ollie Rehn says, political will for continued aid is running low in northern Europe.

In Brussels, we Finns are referred to as "English-speaking Germans," because we pursue the same economic policy principles: stability, sustainable growth and fiscal responsibility. The Germans aren't the only ones who are concerned. There is a certain aid fatigue in all of northern Europe. And we are experiencing a certain reform fatigue in southern Europe. As monetary commissioner, I feel this schizophrenia every day. We must try to build a bridge between these two camps.

Put it all together? Time is running out for Greece.

ECB Fact of the Day

Remember when I said that, by ignoring its legal mandate to not be the lender of last resort, the ECB was the only thing holding the EMU together? Here's what I meant:

As the scope of the Irish losses has grown clearer, private investors have been less and less willing to leave even overnight deposits in Irish banks and are completely uninterested in buying longer-term bonds. The European Central Bank has quietly filled the void: one of the most closely watched numbers in Europe has been the amount the E.C.B. has loaned to the Irish banks. In late 2007, when the markets were still suspending disbelief, the banks borrowed 6.5 billion euros. By December of 2008 the number had jumped to 45 billion. As Burton spoke to me, the number was still rising from a new high of 86 billion. That is, the Irish banks have borrowed 86 billion euros from the European Central Bank to repay private creditors. In September 2010 the last big chunk of money the Irish banks owed the bondholders, 26 billion euros, came due. Once the bondholders were paid off in full, a window of opportunity for the Irish government closed. A default of the banks now would be a default not to private investors but a bill presented directly to European governments. This, by the way, is why there are so many important-looking foreigners in Dublin, dining alone at night. They’re here to make sure someone gets his money back.

To put that into perspective, 86bn euros is roughly 112bn dollars. Irish GDP is about $230bn, so they've borrowed 50% of GDP from the ECB. Without those funds, they'd have to default and (probably) leave the EMU.

That's from Michael Lewis' story on Ireland. I wonder where he's booked his next ticket? Portugal?

UPDATE: Okay, I just finished Lewis' piece. This part stood out:

Ian turns out to have a good feel for what I, or anyone else, might find interesting in rural Ireland. He will say, for example, “Over there, that’s a pretty typical fairy ring,” and then explain, interestingly, that these circles of stones or mushrooms that occur in Irish fields are believed by local farmers to house mythical creatures. “Irish people actually believe in fairies?,” I ask, straining but failing to catch a glimpse of the typical fairy ring to which Ian has just pointed. “I mean, if you walked right up and asked him to his face, ‘Do you believe in fairies?’ most guys will deny it,” he replies. “But if you ask him to dig out the fairy ring on his property, he won’t do it. To my way of thinking, that’s believing.” And it is. It’s a tactical belief, a belief that exists because the upside to disbelief is too small, like the former Irish belief that Irish land prices would rise forever.

Apparently Lewis has a thing for mystical creatures, because that immediately reminded me of his story about the Icelandic belief in elves that lived underground, from his Iceland article (now gated, unfortunately). Among other facts and descriptions in the Iceland piece, the elves story was widely disputed; perhaps the fairies will be too. I don't remember anything from the Greece article, but I may go back and check.

Euro Economics: Only Half the Story

I found Krugman's NYTimes mag article on the economics of the eurozone to be solid. Of course at this point the economics are well-understood by informed observers. What's not is the politics of the eurozone. And on that point Krugman is no help, as evidenced by his closing:

So will Europe’s strong nations let that happen? Or will they accept the responsibility, and possibly the cost, of being their neighbors’ keepers? The whole world is waiting for the answer.

Well, we've been writing about that a lot over the past year or so. So far it seems clear that the strong nations in the EMU (especially Germany) are not prepared to be their neighbors' keepers. They are not ready to ditch the common currency either. So they've taken (perhaps) the worst option: forced austerity for the periphery in exchange for temporary solvency, in order to give the banks in the core time to get their books in order. That, and allow the ECB to take a more active role than they are (technically) legally allowed.

As of today, I think the ball is actually in the peripheral countries' court. If they do a "full Argentina", as Krugman calls it, or even a milder debt restructuring, it will force Frankfurt's hand. If they are willing to stick it out and go through crushing austerity -- the Baltic option -- then the eurozone will survive on something like its present course. I wouldn't put any money on the latter happening in Greece or Spain, although it could work in Ireland.

The point is that, at this point, the economics is merely the backdrop for the politics.

Has the ECB's Independence Gone Up or Down?

The question in the title refers to the fact that central bank independence usually refers to the isolation from the political process that a central bank has in setting policy. Traditionally, the ECB has been considered to have a lot of independence. But it has also had a very narrow, strict mandate: to promote price stability in the eurozone. It did not have a mandate to promote full employment. It did not regulate the European banking system. It was not a lender of last resort. So the ECB's freedom to pursue the goal of price stability was very high, but pre-crisis its freedom to pursue other goals was very low. Depends on what you mean by independence.

That's all changed over the past few years. The Financial Times' stupid, self-hurting TOS prevent cutting, which means (among other things) that I've been linking to them a lot less frequently than I used to, but this article is worth highlighting. Who would have thought in 2006 that the ECB would be intervening in bond markets to prop up Portugal's debt auction? Portugal says it does not need a bailout, but this is a bailout. It's just a monetary bailout rather than a fiscal bailout. The ECB intervened so the auction wouldn't fail.

At this point the ECB looks like the main thing holding EMU together. And it's able to do it because, unlike national governments, it doesn't have to face an election following a fiscal transfer to the PIGS. It can just intervene when necessary, serving as the "lender of last resort" that it claims not to be. In other words, its scope of authority has been greatly expanded since the crisis began, without (as far as I know) any new statutory authority being given to it.

The ECB is still not pursuing employment-boosting monetary policies, but by buying the debt of needy countries it is in effect subsidizing fiscal policies that could boost employment. The alternative is austerity, either self-imposed or demanded by the EFSF/IMF, which involves major internal contraction. And while the ECB is not regulating banking sectors, it is doing whatever it can to prevent a banking collapse, especially in Spain. If the ECB hadn't overstepped its official mandate back in 2007-8, there is little question that the entire European banking sector would have melted down by now.

So the ECB is now acting more like that Fed than it had pre-crisis. I would consider that an increase in the ECB's independence, because it can act in more ways to promote the economic well-being on Europe. The difference is that the Fed has a political mandate to act the way it does. The ECB does not. By intervening in bond (and other) markets, the ECB is essentially spreading the credit risk of the eurozone's riskiest governments across the entire union. If this were properly understood in Frankfurt it would be deeply unpopular. Perhaps it is; my thumb isn't enough on the pulse of Euro domestic politics to know.

There are political battles on the horizon in the eurozone. It will be interesting to see the fate of the ECB in the coming years. My guess is that Europe's leaders will see that a stronger, more flexible ECB would make fiscal union less necessary; given that, I expect the ECB to retain its new-found authority, and perhaps get some more. We'll have to see.

The European Crisis Is About European Politics

Wow. Paul Krugman almost had a Eureka! moment:

A number of commenters have pointed out that unemployment has been falling in Germany over the past few months. Um, yes — but not in the eurozone as a whole. And that is what we’re talking about here, aren’t we? Or is European monetary and fiscal policy to be run solely based on how things are going in one country?

Um, that is exactly what we're talking about here, Professor, where "that" refers to "Who controls monetary and fiscal policy in Europe". That's what all of this is about. Up until now, monetary policy was controlled by one country -- Germany -- and fiscal policy was supposed be to restricted by the Maastricht criteria. But since the Euro isn't an optimal currency area and poorer countries in southern Europe didn't control monetary policy, they had to use rely more on fiscal policy to satisfy domestic demands, which left them all in debt and effectively broke Maastricht. This is what all of this is about.

Somehow Krugman still misses it, tho:

The point is that what amounts to a regional development within an ailing European economy doesn’t signify much.

It does when that region is the one that controls monetary policy for the rest of the Europe.

Does Krugman really not know what this is about? What has he been talking about for the past few months?

Saving the EMU or Postponing the Inevitable?

It has been fashionable over the past few years to examine historical events looking for parallels to the current financial crisis. For obvious reasons the most cited periods have been the 1930s in the U.S. and the 1990s in Japan. (I've pushed back a bit on relying too much on historical narratives here.) But if I were a member of the ECB, or any other policymaker responsible for maintaining the EMU, I'd be begging Sebastian Mallaby's publisher for an advance copy of his new book, More Money Than God: Hedge Funds and the Making of a New Elite. The Atlantic has an excerpt, describing how George Soros and others brought down the British pound in 1992 and ruined any chances of the U.K. joining the Euro. Here's how it went down:

Schlesinger had made it obvious that the Bundesbank was not going to help the pound cling onto its position inside the exchange-rate mechanism by cutting German interest rates. The devaluation of sterling was now all but inevitable.

True to form, European leaders have been hesitant to do much to prevent similar devaluations in the eurozone during this crisis. Interest rate cuts at the ECB have mostly been small and late, and the $1tn bailout fund is only enough to buy time for European banks to repair their damage sheets in advance of a default in Greece (and probably elsewhere). Now we see that Germany is planning austerity measures at home, which will make it far less likely to subsidize other EMU members, while concerns about the debt of Spain, Italy, and even France are steadily mounting.

There is a tipping point, and while we may not be there yet we are getting closer to it every day. When markets become convinced that a devaluation is inevitable they "go for the jugular", to use Soros' language, and it becomes a self-fulfilling prophecy. That happened in 1992, but U.K. officials weren't very quick on the uptake; they cost their citizens hundreds of billions by postponing necessary actions. The same thing may be happening right now. As Mallaby concludes in that excerpt:

The markets had won, and the government had at last recognized it.

In terms of recognizing the inevitable, the sooner the better. But has that lesson been learnt?

UPDATE: Tyler Cowen says things are coming to a head in Spain.

ECB on Wire

Felix Salmon is worried about the eurozone:

Will Greece be giving up fiscal independence in return for bailout funds or German guarantees? I’m sure it’ll agree to stringent conditions, while claiming that it would have kept to such a plan in any case. The question is what happens when — inevitably — it ends up breaking its fiscal promises, or trying to play silly games to get around them. What will Germany be able to do, in that case, to snap Greece back into line? And do the Germans really want to play the role of Europe’s fiscal disciplinarian in any event?

It probably doesn’t matter: Greece is the Bear Stearns of Europe, seemingly too big to be allowed to falter or default, and therefore it must be bailed out somehow. Of course this sets an important precedent for when Spain and/or Italy find themselves in a similar situation — and it’s likely to make countries like Latvia feel a bit miffed, seeing how much fiscal pain they’ve inflicted on themselves with no bailout to show for it at all. The hazard here is that countries, seeing the Greek precedent, refuse to take tough fiscal steps unless the path is sweetened by Germany and France. This isn’t the end of the euro crisis: it’s only the beginning.

That is one hazard. But there is an opposite hazard as well: one of the primary selling points for eurozone members is that their interests will be well-served by a credible, independent central bank. The past two years, however, have illustrated the downsides of a monetary union that is committed to low inflation above all else. Some states in the eurozone clearly need monetary expansionism and currency depreciation to get their economies back on track, but those policy tools have been removed from them.

If the major states (Germany and France) in the monetary union insist on maintaining the policies that benefit them even if they harm other members, but then also refuse to fulfill the "lender of last resort" obligation of a regional monetary hegemon, then the credibility of the union is called into question. And if the major European states keep pawning off their troubled states onto the IMF, they risk drawing the ire of the U.S., Japan, and other major contributors to the IMF. What would Frankfurt say if the U.S. took IMF funds to bail out California?

So Germany and France must simultaneously reassure member states that they will be well-served by the union when they need it the most, without writing a blank check that could encourage moral hazard. It's a very fine line that the ECB hasn't had to walk before; we'll see in the coming year how good their tightrope act is.

Is Greece Too Big to Fail?

We've talked about the dire situation in Greece here before, and now the situation has come to a head: Greece has chosen austerity, much to pleasure of EU officials and displeasure of Greeks, who begun massive strikes. Whenever I hear about a macroeconomic development in the EU, I turn to the indispensable A Fistful of Euros for comment. Edward Hugh doesn't disappoint:

[Public statements from EU officials] have been widely interpreted in the international press as a “no” from Germany and France to any EU bailout of Greece. But is this interpretation justified? Before going further, I think it should be pointed out that the whole argument depends on what you consider a bailout to be. If you take the view that a bailout involves a restructuring of Greek Sovereign Debt, with the EU itself offering to pay a part, then this is clearly not on the cards, at least at this point, and let’s take things a day at a time. But if you consider the “bailout” which is under consideration at the present time to be simply a loan, which in some way shape or form (yet to be determined) would be guaranteed by the EU institutionally, and would thus be available at a cheaper rate of interest than the one the markets are currently charging, then it is hard to see how British or German taxpayers would be having to finance anything, except in the unikely event that Greece were unable to repay.

In other words, the EU is now facing a situation with the sovereign debt of its member states somewhat similar to what the US Treasury and Fed faced with American banks in late 2008: they don't want to fully bail them out and thus exacerbate the moral hazard already in the system, but they also don't want to let them fail and spread contagion throughout the system. Like the US banking "bailouts", there is reason to think that both fates can be avoided by extending credit at attractive rates to cover a short-term liquidity crunch, and that this can be done at limited taxpayer cost (or even potential profit).

But unlike the US Treasury and Fed, the EU seems to be holding out for its pound of flesh: austerity measures, or no funding. Normally this is the purview of the IMF, and that organization is waiting in the wings:

“The IMF stands ready to support Greece in any way we can,” Mr Lipsky said. “It is a matter for the Greek authorities to decide, in collaboration with the European Union, but we are here to help if we are wanted.”

But the ECB seems to want to keep this in-house, perhaps in an attempt to shore up the credibility of the union and forestall the possibility of contagion: if Greece can't get its house in order, then other troubled eurozone economies like the other PIGS (Portugal, Italy, Greece, Spain, to which we can maybe add Ireland) may find their costs of borrowing rise, making it more difficult to service their debts. The ECB is quite rightly concerned about the integrity of the union. The Greek debt crisis may have far-reaching ramifications for European politics.

Who Adjusts?

Now that things have slowed down a bit, regular posting should resume. There's been a lot going on in the past few weeks, but I'm going to let most of it pass since I'm late to the party.

In a recent e-mail, Dr. Oatley mentioned that he thought that my regular postings on financial regulation were somewhat missing the point: the real blame for the economic crisis lies with the large external imbalances that have been building over the past decade. Even though I think that regulatory regimes are interesting and important, I think Dr. Oatley is exactly right to emphasize macroeconomic factors. So I was interested to read ECB Executive Board member Lorenzo Bini Smaghi's recent take on the same topic:

A strengthening of the IMF was agreed after the Asian crisis in the 1990’s, and the G-7 summit in Cologne in 1999 mandated the Fund to play a strong surveillance role to ensure greater transparency and encourage early adjustment by countries with unsustainable balance-of-payments positions.

But, over the last decade, the expectations raised by this mandate have not been met. Some emerging economies did not let their currencies float but, instead, continued to peg them at undervalued exchange rates in order to promote their exports and build up reserves as a form of insurance in case of crisis.

Moreover, the IMF has not succeeded in convincing countries to pursue macroeconomic policies consistent with sustainable current-account positions. Nor have advanced economies, particularly the United States, taken IMF advice fully into consideration. The accumulation of large surpluses, especially in emerging Asian economies and oil-exporting countries, enabled the US to finance its current-account deficit. It also lowered long-term interest rates in the US and made monetary conditions there more expansionary.

In the context of this testy exchange, "some emerging economies" can only mean China. And I suppose it's not surprising that an ECB official would deflect blame from EU countries despite the fact that Germany, for example, also ran large current account surpluses in the run-up to the crisis.

But is it right to criticize the IMF for not succeeding "in convincing countries to pursue macroeconomic policies consistent with sustainable current-account positions"? Not really. Until a crisis hits, the IMF is basically powerless. It can monitor behaviors and help boost transparency, but it has little formal authority to coerce states into allowing their currencies to float, say. How exactly is the IMF supposed to "convince" states to stop acting in their own self-interest? Smaghi doesn't provide an answer, but doesn't see much help coming from multilateralism, arguing that emerging economies that want a larger role in the IMF mostly want to weaken conditionality while increasing access to cheap credit.

Gee, it almost sounds like the global economy needs maintenance from a strong state. But Smaghi never proposes that Europe step into the breach. Actually, he never mentions Europe, or even a single European country, at all. Instead, the U.S. and China are somehow expected to voluntarily cede authority to the IMF while eschewing domestic political concerns to bring their current and capital accounts into balance. Well, color me skeptical.

Interestingly enough, the quickest, easiest feasible way to moderate imbalances is a higher peg for the yuan against the dollar. But this isn't necessarily something that Europe would like to see. So if the U.S. and China act more prudently, it may come at the expense of the Eurozone. What would Smaghi say then?

Role Reversal in Europe

This is a shocking sentence:

It has come to this: Germany will almost certainly have a bigger budget deficit next year than Italy will.

In fact, Italy isn't the only EU country showing more restraint than Germany:

“There is something really odd going on here, with Italy being more prudent, Spain getting more serious and even the French talking about pension cuts,” said Gilles Moëc of Deutsche Bank. “Germany is the odd one out.”

Of course inflation has traditionally been a more salient concern in Germany than budget deficits, and despite Frankfurt's influence in the ECB it will likely not be able to jigger the Euro to get out of budget problems. But with debt pressures mounting all over Europe, the coming months might put more pressure on the Euro and ECB than ever before.

To be continued...

Was I Wrong to Be Worried About Deflation?

Last fall Dr. Oatley told me not to freak out about deflation as price indices fell despite the fact the Fed had dropped interest rates practically to zero. Since that time the Fed has engaged in unprecedented "quantitative easing" policies while keeping interest rates near the zero bound. Thankfully these actions, along with the bailouts and stimulus policies of the Bush and Obama Treasury Departments, have kept the American economy out of a deflationary spiral. The most recent data show a core CPI inflation rate (excluding energy and food prices) in the black.

So was I overreacting? I don't think so. For one thing it was not clear back in November that the Fed would engage in quantitative easing, or that those actions would have much traction. It also was not yet clear how long the credit crisis would persist, what actions the Treasury Department would take, or what effect a stimulus bill that was still months away would have. In fact, some of those questions are still unanswered.

But one thing is clear. The ECB and Bank of Japan adopted less drastic monetary and fiscal policies than the U.S., and the result has been record-setting falls in their price levels. They are still not in end-of-the-world territory yet (especially in Europe), but they are firmly in the danger zone. As Dr. Oatley wrote back in November, this is cause for concern for following reasons:

1. Debtors suffer as the real value of their debt rises. Hence, more difficulties to service loans (think about housing price collapses and mortgage foreclosures). Rising debt service problems can harm financial institutions (that's an ironic understatement).
2. Creditors benefit as the real value of their assets rises. Of course, this assumes that debtors continue to pay.
3. Consumers benefit, because things get cheaper every day.
4. Not so good at the aggregate level. If we expect everything to be cheaper next month, we won't buy it this month. If we all defer our purchases in expectation of lower prices in the future, our aggregate demand falls and we produce less--which means we employ fewer people. With less income from lower production, prices fall further, so we push our big purchases off to the future again. And so on and so on. Deflationary spiral, I believe it is called. This is pretty much what happened in 1929-1933.

And while arguing by anecdotes is logically fallacious, acknowledging them can be fun. So I observed with bemusement Emmanuel's suit-shopping adventure, in which he bought a Hugo Boss suit at a low rate. Looking sharp, Emmanuel, but couldn't you have gotten them to toss in a better tie?

The End of an Era?

We've been mostly focusing on the domestic aspects of the financial crisis, but it's important to remember that this is a global crisis. In Europe, the major leaders are coming together to coordinate their responses:

French President Nicolas Sarkozy along with Germany's Chancellor Angela Merkel said Saturday that the "global financial crisis needs a global response."

Ms. Merkel and Mr. Sarkozy were speaking to the press ahead of a summit in Paris of leaders of the European members of the Group of eight leading countries, along with Eurogroup Chairman Jean-Claude Juncker and European Commission President Jose-Manuel Barroso, to discuss the financial turmoil.

"It's a global crisis that requires a global response. In today's world, Europe must show the will for a solution. That will reassure everyone, including savers," Mr. Sarkozy said.

Ms. Merkel said that all countries must take responsibility in sorting out the financial crisis and added that "those who caused the damage will have to contribute to the global effort.

In the past, this sort of coordinated European action would have been undermined by the U.S., and without U.S. support such a proposal would wither on the vine. As Drezner notes, both Japan and Europe tried something similar following the Asian financial crisis a decade ago, but the U.S. scuttled the efforts. If Europe is successful this time around, it may signal the decline of America as the hegemon of the global financial system.

The ECB, Asymmetric Shocks, and Monetary Policy Dilemmas

Standard theories of monetary union suggest that they work best when the participating countries experience the same shocks. They work least well when they experience asymmetric shocks. I have always found it difficult to teach this, because until now the EU's monetary union has not really had to deal with a big shock. The fall out from the US sub-prime crisis is imposing an asymmetric shock on euroland. Consequently, we now begin to see the dilemma that EMU creates for its members and its single central bank.

The core problem is that the ECB must choose between inconsistent objectives. As the Telegraph summarizes, "Mr Trichet has to tread a delicate path between the eurozone's Germanic and Latin blocs, pulling ever further apart. The credit and housing booms have begun to deflate in the Club Med region. The Bank of France's governor, Christian Noyer, said this week that Europe was facing a "huge shock" as contagion spread from the US sub-prime crisis...Spain in particular is now in serious trouble, with a "staggering" current account deficit of 9pc of GDP and a huge overhang of unsold property from the housing bubble."

Germany, in contrast, is struggling with rising inflation: "The hard-line bloc [is] led by the two German council members, Bundesbank chief Axel Weber and the ECB's chief economist Jurgen Stark. The latest spike in oil and food costs has pushed German inflation to 3pc, the highest since the launch of the euro and fast approaching the level where it may erode popular support for the currency."

Thus, one monetary policy but divergent economic developments across euroland. Someone has to accept a monetary policy that not only fails to address their current needs but will actually further worsen their situation. The dilemma is complicated by uncertainty; the more German unions question whether the ECB will use policy to keep inflation down in Germany (i.e., the more they believe that monetary policy will target Spain and the Med) the larger the nominal wage increases they will seek. Hence, to keep inflation down in Germany, the ECB must be hard line and build a reputation. But, being willing to raise interest rates to build this reputation risks making things even worse for "club med."

Not surprisingly, this "technical decision" is spilling over into politics, as French and Italian politicians have chastened Trichet for the hard line he is adopting.

It is precisely this problem that caused me to write, more than ten years ago, that EMU is not obviously a very good idea.

US Sneezes; World Gets Sick

While the US struggles to manage the sub-prime problem, Europeans are beginning to feel unwell. A story in The Daily Telegraph (UK) nicely spells out the European Central Bank's dilemma--caught between slowing growth and rising inflation and then wonders whether EMU is at risk.

"Interest rate spreads between government bonds in France, Spain, Germany and Italy have lately got wider and wider. In other words, believe it or not, the markets are increasingly betting on the eurozone breaking up – as political tensions rise, and the needs of inflation-averse nations like Germany can’t be reconciled with much weaker debt-driven members like Ireland and Spain. Could it happen? Why not? Every other currency union in the history of man has broken up – unless, like the US and UK, it has been preceded by generations of political union, and held together with a federal tax system. It sounds far-fetched, I know. But the ultimate victim of this sub-prime crisis could be nothing less than the single currency’s existence."

Wishful thinking from a euroskeptic? Perhaps, but this is the first real test of the EU's ability to weather a real economic problem (and an asymmetric shock) with a single monetary policy.

A thousand miles north, a tiny Norwegian town above the Arctic circle struggles to recover from the losses it suffered from investing in assets derived from sub-prime mortgages. The town government invested a quarter of its annual budget of $163 million, and lost a substantial share of the investment (how much is not fully clear).

Residents are unhappy: "As the losses begin to bite, the political finger-pointing has begun. Down the hall from Ms. Kuvaas, the town’s opposition leader, Torgeir Traeldal, is calling for an investigation of how and why Narvik could have made such an ill-advised investment. “Heads are going to roll,” Mr. Traeldal said, repeating the phrase a few times to drive home his point."

The Euro, the ECB, and French Elections

The European Central Bank is one of the most politically independent central banks in the world. In designing this institution, governments sought to insulate it from political pressure. Yet, the ECB has become an issue in the French presidential election.

French presidential candidate Nicolas Sarkozy said "he wants a ``real conversation'' with the European Central Bank on monetary policy, seeking a weaker euro currency to increase competitiveness. ``If we have created the euro, it's to use it,'' Sarkozy told reporters today at a briefing today. ``I will act within the eurogroup to give us an economic policy and to avoid economic shocks, get rid of the legal confusion regarding the exchange rate policy, and organize a real conversation between the eurogroup and the ECB.''

This should resonate with those of you who have read the last section of chapter 13 of my textbook (Independent Central Banks and Exchange Rates): "Because monetary and exchange-rate policies are two sides of the same coin, government control of exchange-rate policy can be used to force the central bank to pursue the monetary policies that the government and its supporters desire." This seems to be what Sarkozy is up to--using exchange rate policy to press the ECB into a looser monetary policy.

Segolene Royal has also criticized the ECB. "While Royal has criticized ECB President Jean-Claude Trichet -- pushed by French President Jacques Chirac for the post -- Socialists focused their attacks today on Sarkozy. `I will not defend Mr. Trichet here and I will not defend the ECB,'' said Socialist Party leader Francois Hollande today. ``But who appointed Mr. Trichet? We should find the person responsible for that.''

Such political dynamics is precisely why governments created an independent central bank at the center of euroland.