Tag Archives: Europe

Martin Wolf’s Warning

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It is time for the 2014 Globie—a (somewhat fictitious) prize I award once a year to a book that deserves recognition for its treatment of the consequences of globalization. (Previous winners can be found here.) The financial turmoil of the last week makes this year’s award-winner particularly appropriate: Martin Wolf for The Shifts and the Shocks: What We’ve Learned–and Have Still to Learn–from the Financial Crisis. Wolf, a distinguished writer for the Financial Times, once viewed globalization as a positive force that enhanced welfare. But the events of the last few years have changed his views of financial markets and institutions. He now views financial flows as inherently susceptible to the occurrence of crises. And Wolf’s intellectual evolution leaves him deeply concerned about the consequences of financial globalization.

Part I of the book deals with the “shocks” to the global economy. Wolf begins in the U.S. with the crisis of 2008-09 and the relatively weak recovery. He shares the view of Richard Koo of Nomura Research that this was a “balance sheet recession,” with the private sector seeking to shed the debt it had built up during the pre-crisis period. The cutback in private sector spending was initially matched by an increase in the government’s fiscal deficit, which arose as expenditures on unemployment benefits and other programs grew and revenues fell. The rise in the fiscal deficit was particularly appropriate as the “liquidity trap” limited the downward fall of interest rates and the expansionary effects of monetary policy. However, the political acceptance of deficits and debts ended prematurely in 2010, and the recovery has not been as robust as it needs to be.

Wolf then turns to the Eurozone, which experienced its shift towards fiscal austerity after the crisis in Greece erupted. Wolf views the monetary union as “incomplete and imperfect.” On the one hand, its members have sovereign powers that include issuing debt; on the other hand, they do not have the risk-sharing mechanisms that a federal union possesses. When the capital flows that had fed housing bubbles in Spain and Ireland and financed fiscal deficits in Greece and Portugal ended, the borrowing countries were encumbered with  the debt they had accumulated either directly through fiscal borrowing or indirectly as they bailed out their domestic banks. Those increases in public  debt were seen by Germany and others as proof that the crises were due to fiscal excess, which had to be met by fiscal austerity. But Wolf claims that the German view “…was an effort at self-exculpation: as the Eurozone’s largest supplier of surplus capital, its private sector bore substantial responsibility for the excesses that led to the crisis.”

After surveying the relartvely more benign experience of the emerging and developing countries during the crisis, Wolf turns to the “shifts” that led to the breakdown of the financial system. These include the liberalization of market forces, particularly finance; technological change, which speeded up the integration of markets and financial markets; and ageing, which transformed the savings-investment balance in high-income countries. These led to an increase in financial fragility that made financial markets unstable and crises endemic. The changes took place in a global economy where global savings where channeled from oil-exporters and Asian economies, particularly China, to the U.S., thus reinforcing the credit boom.

The last section of the book deals with solutions to the crises. Wolf is ready to consider “radical reform,” which includes higher capital ratios for the banks and macroprudential policies that seek to achieve both asset market and macroeconomic stability. Policies to rebalance the global economy include encouraging less risky forms of finance, increasing insurance against external shocks, and moving towards a global reserve asset. The steps needed to assure the continued existence of the euro start with a mechanism to assure symmetrical adjustment across the Eurozone, debt restructuring, and a banking union.

None of these measures will be easy to implement. But Wolf’s willingness to discuss them is a sign of how much the crisis has unsettled those who thought they understood the risks of financial globalization. Wolf attributes the responsibility for the crisis to “Western elites,” who misunderstood the consequences of financial liberalization, allowed democracy to be weakened, and in the case of the Eurozone, imposed a system without accountability. The loss in public confidence, he writes, reduces trust in domestic legitimacy.

The title of the last chapter, “Fire Next Time,” is taken from James Baldwin’s book of the same name, which in turn borrowed from an African-American spiritual: “God gave Noah the rainbow sign, no more water but fire next time.” Wolf warns that the next global economic crisis “could end in the fire.” While he  does not explicitly explain what this fire will be, he mentions in the preface that his father was a Jewish refugee from Austria in the 1930s, and the historical reference is clear. At a time when right-wing parties are ascendant in Europe, Wolf’s warning is a sober reminder that unsettled economic circumstances can lead to political extremism and instability.

The IMF and Sovereign Debt

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The continuing inability of the Eurozone economies to break out of their current impasse means that any optimistic projections of declining debt to GDP ratios are unlikely to be achieved. As long as European governments continue to raise funds in the financial markets on favorable terms, the current situation remains sustainable.  But the IMF is thinking ahead to the day when there is a change in the financial climate, and is proposing a change in the rules governing its ability to lend to governments that may need its assistance if they are to continue repaying their debt.

The Fund’s rethinking has been prompted by its concerns over its lending to Greece. The IMF, as part of a “troika” with the European Commission and the European Central Bank, participated in a loan arrangement in May 2010. The IMF’s contribution consisted of a $40 billion Stand-By Arrangement. The Fund had a problem, however: this amount far exceeded the normal amount of credit that the IMF normally provided to its members. Exceptions were allowed, but there were criteria to govern when “exceptional access” was permitted. One of these was a high probability that a government’s public debt was sustainable in the medium term. It was difficult to claim that was true for Greece in 2010, so an alternative criterion was established: exceptional access could also be provided if there was a “high risk of international systemic spillover effects.” This was used as grounds to justify the lending arrangement to Greece.

A restructuring of the Greek debt did take place in 2012. The IMF subsequently issued a review of its own response to debt crises, and found that “debt restructurings have often been too little and too late, this failing to re-establish debt sustainability and market access in a durable way.” The IMF was concerned that its money was used to pay off creditors who would otherwise have been forced to negotiate changes in the debt’s conditions with the Greek government.

The IMF has come back with a new lending framework for governments with problems in paying off their debt. The new option would be relevant for a country that has lost access to the capital markets, and when there are concerns about the sustainability of its debt. The government would ask for a “reprofiling” of its debt by creditors, which would consist of an extension of its maturity without a reduction in the principal or interest, while the IMF offered financial support with a plan for economic policy adjustment. Fund officials claim that “reprofiling tends to be less costly to creditors than debt reduction, less disruptive to financial markets, and hence less contagious.”

The new option would allow the IMF to operate in situations where the sustainability of a country’s debt is ambiguous. Those cases are more common than creditors want to admit. Ireland and Portugal have graduated from their respective IMF programs, and can obtain credit again. But the “good outcome” occurred in part because Mario Draghi, President of the European Central Bank, pledged to do “whatever it takes” to preserve the euro, and market participants took him at his word. To date, no one has called upon Mr. Draghi to back up his pledge, and lending rates to all the Eurozone members have fallen. But it is not too difficult to imagine a scenario in which the ECB’s credibility crumbles, particularly if deflation takes hold. What then happens to perceptions of debt sustainability?

As an agent of 188 sovereign principals (the member governments), the IMF is constrained in what it can do on its own initiative. But any ambiguity of the sustainability of debt gives the IMF some scope for autonomy. In addition, differences in the objectives of the members provide policy “space” for the IMF to maneuver.

Extending the maturity date of an existing bond would lower its net present value of the debt. Lenders, therefore, are unlikely to embrace the IMF’s proposal. But the concerns over the repayment of Argentine debt threaten to extend to other markets (see here), and are another source of uncertainty.  An association of lenders has issued a call for more flexibility in the terms governing collective action clauses, but these take time to implement. Moreover, European finance ministers are preoccupied by other, more pressing concerns.

As long as debt markets remain calm, “reprofiling” will be considered as an interesting policy proposal, which will be sent off for further study. But once the interests of the major stakeholders—which continue to be the G7 countries—are involved, then there will be an assessment based on the financial interests at stake. The response to the Greek debt crisis demonstrated that the European countries are quite willing to rewrite the rules governing the IMF’s policy options when they see an advantage for their national interests. But the response to a similar situation in another part of the world could be very different. And it is precisely that perception of unequal treatment that is driving dissatisfaction with current arrangements at the IMF.

 

The Challenges of Achieving Financial Stability

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The end of the dot.com bubble in 2000 led to a debate over whether central banks should take financial stability into account when formulating policy, in addition to the usual indicators of economic stability such as inflation and unemployment. The response from many central bankers was that they did not feel confident that they could identify price bubbles before they collapsed, but that they could always deal with the byproducts of a bout of speculation. The global financial crisis undercut that response and has led to the development of macroprudential tools to address systemic vulnerabilities. But regulators and other policymakers who seek to achieve financial stability face several challenges.

First, they have to distinguish between the signals given by financial and economic indicators, and weigh the impact of any measures they consider on anemic economic recoveries. The yields in Europe on sovereign debt for borrowers such as Spain, Portugal and Ireland are at their lowest levels since before the crisis. Foreign investors are scooping up properties in Spain, where housing prices have fallen by over 30% since their 2007 highs. But economic growth in the Eurozone for the first quarter was 0.2% and in the European Union 0.3%. Stock prices in the U.S. reached record levels while Federal Reserve Chair Janet Yellen voiced concerns about a weak labor market and inflation below the Federal Reserve’s 2% target. When asked about the stock market, Yellen admitted that investors may be taking on extra risk because of low interest rates, but said that equity market valuations were within their “historical norms.” Meanwhile, Chinese officials seek to contain the impact of a deflating housing bubble on their financial system while minimizing any economic consequences.

Second, regulators need to consider the international dimensions of financial vulnerability. Capital flows can increase financial fragility, and the rapid transmission of financial volatility across borders has been recognized since the 1990s. Graciela L. Kaminsky, Carmen M. Reinhart and Carlos A. Végh analyzed the factors that led to what they called “fast and furious” contagion. Such contagion occurred, they found, when there had been previous surges of capital inflows and when the crisis was unanticipated. The presence of common creditors, such as international banks, was a third factor. U.S. banks had been involved in Latin America before the debt crisis of the 1980s, while European and Japanese banks had lent to Asia in the 1990s before the East Asian crisis.

The global financial crisis revealed that financial integration across borders exacerbated the downturn.  The rise of international financial networks that transmit risk across frontiers was the subject of a recent IMF conference. Joseph Stiglitz of Columbia University gave the opening talk on interconnectedness and financial stability, and claimed that banks can be not only too big to fail, and can also be “too interconnected, too central, and too correlated to fail.” But dealing with interconnected financial networks is difficult for policymakers whose authority ends at their national borders.

Finally, officials have to overcome the opposition of those who are profiting from the current environment. IMF Managing Director Christine Lagarde has attributed insufficient progress on banking reform to “fierce industry pushback” from that sector. Similarly, Bank of England head Mark Carney has told bankers that they must develop a sense of their responsibilities to society. Adam J. Levitin, in a Harvard Law Review essay that summarizes the contents of several recent books on the financial crisis, writes that “regulatory capture” by financial institutions has undercut financial regulation that was supposed to restrain them, and requires a political response. James Kwak has emphasized the role of ideology in slowing financial reform.

Markets for financial and other assets exhibit little sign of stress. The Chicago Board Options Exchange Volatility index (VIX), which measures expectations of U.S. stock price swings, fell to a 14-month low that matched pre-crisis levels. Such placidity, however, can mask the buildup of systemic stresses in financial systems. Regulators and other policy officials who seek to forestall another crisis by acting peremptorily will need to possess political courage as well as economic insight.

The IMF and Ukraine

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The International Monetary Fund last week announced an agreement with Ukraine on a two year Stand-By Arrangement. The amount of money to be disbursed depends on how much other financial support the country will receive, but will be total at least $14 billion. Whether or not this IMF program will be fully implemented (unlike the last two) depends on the government’s response to both the economic crisis and the external threat that Russia poses. There is also the interesting display of the use of the IMF by the U.S., the largest shareholder, to pursue its international strategic goals even though the U.S. Congress will not approve reforms in the IMF’s quota system.

Ukraine’s track record with the IMF is not a good one. In November 2008 as the global financial crisis intensified, the IMF offered Ukraine an arrangement worth $16.4 billion. But only about a third of that amount was disbursed because of disagreements over fiscal policy.  Another program for $15.3 billion was approved in 2010, but less than a quarter of those funds were given to the country.

The recidivist behavior is the product of a lack of political commitment to the measures contained in the Letters of Intent signed by the government of Ukraine. Ukraine, like other former Soviet republics, was slow to move to a market system, and therefore lagged behind East European countries such as Poland and Romania in adopting new technology. Andrew Tiffin of the IMF attributed the country’s economic underachievement to a “market-unfriendly institutional base” that has allowed continued rent-seeking. Promises to enact reform measures have been made but not fulfilled.

Are the chances of success any better now? Peter Boone of the Centre for Economic Performance at the London School of Economics and Simon Johnson of MIT are not convinced that there has been a change in attitude within the Ukrainian government, despite the overthrow of President Viktor Yanukovych (see also here). Consequently, they write: “There is no point to bailing out Ukraine’s creditors and backstopping Ukrainian banks when the core problems persist: pervasive corruption, exacerbated by the ability to play Russia and the West against each other.”

Leszek Balcerowicz, a former deputy prime minister of Poland and former head of its central bank, is more optimistic about the country’s chances. The political movement that drove out Yankovich, he claims, is capable of promoting reform. Further aggression by Russia, however, will threaten whatever changes the Ukrainian people seek to undertake.

The “back story” to the IMF’s program for Ukraine has its own intramural squabbling. The U.S. Congress has not passed the legislation needed to change the IMF’s quotas so that voting power would shift from the Europeans to the emerging market nations. The changes would also put the the Fund’s ability to finance its lending programs on a more regular basis. Senate Majority Leader Harry Reid sought to insert approval of the IMF-related measures within the bill to extend assistance to the Ukraine, but Republicans lawmakers refused to allow its inclusion. While U.S. politicians expect the organization to serve their political ends, they reject changes that would grant the IMF credibility with its members from the developing world.

The Economist has called the failure of Congress to support the IMF “shameful and self-defeating.” Similarly, Ted Truman of the Peterson Institute for International Economics warns that the U.S. is endangering its chances of obtaining support for Ukraine. The Europeans, of course, are delighted, as they will keep their place in the Fund’s power structure while the blame is shifted elsewhere. And the response of the emerging markets to another program for Ukraine, despite its dismal record, while they are refused a larger voice within the IMF? That will no doubt make for some interesting discussions at the Annual Spring Meetings of the IMF and the World Bank that begin on April 11.

High Road, Low Road

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Among the many thorny issues that would arise if Scotland were be become an independent nation is the question of its choice of a currency. The first minister of Scotland claims that an independent Scotland would continue to use the pound. But Mark Carney, the governor of the Bank of England, has raised several caveats and stipulations—including limitations on fiscal autonomy—that would be required if a currency union were to be formed. Moreover, British elected officials have thrown cold water on the idea. And that could be a problem for an independent Scotland, as there is no obvious good alternative.

Scotland could unilaterally decide to continue using the pound, just as Panama and Ecuador use the U.S. dollar. But dependence on the United Kingdom for its money is not fully compatible with political independence. Nor is it congruent with the international status that the new country would undoubtedly seek.

How about adopting the euro? Scotland would join the current 18 members of the Eurozone, and would have to hope that it did not suffer from any Scotland-specific shocks. Optimal currency theory spells out the alternative mechanisms a country needs to address an asymmetric shock: mobile labor, flexible prices and wages, and/or a fiscal authority that can direct funds to the area facing the shock. The sight of Irish, Spanish, etc., workers leaving their respective homelands in search of work outside of Europe has hardly been reassuring to prospective members. The Baltic states have shown that prices and wages will fall in response to a policy of austerity, but the economic cost is severe. And no Scottish government would survive the harsh policy conditions attached to the financial assistance extended to Greece, Ireland and Portugal by their European partners and the IMF. Joining the Eurozone at this stage of its existence would not be consistent with Scottish canniness.

If Scotland can not—or will not—join an existing monetary union on terms it deems acceptable, should its create its own currency? The prospect of a Scottish currency has drawn a fair amount of comment: see, for example, here and here and here.  A study by Angus Armstrong and Monique Ebell of the National Institute of Economics and Social Research makes the point that the viability of an independent currency for the country would depend on the amount of sovereign debt the new government would have to take on after a breakup witht the United Kingdom versus its anticipated oil revenues. Standard & Poor’s issued a nuanced assessment of how it would rate Scotland’s debt that noted the country’s economic wealth, which is largely based on oil and gas. But the report also raised concerns about the viability of Scotland’s financial sector in the absence of a reputable lender of last resort.

If an independent Scotland issued its own currency, it would be joining other north European countries that either do not belong to the European Union (Iceland, Norway) or have not adopted the euro (Denmark, Sweden). These countries have certainly suffered bouts of volatility and instability (particularly Iceland), but have not fared any worse than many members of the Eurozone. Their decision not to enter the Eurozone itself is interesting and worth further analysis.

But none of them is as deeply tied to another single country as Scotland is to the United Kingdom. Disentangling those ties for the purpose of establishing national autonomy would be difficult and most likely costly. Proclaiming monetary independence, therefore, would be a policy action that makes limited sense in economic terms but carries a great deal of nationalistic baggage. And those types of ventures do not usually end well.

The Spirit of Versailles?

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The newly-approved U.S. budget bill did not include authorization for changes at the IMF in funding and quotas (see also here). Those measures require approval of 85% of the voting power of the IMF’s members, and since the U.S. controls 17.67%, the reforms cannot be enacted. This leaves the U.S and the Fund in difficult positions.

The IMF received loans from its members during the 2007-09, but has sought to convert these to increases in the quotas that provide the funding for the IMF’s lending programs. The IMF is not about to run out of money, but the opportunity to put its financing on a regular basis has been (at best) delayed.  The IMF’s members also agreed to shift quota shares, which also determine voting powers, to the emerging market nations while reducing the European presence on its Executive Board. China has made clear that it wants a larger voting share, and the other middle-income countries have taken a similar position. The postponement in increasing their quotas allows their governments to adopt a position of high dudgeon when the IMF next advocates policy changes in their countries. The Europeans, on the other hand, must be delighted that the they are no longer on the spot for obstructing the realignment.

What important Constitutional principle was at stake in the refusal of Congress to approve the measures? According to the New York Times, it was a lack of willingness to support multilateral financial institutions. This ties in with popular opposition in the U.S. to foreign aid, always a perennial target of right-want opprobrium, and it bodes poorly for the future. If a significant segment of political opinion consistently opposes U.S. involvement in international ventures and forums, then the U.S. will pay a price in diminished global influence.

Is it too dramatic to compare this event with the failure of the U.S. Senate to approve the Treaty of Versailles? Probably, but the similarities are suggestive of what is driving the rejection. A significant part of the American electorate was tired then of foreign wars and wished to retreat from foreign obligations, just as many do today. Anything that seems to support the financial sector is also viewed with suspicion.  Personal enmity between President Woodrow Wilson and Republican Senator Henry Cabot Lodge is echoed in the animosity between President Barak Obama and members of the Republican Congressional delegation. Lodge was concerned that the League would supersede the U.S. government’s ability to conduct foreign affairs, just as many contemporary conservatives are worried about the influence of the United Nations on domestic matters. Both Wilson and Obama have been accused of being unwilling (or unable) to persuade opponents of the need to approve the desired measures.

While the U.S. never joined the League of Nations, it is not about to leave the IMF. But the refusal to ratify the changes in the IMF’s governance will leave the U.S. vulnerable to the charge that it seeks to retain control of an organization that was established at the end of World War II long after its hegemonic position had ebbed. If this were the reason for these developments, it would at least be understandable from a realpolitik perspective. The truth may be more dispiriting: perhaps we do not understand what we have to lose.

As Time Goes By

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Depending on how the beginning of the European debt crisis is dated (2010? 2008? 1999?), it has been several years since the governments of several nations have sought to relieve investors’ fears regarding their debt. The governments of four countries (Cyprus, Greece, Ireland, Portugal) turned to the IMF and other Eurozone nations for assistance, while Italy and Spain have undertaken policies designed to avoid the need for external assistance. To paraphrase a former mayor of New York, how are those governments doing?

To answer that question, we can draw upon Jay Shambaugh’s insight that there are actually three interlocking crises: a macroeconomic crisis, a debt crisis and a banking crisis.

First, we examine current data for the prevailing (2013) macro conditions in the (in)famous PIIGS, as well as the entire Euro area and, for the sake of comparison, the U.S. and Japan. We exclude Cyprus as its crisis occurred more recently:

%

GDP Growth

 Unemployment Budget/GDP

Cur Acc/GDP
Greece

-4.0

 27.3 -2.4 0.1
Ireland

0.3

 13.2 -7.4

4.0
Italy

-1.8

 12.5 -3.3

0.4
Portugal

-1.8

 15.6 -5.9

0.3
Spain

-1.3

 26.6 -7.1

0.8
Euro Area

-0.4

 12.2 -3.0

1.9
U.S.

1.6

 7.3 -4.0

-2.5

Japan

 1.9 4.0 -8.3

1.2

In the Eurozone countries, only Ireland (barely) has avoided a negative growth rate, while both the U.S. and Japan are doing better. The unemployment rates reflect the depths of the continuing downturns. The budget balances continue to record deficits that largely reflect cyclical conditions; Greece and Italy have primary budget surpluses. The current accounts all register surpluses, unlike the U.S. Nikolas Schöll at Bruegel examined the data to uncover the sources of the reversals of the trade deficits, and pointed out that Ireland, Portugal and Spain recorded large increases in exports, while Greece had a dramatic drop in imports.

Will 2014 be any better? The IMF’s October 2013 World Economic Outlook forecasts a swing to positive growth rates in all of Europe except Slovenia. But, it warned, “Additional near-term support will be needed to reverse weak growth…” and called for further monetary easing. The ECB has obliged by lowering its refinancing rate to 0.25% in response to falling inflation, not a hopeful sign of recovery.

How do these countries do on their sovereign debt? We can compare the debt/GDP data for 2010 with this year’s and next year’s expected levels:

Debt/GDP

2010

2013

2014
Greece

148.3

 175.7

174.0
Ireland

91.2

 123.3

121.0
Italy

119.3

 132.3

133.1
Portugal

94.0

 123.6

125.3
Spain

61.7

 93.7

99.1
Euro Area

85.7

 95.7

96.1
U.S.

95.2

 106.0

107.3
Japan

216.0

 243.5

242.3

Several years of recession have pushed the ratios up despite fiscal constraint, and the IMF’s October 2013 Fiscal Monitor does not see any short-term improvement outside of Ireland. The increase in the U.S. ratio is not quite as large thanks to its economic recovery, while Japan continues to serve as an outlier. Charles Wyplosz thinks that Greece will require another debt rescheduling, and there are concerns regarding the need for another bailout in Portugal. Falling real estate prices in Spain continue to threaten its banks, while Italy’s largest burden is its politics. Ireland no longer needs external assistance, but it will take years to pay back the loans it received from the IMF and other European governments.

And interest rates? With the 10-year rate on German government bonds at 1.72%, the spreads for the other European countries last week were (in ascending order): Ireland 1.81%; Spain, 2.36%; Italy, 2.38%; Portugal, 4.29%; and Greece, 7.09%. The rates are not onerous despite mediocre economic conditions and steady debt burdens, and have fallen over the last year. What accounts for this remarkable sangfroid by investors?

The answer may be the status of the third crisis: banking. Last year the European Central Bank (ECB) under Mario Draghi instituted a new three-year Long-term Refinancing Operation (LTRO). Banks in southern Europe took the relatively cheap funds and bought the bonds of their own governments, which still carry zero-risk weights in the Basel capital regulations. As a result, according to Silvia Merler (also at Bruegel), banks in those European countries have “renationalized,” with domestic debt accounting for large proportions of their portfolios, and much of this debt consisting of government debt. Moreover, the ECB also announced that it would purchase a government’s sovereign bonds under its Outright Monetary Transactions program if necessary to maintain its target interest rate. Combine bank purchases of government debt with a guarantee of central bank intervention if markets deteriorate and the fall in yields is the obvious result.

All this has the appearance of a Rube Goldberg machine, with a feedback loop uniting the ECB, European banks and sovereign debtors. But is it sustainable? Must the ECB continue renewing the LTRO to keep the banks solvent? Will the European Banking Authority, currently undertaking stress tests of the banks, accept the arrangement? What if the fragile recovery turns out to be really fragile? And what will happen if/when the Federal Reserve does taper off its asset purchases? However many years this crisis has been going on, the exit is not visible yet.