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When Safe Assets Are No Longer Safe

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The U.S. has long benefitted from its ability to issue “safe assets” to the rest of the world. These usually take the form of U.S. Treasury bonds, although there was a period before the 2008-09 global financial crisis when mortgage-backed securities with Triple A ratings were also used for this purpose. The inflow of foreign savings has offset the persistent current account deficits, and put downward pressure on interest rates. But what will happen if U.S. government bonds are no longer considered safe?

The word safe has been used to describe different aspects of financial securities. The U.S. government in the past was viewed as committed to meeting its debt obligations, although the political theater around Congressional passage of the federal debt limit has introduced a note of uncertainty. In an extreme case, the U.S., like other sovereign borrowers with their own currencies, has the ability to print dollars to make debt payments. However, there is also a constituency of U.S. bondholders who would vehemently object if they were paid in inflated dollars.

Safety has also been linked with liquidity. U.S. financial markets are deep and active. Moreover, there is little concern that the government will impose capital controls on these portfolio flows (although FDI is now being scrutinized to deny access to domestic technology). Therefore, foreign holders of U.S. Treasury bonds can be confident that they can sell their holdings without disrupting the bond markets and contributing to sudden declines in bond prices.

However, there has always been another implicit component of the safety feature of Treasury bonds. Bondholders expect that they can claim their assets whenever they need to use them. The decision by the U.S. and European governments to deny the Russian central bank access to its own reserves has shown that foreign holders of assets placed on deposit in the U.S. or the other G7 countries (Canada, France, Germany, Italy, France, United Kingdom) may not be able to use these assets at precisely the times when they are most needed. The Russian central bank had accumulated about $585 billion, but approximately half of that amount is no longer available. The central bank still has access to about $80 billion held in China and $29 billion at international institutions, as well as its holdings of gold. But the latter will be hard to convert to foreign currency if potential buyers are concerned about retaliatory sanctions.

The loss of access deprives the Russian central bank of foreign currency that could have helped the government deal with sanctions on its foreign trade. Moreover, the monetary authorities have not been able to use their reserves to halt the rapid decline in the ruble’s value. The other sanctions, therefore, will have a deep impact on the Russian economy. The Institute of International Finance has issued a forecast of a drop in its GDP of 15% in 2022 and another decline the following year.

The use of sanctions to cut off a central bank’s access to its own reserves raises questions concerning the structure of the international financial system. Other central banks will reassess their holdings and consider alternatives to how they are held. But what other country has safe and liquid capital markets that are not subject to capital controls and are not vulnerable to U.S. and European sanctions?  The Chinese currency is used by some central banks, but it is doubtful that there will be a wide-spread transition from dollars to the renminbi.

Another concern has arisen regarding the ability of the U.S. government to meet its obligations. In order to satisfy a continued demand for safe assets, the government will need to continue to run budget deficits. But increases in the debt/GDP ratio leads to concerns about the creditworthiness of the government. This problem has been called a “new Triffin dilemma,” similar to the problem that emerged during the Bretton Woods era when the U.S. was pledged to be ready to exchange the dollar holdings of foreign central banks for gold. Economist Robert Triffin pointed out that the ability of the government to meet this obligation was threatened once the dollar liabilities of the U.S. exceeded its gold holdings. The “gold window” was finally shut in the summer of 1971 by President Richard Nixon.

These long-term concerns are arising just as the market for U.S. Treasury bonds has entered a new phase. The combination of higher inflation and changes in the Federal Reserve’s policy stance have led to increases in the rate of return on U.S. Treasury bonds to about 2.5%. With an annual increase in the CPI minus food and energy of approximately 6%, that leaves the real rate at -3.5%. Several more increases in the Federal Funds Rate will be needed to raise the real rate to positive values.

A fall in the demand for U.S. Treasury bonds by foreign banks and private holders would contribute to lower bond prices and higher yields. All this could affect the Federal Reserve’s policy moves if the Fed thought that it needed to factor lower foreign demand for Treasury bonds into their projections. Moreover, a shift from U.S. bonds would affect the financial account of the U.S., and the ability to run current account deficits.  The exchange rate would also be affected by such a transition.

None of these possible changes will take place in the short-run. Central bankers have more pressing concerns, such as the impact of higher food and fuel prices on domestic inflation rates, and foreign central bankers will focus on the changes in the Fed’s policies, as well as those of the European Central Bank. But the sanctions on the use of foreign reserve assets will surely lead to changes over time in the amounts of reserves held by central banks as well as their composition. The imposition of these measures may one day be seen as part of a wider change in the international financial system that marks the end of globalization as we have known it.

The Euro At Twenty: Mody’s EuroTragedy

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The euro will mark its twentieth anniversary in 2019. Is this a cause of celebration and congratulations? Or a case of a well-intentioned policy gone awry? Ashoka Mody in his new book , EuroTragedy: A Drama in Nine Acts, offers an account that shows that the joint currency was flawed from the outset, and has been further weakened by poor policy choices.

Mody, a distinguished research economist at the IMF for many years, is currently the Charles and Marie Robertson Visiting Professor in International Economic Policy at the Woodrow Wilson School at Princeton University. His book is a combination of scholarship and storytelling, as Mody analyzes the background of the euro, its evolution and future prospects. He does a wonderful job in portraying the European figures who advanced the monetary union, often in the face of public indifference or opposition. At the end, he is deeply pessimistic about the viability of the common currency and its impact on the European economies that use it.

The decision to introduce the euro was based on political aspirations, not economic need. The history begins with the European Coal and Steel Community formed in 1951 by France, Germany, Italy, Belgium, the Netherlands and Luxembourg. This was followed in 1958 by the formation of the European Economic Community, a common market and customs union for the same six nations. These associations sought to bind together the economies of Europe, which had been shattered by two world wars and the Great Depression. However, national sovereignty over domestic policies, particularly taxes and government expenditures, was asserted by the leaders of the member countries from the very beginning.

The next step took place in 1969 when French President Georges Pompidou called for a European monetary union. Pompidou was motivated by a desire to end the chronic devaluations of the French franc against the German mark. Despite skepticism over the feasibility of a common currency, West German Chancellor Willy Brandt , whose main priority was the reunion of both halves of Germany, gave a tentative endorsement, based on an understanding that there would be “harmonization” of fiscal policies. But this was a conditional agreement, and the terms were left undefined. The consequences of that ambiguity have bedeviled the implementation of the euro to the current day.

Denmark, Ireland and the United Kingdom joined the original six nations in 1973, and more joined in the 1980s. The formation of the European Monetary System in 1978 to fix exchange rates amongst these nations was a step on the road to a monetary union. The currency crises of 1981 and 1982, however, showed the risks in such integration, and for much of the 1980s further progress seemed stalled. Mody tells well the story of the change in the position of Germany’s leader Helmut Kohl, who sought to unify Europe after his own country came together in 1989. Kohl’s endorsement ensured that there would be sufficient support amongst European leaders for the euro. Kohl, however, never overcame the doubts and concerns of German policymakers and business leaders over how a common currency would affect Germany itself. The Germans were particularly wary of the possibility that they would be required to come to the assistance of other less credit-worthy members.

In addition to German concerns about its responsibilities, there were flaws in the design of the euro. Those countries that join a monetary union lose the ability to use national monetary policy to stabilize their national economies. In theory, this vulnerability can be offset by fiscal transfers from a central source to the areas affected by asymmetric shocks that the union’s central bank does not address, much as the U.S. federal government can allocate funds to areas in emergency.  But such a redistribution mechanism was never established for the Eurozone, in large part due to opposition from Germany and other members. In addition, domestic fiscal policy is constrained by the Stability and Growth Pact (SGP), which puts a limit on budget deficits of 3% of GDP. Since an economic contraction lowers tax revenues, a government facing a recession will already be in danger of violating the SGP mandate, and therefore cannot increase its own spending to counter the downturn.

In addition to this fundamental flaw, the viability of the euro has been hampered by the policies of the European Central Bank (ECB).  The ECB has a single mandate: maintain price stability.  The limitations of that charge became quite clear during the global financial crisis, but were amplified by the unwillingness of ECB President Jean-Claude Trichet to acknowledge the depth of the crisis and formulate an adequate response. Federal Reserve Chair Ben Bernanke was much more aggressive in responding with unconventional policy moves such as Quantitative Easing. This timidity was compounded by premature calls for fiscal austerity during the slow economic recovery.

The Greek debt crisis amply demonstrated the division within the Eurozone over what obligations member governments have to come to the aid of another member in fiscal distress. Mody believes that Italy now poses the biggest current threat to the structure of the Eurozone. That country adopted the euro in the belief that it would act as a “vincolo esterno,” an external constraint that would impose sound policies on a fractious political system. But a common currency cannot improve low productivity growth due to poor governance and institutions.

The protracted pace of the recovery in Italy from the global crisis has frustrated its citizens, who have turned to populist parties—the Northern League and the Five Star Movement—that were once seen as fringe movements. The parties have dropped their opposition to the euro because of public sentiment. But the new government is determined to proceed with its fiscal plans, which include a flat tax rate and a universal income. The resulting deficit would violate the European Commission’s fiscal rules and raise Italy’s debt burden. The current public debt/GDP ratio of 131% is exceeded within the Eurozone only by that of Greece. While an Italian exit from the European Union seems impossible, the Italian government and the European Commission each seem determined to make the other side move first towards a compromise in an international game of chicken.  In such circumstances there is ample opportunity for miscommunication and misunderstanding. Given the size of the Italian economy, any rupture could be catastrophic.

Mody is not anti-European. Indeed, he calls for a renewal of the European identity of a group of nations that compete in the “marketplace of ideas,” and together form a European Republic of Letters. But the euro has not fostered that identity, and in is based on an inherent flaw:

“The original conundrum remains. A single monetary policy for diverse countries cannot operate effectively without a mechanism to share risks in crisis conditions. Eurozone leaders cannot agree to a risk-sharing mechanism based on a democratically legitimate political contract. Under pressure during the crisis years, they agreed on technical agreements to share risks. These arrangements can be undone politically at an inopportune moment.”  (Mody, p. 385)

Mody’s book provides an important lesson: policies imposed by political elites that are not endorsed by the public who are supposed to benefit from them have weak underpinnings. A crisis uncovers the flaws in the institutional architecture, and these exacerbate the impact of the crisis. The resulting tragedy affects everyone, not just those who promoted a solution to a problem that did not exist.

A Guide to the (Financial) Universe: Part II

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(Part I of this Guide appears here.)

3. Crisis and Response

The global crisis revealed that the pre-crisis financial universe was more fragile than realized at the time. Before the crisis, this fragility was masked by low interest rates, which were due in part to the buildup of foreign reserves in the form of U.S. securities by emerging market economies. The high ratings that mortgage backed securities (MBS) in the U.S. received from the rating agencies depended on these low interest rates and rising housing prices. Once interest rates increased, however, and housing values declined, mortgage borrowers—particularly those considered “subprime”—abandoned their properties. The value of the MBS fell, and financial institutions in the U.S. and Europe sought to remove them from their balance sheets, which reinforced the downward spiral in their values.

The global crisis was followed by a debt crisis in Europe. The governments of Ireland and Spain bolstered their financial institutions which had also lent extensively to the domestic housing sectors, but their support led to a deterioration in their own finances. Similarly, the safety of Greek government bonds was called into question as the scope of Greek deficit expenditures became clear, and there were concerns about Portugal’s finances.

Different systems of response and support emerged during the crises. In the case of the advanced economies, their central banks coordinated their domestic policy responses. In addition, the Federal Reserve organized currency swap networks with its counterparts in countries where domestic banks had participated in the MBS markets, as well as several emerging market economies (Brazil, Mexico, South Korea and Singapore) where dollars were also in demand. The central banks were then able to provide dollar liquidity to their banks. The European Central Bank provided similar currency arrangements for countries in that region, as did the Swiss National Bank and the corresponding Scandinavian institutions.

The emerging market countries that were not included in such arrangements had to rely on their own foreign exchange reserves to meet the demand for dollars as well as respond to exchange rate pressures. Subsequently, fourteen Asian economies formed the Chiang Mai Initiative Multilateralization, which allows them to draw upon swap arrangements. China has also signed currency swap agreements with fourteen other countries.

In addition, emerging market economies and developing economies received assistance from the International Monetary Fund, which organized arrangements with 17 countries from the outbreak of the crisis through the following summer. The Fund had been severely criticized for its policies during the Asian crisis of 1997-98, but its response to this crisis was very different. Credit was disbursed more quickly and in larger amounts than had occurred in past crises, and there were fewer conditions attached to the programs. Countries in Asia and Latin America with credible records of macroeconomic policies were able to boost domestic spending while drawing upon their reserve holdings to stabilize their exchange rates. The IMF’s actions contributed to the recovery of these countries from the external shock.

The IMF played a very different role in the European debt crisis. It joined the European Commission, which represented European governments, and the European Central Bank to form the “Troika.” These institutions made loans to Ireland in 2010 and Portugal in 2011 in return for deficit-reduction policies, while Spain received assistance in 2012 from the other Eurozone governments. In 2013 a banking crisis in Cyprus also required assistance from the Troika.These countries eventually recovered and exited the lending programs.

Greece’s crisis, however, has been more protracted and the provisions of its program are controversial. The IMF and the European governments have been criticized for delaying debt reduction while insisting on harsh budget austerity measures. The IMF also came under attack for suborning its independence by joining the Troika, and its own Independent Evaluation Office subsequently published a report that raised questions about its institutional autonomy and accountability.

In the aftermath of the crisis, new regulations—called “macroprudential policies”—have been implemented to reduce systemic risk within the financial system. The Basel Committee on Banking Supervision, for example, has instituted higher bank capital and liquidity requirements. Other rules include restrictions on loan-to-value ratios. These measures are designed both to prevent the occurrence of credit bubbles and to make financial institutions more resilient. A European Banking Authority has been established to set uniform regulations on European banks and to assess risks. In the U.S., a Financial Stability Oversight Council was given the task of identifying threats to financial stability.

The crisis also caused a reassessment of capital account restrictions. The IMF, which had urged the deregulation of capital accounts before the Asian crisis of 1997-98, published in 2012 a new set of guidelines, named the “institutional view.” The Fund acknowledged that rapid capital flows surges or outflows could be disruptive, and that under some circumstances capital flow management measures could be useful. Capital account liberalization is appropriate only when countries reach threshold levels of institutional and financial development.

One legacy of the response to the crisis is the expansion of central bank balance sheets. The assets of the Bank of England, the Bank of Japan, the European Central Bank (ECB) and the Federal Reserve rose to $15 trillion as the central banks engaged in large-scale purchases of assets, called “quantitative easing”. The Federal Reserve ceased purchasing securities in 2014, and the ECB is expected to cut back its purchases later this year.  But the unwinding of these holdings is expected to take place gradually over many years, and monetary policymakers have signaled that their balance sheets are unlikely to return to their pre-crisis sizes.

(to be continued)

The Challenges of the Greek Crisis

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The Greek crisis has abated, but not ended. Representatives of the “troika” of the European Commission, the European Central Bank and the International Monetary Fund returned to Athens for talks with the Greek government about a new bailout. This pause allows an accounting of the many challenges that the events in Greece pose to the international community.

The main challenge, of course, is to the Greek government itself, which must implement the fiscal and other measures contained in the agreement with the European governments. These include steps to liberalize labor markets as well as open up protected sectors of the economy. While these structural reforms should promote growth over time, in the short-run they will lead to layoffs and reorganizations. At the same time, Prime Minister Alex Tsipras must oversee tax rises and cuts in spending. The combined impact of all these measures, which follow the virtual shutdown of the financial sector during the protracted negotiations with the European governments, will postpone any resumption in growth that past efforts may have generated.

It is not clear how long the Greek public will endure further misery. Any form of debt restructuring may give policymakers some justification to continue with the agreement. New elections will clarify the degree of political support for the pact. But the possibility of an exit from the Eurozone has not been removed, either in the eyes of Greek politicians or those of officials of other governments.

The Greek crisis, however, is not the only hazard that the Eurozone faces. The Eurozone’s governments have yet to come to terms with the effects of the global financial crisis on its members’ finances. A split prevails between those countries that ally themselves with the German position that debt must be repaid and those that seek with France to find some sort of middle ground. Other European countries with debt/GDP ratios of over 100% include Belgium, Portugal, and Italy. Weak economic growth could push any of them into a situation where the costs of refinancing become daunting. How would the Eurozone governments respond? Would they bail out another member? If so, would the terms differ from those imposed on Greece? Would European banks be able to pass the distressed debt on to their own governments?

In the long-term, the governments of the Eurozone face the dilemma of how to reconcile centralized rule-making with national sovereignty. The ECB, for example, has been granted supervisory oversight of the banks in the Eurozone. It will exercise direct oversight of over 100 banks deemed to be “significant,” while sharing responsibility with national supervisors for the remaining approximately 3,500 banks. The ECB has a Supervisory Board, supported by a Steering Committee, to plan and executes its supervisory tasks, which supposedly allows it to separate its bank supervisory function from its role in setting monetary policy. All these agencies and committees must work out their respective jurisdictions and responsibilities. Meanwhile, the European Commission, which oversees fiscal policies, faces requests for exemptions from its budget guidelines by governments with faltering growth. But if it shows flexibility in enforcing its own rules, it will be derided as weak and ineffective.

The IMF has its own set of challenges. The IMF was sharply criticized for its response to the wave of crises that struck emerging markets in the last 1990s and early 2000s, beginning with Mexico in 1994 and extending to Turkey and Argentina in 2001. Critics charged that the IMF was slow to respond to the rapid “sudden stops” of capital outflows that set off and exacerbated the crises. When the Fund did act, it attached too many conditions to its programs; moreover, these conditions were harsh and inappropriate for crises based on capital outflows.

The global financial crisis gave the IMF a second chance to demonstrate its crisis-management abilities (for a full account, see here). The Managing Director at the time, Dominique Strauss-Kahn, seized the opportunity to redeem the IMF ‘s reputation, as well as reestablish his own political career in France. The IMF lent quickly to its members, attached relatively few conditions to the loans, and allowed the use of fiscal measures to stabilize domestic economies. The result was less severe adjustment, the avoidance of excessive exchange rate movements and a resumption of economic growth. By the time the global economy recovered, the IMF had proven that it could respond in a flexible manner to a financial emergency.

The IMF’s response in 2010 to the Greek debt crisis was very different. The IMF’s loan to Greece was the first to a Eurozone member; moreover, the loan was much larger than any the IMF had extended before, whether measured by the total amount of credit or as a percentage of the borrowing country’s quota at the Fund. To make the loan, the IMF had to overlook one of it own guidelines for granting “exceptional access” by a member to Fund credit. Such loans were to be made only if the borrowing government’s debt would be sustainable in the medium-term. Greece’s debt burden did not pass this criterion, so the Fund justified its actions on the grounds that there was a risk of “international systemic spillovers.”

The IMF’s involvement in the Greek program was also unusual in another sense: the IMF’s contribution, as large as it was, was still smaller than that of the European governments. The IMF was, in effect, a “junior partner.” While it had worked with other governments before (such as the U.S. when it lent to Mexico in 1994-95), this was the first time that the IMF was not in a lead position. This may have initially made it reluctant to disagree with the other members of the troika.

The subsequent contraction in the Greek economy far exceeded the IMF’s forecasts. The IMF later admitted that it underestimated the size of the multipliers for the fiscal policies contained in the program in a paper co-authored by the head of the IMF’s Research Department, Olivier Blanchard (see also here). The failure to properly estimate the impact of these conditions calls into doubt the basic premises of the 2010 and 2012 programs.

More recently, the IMF has challenged its European partners over their projections for the Greek debt, as well as the budget and fiscal targets contained in the latest agreement. The Fund claims that the debt projections are much too optimistic. Greece’s debt will only be sustainable if there is debt relief on a much larger scale than the European governments have been willing to undertake. Moreover, the IMF states that it will not be part of any new programs for Greece if debt relief is not a component.

The public admission of error and the rebukes of the European governments will only partially restore the IMF’s reputation. The generous treatment of Greece as well as Ireland and Portugal reinforces the belief that the European countries and the U.S. control the IMF. The members of the European Union have a total quota share of almost one-third, much larger than their share of world GDP. This voting share combined with the U.S. quota gives these countries almost half of all the voting shares at the IMF. The need for a realignment of the quotas to give the emerging market nations a larger share has long been acknowledged, but approval of the reform measures is mired in the U.S. Congress.

Another aspect of European and U.S. control of the “Bretton Woods twins”—the IMF and the World Bank—has been their selection of the heads of these organizations. All the Managing Directors of the IMF have been Europeans, and until the appointment of Ms. Lagarde, European males. All the heads of the World Bank have been U.S. citizens. Ms. Lagarde’s term expires next July, and the pressure to name a non-European will be tremendous. How the Europeans and U.S. respond to this challenge will go a long way in determining whether these institutions will be shunted aside by the emerging market nations in favor of institutions that they can control.

The last challenge of the Greek crisis comes for the Federal Reserve. Federal Reserve Chair Janet Yellen has been explaining that a rise in the Fed’s policy rate, the Federal Funds rate, is likely to occur later this year. This forecast, however, is contingent on continued economic growth and favorable labor market conditions. These plans could be threatened by any financial volatility that followed a disruption in the latest Greece bailout.

The Federal Reserve is also aware that a rise in interest rates would affect the dollar/euro exchange rate. The euro, which has been depreciating, could fall lower when the Fed raises rates while the ECB keeps its refinancing rate at 0.05%. A further appreciation of the dollar would threaten U.S. exports, thus endangering a recovery.

The Fed also faces concerns about the broader impact of its policy initiatives on the world economy. The IMF is worried about how a rate rise would affect the global economy, and has urged the Fed to hold off on interest rate increases until 20016. Companies that borrowed in dollars through bonds and bank loans will be adversely affected by the combined effects of an interest rate rise and a dollar appreciation.

Greece’s GDP accounts for only 0.4% of world GDP and about 1.3% of the European Union’s total output. But the global financial crisis demonstrated how financial linkages across sectors and countries can disrupt economic activity no matter what their source. The response to these incidents by national and international authorities can risk global stability if they are based on self-interest and organizational agendas. Commitments to cooperation disappear quickly when national concerns are threatened.

(A Powerpoint version of this post is available here.)

Greek Tale(s)

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No matter what new twist the Greek debt crisis takes, there can be no question that it has been a catastrophe for that country and for the entire Eurozone. The Greek economy contracted by over a quarter during the period of 2007 to 2013, the largest decline of any advanced economy since 1950. The Greek unemployment rate last year was 26.5%, and its youth unemployment rate of 52.4% was matched only by Spain’s. But who is responsible for these conditions depends very much on which perspective you take.

From a macroeconomic viewpoint, the Greek saga is one of austere budget polices imposed on the Greek government by the “troika” of the International Monetary Fund, the European Commission and the European Central Bank in an attempt to collect payment on the government’s debt. The first program, enacted in 2010 in response to Greece’s escalating budget deficits, called for fiscal consolidation to be achieved through cuts in government spending and higher taxes. The improvement in the primary budget position (which excludes interest payments) between 2010-11 was 8% of GDP, above its target. But real GDP, which was expected to drop between 2009 and 2012 by 5.5%, actually declined by 17%. The debt/GDP level, which was supposed to fall to about 155% by 2013, actually rose to 170% because of the severity of the contraction in output. The IMF subsequently published a report criticizing its participation in the 2010 program, including overly optimistic macroeconomic assumptions.

To address the continuing rise in the debt ratio, a new adjustment program was inaugurated in 2012, which included a writedown of Greek debt by 75%. Further cuts in public spending were to be made, as well as improvements in tax collection. But economic conditions continued to deteriorate, which hindered the country’s ability to meet the fiscal goals. The Greek economy began to expand in 2014, and registered growth for the year of 0.8%. The public’s disenchantment with the country’s economic and political status, however, turned it against the usual ruling parties. The left-wing Syriza party took the lead position in the parliamentary elections held this past January, and the new Prime Minister, Alexis Tsipras, pledged to undo the policies of the troika. He and Finance Minister Yanis Varoufakis have been negotiating with the IMF, the ECB and the other member governments of the Eurozone in an attempt to obtain more debt reduction in return for implementing new adjustment measures.

The macroeconomic record, therefore, seems to support the position of those who view the Greek situation as one of imposed austerity to force payment of debt incurred in the past. Because of the continuing declines in GDP, the improvement in the debt/GDP ratio has remained an elusive (if not unattainable) goal. (For detailed comments on the impact of the macroeconomic policies undertaken in the 2010 and 2012 programs see Krugman here and Wren-Lewis here.)

Another perspective, however, brings an additional dimension to the analysis. From a public finance point of view, the successive Greek governments have been unable and/or unwilling to deal with budget positions—and in particular expenditures through the pension system—that are unsustainable. Pension expenditures as a proportion of GDP have been relatively high when compared to other European countries, and under the pre-2010 system were projected to reach almost 25% of GDP by 2050.  Workers were able to receive full benefits after 35 years of contributions, rather than 40 as in most other countries. Those in “strenuous occupations,” which were broadly defined, could retire after 25 years with full benefits.  The amount that a retiree received was based on the last year of salary rather than career earnings, and there were extra monthly payments at Christmas and Easter. The administration of the system, split among over 100 agencies, was a bureaucratic nightmare.

Much of this has been changed. The minimum retirement age has been raised, the number of years needed for full benefits is now 40, and the calculation of benefits changed so as to be less generous. But some fear that the changes have not been sufficient, particularly if older workers are “sheltered” from the changes.

Moreover, government pensions are important to a wide number of people. The old-age dependency ratio is around 30%, one of the highest in Europe. The contraction in the Greek economy means that the pension is sometimes the sole income payment received by a family. It is hardly surprising, therefore, that the pension system is seen as a “red line” which can not be crossed any further in Greece.

The challenge, therefore, is for the government to establish its finances on a sound footing without further damaging the fragile economy. This will call for some compromises on both sides. The IMF’s Olivier Blanchard has called for the Greek government “to offer truly credible measures“ to attain the targets for the budget, while showing its commitment to a limited set of reforms, particularly with pensions. But he also asks the European creditors to offer debt relief, either through rescheduling or a further “haircut.” Other proposals have been made (see here) that also attempt to satisfy the need to restructure the government’s finances while offering the Greek people a way to escape their suffering. There may be a strategy that allows Greece to reestablish itself on a new financial footing. But if the European governments insist that Greece must also pay back all its outstanding debt, then there is only one possible ending for this saga, and it will not be a happy one.

The ECB’s Daunting Task

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Mario Draghi, head of the European Central Bank, and the members of the ECB’s Governing Council are receiving praise for the initiatives they announced last week to avoid deflation (see here and here). The immediate impact of the announcement was a rise in European stock prices. But the approval of the financial sector does not mean that the ECB will be successful in its mission to rejuvenate the Eurozone’s economy.

The ECB is taking several expansionary steps. First, it has cut the rate paid on the deposits of banks at the ECB to a negative 0.1%, thus penalizing the banks for not using their reserves to make loans. Second, it is setting up a new lending program, called “Targeted Longer-Term Refinancing Operations (TLTROs),” to provide financing to banks that make loans to households and firms. Third, it will no longer offset the monetary impact of its purchases of government bonds, i.e., no “sterilization.” Moreover, Draghi’s announcement included a pledge that the ECB will consider further steps, including the use of “…unconventional instruments within its mandate, should it become necessary to further address risks of too prolonged a period of low inflation.”

Draghi’s promise to take further steps are reminiscent of his announcement in 2012 that the ECB was “…ready to do whatever it takes to preserve the euro.” That promise was successful in calming concerns about massive defaults and a break-up of the Eurozone. Consequently, the returns that sovereign borrowers in the Eurozone had to pay on their bonds began a decline that has continued to the present day.

But the challenges now facing the ECB are in many aspects more daunting. The current Eurozone inflation rate of 0.5% is an indicator of the anemic state of European economies.  Achieving the target inflation target of the ECB of 2% will require a significant increase in spending. The latest forecast for 2014’s GDP Eurozone growth from The Economist is 1.1%, which would be a pick-up from the 0.7% in the latest quarter, with an anticipated inflation rate for the year of 0.8%. Unemployment for the area is 11.7%, and this includes rates of 25.1% in Spain, 26.5% in Greece, and 12.6% in Italy.

More bank lending would encourage economic activity, but it is not clear that European banks are willing to make private-sector loans. Many banks are still dealing with past loans that will never be repaid as they seek to pass bank stress tests. And Draghi’s success in calming fears about sovereign default has (perhaps paradoxically) resulted in banks holding onto government bonds, which are now seen as relatively safe compared to private loans.

There is one other aspect of the European situation that can derail the ECB’s efforts: the distribution of financial wealth. The recent publication of House of Debt by Atif Mian and Amir Sufi has led to discussions of the deterioration of household balance sheets during the global financial crisis, and the economic consequences of the massive decline in household wealth. Larry Summers has praised the authors’ contribution to our understanding of the impact of the crisis on economic welfare by focusing on this channel of transmission.

Mian and Sufi have claimed that income distribution has a role in the response of households to policies that seek to boost spending. Low-income households, they point out, will spend a higher fraction of fiscal stimulus income checks than high-income households. They would most likely also spend a higher proportion of a rise in their financial worth. A concentration of such wealth in the hands of a small proportion of European households, therefore, limits the increase in spending due to higher asset prices.

The ECB, therefore, may find that the plaudits they have earned do not translate to a better policy outcome. The situation they face is not unique, and resembles in many ways the challenges that the Bank of Japan in has faced. Draghi and the ECB may have to follow their lead in devising new measures if European spending and inflation do not pick up.