Monday, August 13, 2012

Plan B and the Euro(pean) Debt Crisis

. Monday, August 13, 2012

A former student asks: "I've been a staunch euro-break-up skeptic. What are your thoughts?"--and linked to an Economist piece that argues that "For the moment, breaking up the euro would be more expensive than trying to hold it together. But if Europe just keeps on arguing, that calculation will change." The piece evaluates two scenarios for breaking up the euro--one throws out the Greeks and the second throws out most of Club Med. This so-called "Plan B" would "save the euro by surgery, excising states that cannot cope rather than clinging to the vain hope that they can regain their health within the euro zone."

Here are my thoughts. I see no problem in the EU that breaking up the euro solves. There are two solutions to the EU's debt problem. Either Club Med services the debt, or the northern countries "forgive" it. Currency arrangements have nothing to do with either solution. Let me elaborate.

1. The problem in the EU is debt. Club Med states owe too much to their northern partners. Some is sovereign debt, some is private debt. Take Greece or Spain or Portugal or Italy (or all of them) out of the euro and what do you have left? Debt: Club Med states owe too much to their northern partners. German banks and French banks face the same challenges regardless of currency arrangements.

2. Pushing Club Med out of euroland would simply substitute currency crises for the present bond market unrest. We would not see greater stability in such arrangements than we see at present. We would simply see a different target (currency pegs) (does anyone think Club Med would free float?). And we would see no more stability because the central problem (debt) would remain.

3. I suppose that nominal currency devaluation is what people have in mind when they advocate the breakup of euroland. With their own currencies, Club Med states can devalue and with cheaper domestic goods export more (and import less). And being able to export more will free up resources for debt service. Yet, European leaders long ago ceased to believe that small open economies can achieve a real devaluation via a nominal devaluation. In fact, it was precisely this that justified much of the political economic rationale for the EMS in the 1980s (and then EMU in the 1990s). Devalue and export to prosperity didn't work for Italy in the 1970s and is unlikely to work for Greece in the 2010s. And even if governments could achieve a real devaluation in this way, one must still worry about relative elasticities--does the extra export revenue generated by a real devaluation more than offset the higher debt service cost resulting from higher interest rates and dearer foreign currency?

5. At the end of the day, the EU crisis will end the way all debt crises end: through debt restructuring that is painful for creditors and austerity measures that are painful for debtors. The only issue is how the costs will be distributed between the debtor and creditor. The fact that EU solutions must be negotiated among umpteen governments ensures that this distribution will take far too long to reach and will claim far more innocent victims than it should. (See Dissolution of Yugoslavia).


Morten Lynge said...

The problem is not in fact debt... That's just a symptom of the real problems...

The real problems are two-fold, balance of payments, and competitiveness, and number 1 is tightly tied to number 2...

Imagine this scenario:
A German (efficiently) produces a Hammer. It costs him €1.
A Greek (inefficiently) produces a Hammer. It costs him €2.
A German goes to buy a Hammer. He of course buys the German one.
A Greek goes to buy a Hammer. He of course buys the German one.

That example shows the real problem. Because of the differences in competitiveness (brought on not so much by the workers, but more by bureaucracy, corruption, work market policies and unions), money will flow from the inefficient countries to the efficient ones, and there is NO mechanism for them to flow back!

In a different currency union, the US, there are the federal budget transferring money from well-off to less well-off states, through programs like medicare and medicaid, not to mention the military (the bases are generally in less well-off places, and most soldiers come from less-privileged groups). The EZ has NO such transfers!

Thus the Euro zone simply CAN NOT WORK until such transfers are put in place. Trying to make the countries more alike competitiveness wise will fail, because how have for example the Germans become more efficient than the Greek? Because they're MORE efficient AT becoming efficient, so when they see their work places start to move to Greece, they immediately take action (as they've shown over the last 10 years).

So, either the EZ implements a transfer union, something strongly opposed by the North, or it falls apart. Even implementing eurobonds (sharing debt) will not matter (though it will kick the can down the road for a few years) since the fundamental problem will still be there.

Thomas Oatley said...

Hi Morton--

Your assertion that the EZ can not work without intra-regional transfers rests on an implicit belief that the Greeks should be able to enjoy a standard of living greater than their actual productivity affords. For if the Greeks were willing to consume only the income they generate, they would not need to borrow from Germany (and the rest of Europe). Had they never borrowed, we wouldn't be facing a sovereign debt crisis.

Hence, the issue becomes competitiveness only once you grant the Greeks a given standard of living. (It must be, otherwise you are suggesting that there is no standard of living at which the Greeks would not accumulate debt to Germany. Or, put differently, the Greeks could never run a current account surplus as long as they are in the euro. And both of these statements are incorrect).

Thus, if all societies agreed to live within their means, the EZ would have no balance of payments problems.

Your point about the US is well-taken even if not quite correctly formulated. The entitlement programs (medicaid, medicare, etc.) are not intra-regional transfers and transfers are necessary (according to optimal currency area theory) only in the face of an asymmetric shock (and thus not on a continuous basis). Better examples would be the bailout of the auto industry in 2009 (Detroit) and of the financial sector in 2008 (New York City).

Yet, the EZ is creating precisely these intra-regional transfers via the ECB's shadow operations, via debt restructuring, and via the European stability fund. All of these mechanisms transfer income from the relatively prosperous north to the relatively poor south.

Morten Lynge said...

When has anyone been willing to live within their means? :-p

Even if it was so, it would not do anything about the balance of payments. Money would still flow from the less efficient states to the more efficient ones, simply because people in BOTH states would buy the cheapest goods (which are generally produced by the efficient country), and there'd still not be any way for them to flow back. The debt symptom would be lessened, but the inefficient countries would get poorer and poorer as money flowed out...

It is correct that transfers are not needed continuously within a currency union, the the ABILITY is needed to correct matters when shocks hit (as you say), but the EZ hasn't got it, and what it is currently experiencing COULD be termed a severe shock :-p

There are also the other things needed for an optimal currency area that aren't present in the EZ, like for example worker mobility.

The ECB operations does next to nothing to remedy the balance of transfers. Most of them are simply replacing one type of debt with another, and not much money is transferred back into the economies under stress.

Thomas Oatley said...

So, you are claiming that Greece cannot run a current account surplus in the EZ? I think we must agree to disagree on this one.

As for the ECB, it is enabling Spain and Italy to borrow at lower rates than they could otherwise, and it is enabling rich country creditors to get out from under their burden by selling distressed assets to the central bank, which as a consequence is socializing the expected losses from debt write downs across the entire EU. Thus, quite apart from whether Club Med get new money from the ECB directly, the ECB is doing exactly what you suggest (and I agree) is necessary.

I also agree fully that EZ without labor mobility (and without fiscal union) was and is a disaster waiting to happen.

JR said...

I have a bit of a technical question - I've seen in this post, and others, the statement that devaluing makes servicing external debts more difficult. How does this work? I thought inflation/debasement benefited debtors.

Thomas Oatley said...

JR--Suppose Greece goes back to the Drachma. It must now buy euros to service its euro-denominated debt. If it devalues the drachma, it increases the price of euros in terms of drachma. Hence, devaluing raises the local currency cost of servicing debt denominated in a foreign currency.

Kindred Winecoff said...

First off, I hope the title is a reference to Ed Wood. I suspect it isn't.

Secondly, there is one problem that a EU break-up solves: it provides an opportunity for a debt reorganization. This may come in the form of an official default through debt repudiation, or to an unofficial default through repayment with debased (local) currencies. It is very unlikely that the Club Med countries can default while staying in a political union with the other European countries. Leaving the EMU gives them an opportunity to make a clean break -- of the debt burden, of the political burden, of the currency burden -- all at once. Most likely none of those burdens can be resolved without all of them being resolved.

In terms of the technical challenge you are completely right: leaving the EMU changes nothing. But in terms of deciding the "who pays" question, which is a political question, it changes quite a bit.

Thomas Oatley said...

No reference (intentional anyway) to Ed Wood.

"It is very unlikely that the Club Med countries can default while staying in a political union with the other European countries."

1. Why?
2. Even if they leave the euro, they stay in the EU, and thus are still in a political union with their primary creditors.
3. Greece has already restructured its sovereign debt. "As part of the debt restructuring, private creditors including banks, funds and insurance companies are swapping their old Greek government bonds for new securities with a lower nominal value and longer maturity periods that in some cases extend to up to 30 years. The creditors will forfeit a minimum of 53.5 percent of the nominal value of their bond holdings."

4. Therefore, leaving the euro is in no way necessary to restructure debt.

Kindred Winecoff said...

1. Because the strategic dynamics are awful. Suppose you were one of the defaultees, not defaulters: would you like to remain in an economic union with someone who has just cheated on you, is cheating on you, and will likely to continue to cheat on you? At some point the answer will be "no".

2. EMU is a different political arrangement from EU.

3. I know. There's plenty more to go, however.

4. It is not necessary. I did not mean to suggest that it was. Only that, as a political action, it could provide an opportunity for a major economic reorganization that would be much more difficult (again, politically) within the constraints of the EMU.

Plan B and the Euro(pean) Debt Crisis




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