Tag Archives: Eurozone

European Doldrums

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European economies are faltering.  The German economy contracted in the second quarter, as did those of France and Italy. Growth in Spain and the Netherlands was not enough to offset the slowdown in the Eurozone’s largest members.  An escalation in the confrontation with Russia would send shockwaves rippling from the Ukraine westwards that world worsen the situation.

The continuing slump confirms Jay C. Shambaugh’s observation (which appears in his paper in the new volume, What Have We Learned? Macroeconomic Policy After the Crisis) that much of what happened during the global financial crisis was consistent with standard international macroeconomics. For example, countries with flexible exchange rates were able to adjust more easily to the shock than those with fixed rates. Shambaugh also compares unemployment rates in the Eurozone with those across the U.S., and notes that while both the range and standard deviation of unemployment rates began to fall in the U.S. in 2010, the dispersion of national unemployment rates continued in the Eurozone. Labor conditions improved in some countries, but not others. Shambaugh cites this as evidence that there is a lack of adequate shock absorbers, such as labor mobility, within the Eurozone.

These structural problems have been exacerbated by fiscal austerity policies. Governments have sought to reestablish fiscal balance despite the impact on economic performance. The latest announcements of lowered growth have led to calls for relaxing fiscal constraints. But the incoming head of the EU Commission, Jean-Claude Juncker, shows little interest in relaxing the limits on fiscal policies, nor does German Chancellor Angela Merkel.

This leaves (once again) Mario Draghi and the European Central Bank as the focus of hope and attention. The central bank is waiting for the impact of policy measures announced in June to take place. But the disappointing economic news only reinforces calls for the ECB to enact a European version of quantitative easing.

The European GDP data have troubling implications for the larger issue of European debt. Last April, the IMF offered projections for the debt/GDP ratios this year and next:

 

2014 2015
France 95.8 96.1
Greece 174.7 171.3
Ireland 123.7 122.7
Italy 134.5 133.1
Spain 98.8 102.0
Eurozone 95.6 94.5

 

The new data will not improve the forecasts for these countries. Greece’s situation, in particular, appears as dire as ever. The Greek government hopes that a cyclically-adjusted fiscal surplus of 2.1% for 2013 will allow it some reduction in the interest rates it must pay and an extension of debt repayments. But the official targets for debt/GDP ratios of 124% in 2020 and 110% in 2022 appear unrealistic.

In a recent paper by Manuel Ramos-Francia, Ana María Aguilar-Argaez, Santiago García-Verdú and Gabriel Cuadra-García (all of the Banco de México) that appeared in the English edition of Monetaria, the authors compare the Latin American debt crisis with the European crisis. They point out that the macro imbalances and the magnitudes of the debt are larger in the peripheral European countries than they were in Latin America. Moreover, the Europeans are not able to rely on exchange rate devaluations to deal with the costs of fiscal austerity. They also remind us that the Latin American situation was finally resolved in 1989 by a reduction in debt and the issuance of “Brady bonds” (see Chapter 4 here), and suggest that some form of debt relief be granted in Europe.

It took seven years from the outbreak of the Latin American crisis for a resolution to be achieved. By that reckoning, European countries have several years of continued stagnation ahead. Political leaders who have seen their predecessors swept out of office by angry voters may not be willing to wait that long.

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.

Recovery in Europe?

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Greece has returned to the bond market, issuing $4.2 billion of five-year bonds at an interest rate of 4.95%. The government’s ability to borrow again is a “reward” for posting a surplus on its primary budget (although the accounting that produced the surplus has been questioned).  This has been viewed as a sign, albeit fragile, of recovery. Portugal has also sold bonds and hopes to exit its bailout program this spring. But what does recovery mean for these countries, and is it sustainable?

Growth for these countries reflects a rise from a brutally harsh downturn. Greece has an unemployment rate of 26.7%, with much higher rates for its youth. Portugal’s unemployment rate of 15.3% was achieved in part by emigration.

A look forward indicates that the debt that drove these countries to borrow from their European neighbors and the IMF will fall in the next five years but continue at elevated levels. The latest Fiscal Monitor of the International Monetary Fund forecasts gross government debt to GDP ratios for these countries, as well as for the Eurozone:

2015 2016 2017 2018 2019
Greece 171.3 162.5 153.7 146.1 137.8
Portugal 124.8 122.6 119.1 116.6 113.8
Eurozone 94.5 92.6 90.4 88.1 85.5

Even if the debt/GDP ratios above the Reinhart-Rogoff 90% threshold do not pose a threat to growth, it is noticeable that the Eurozone’s debt does not fall below it until 2018, while debt/GDP in Greece and Portugal will be in triple digits for many years.

These debt levels become more worrisome in light of fears of deflation in the Eurozone. Greek consumer prices have been falling, and inflation in the Eurozone is below its 2% target level. European Central Bank head Mario Draghi has downplayed these concerns, pointing to rising prices in other Eurozone countries.  But IMF economists Reza Moghadem, Ranjit Teja and Pelin Berkman point out that even low inflation can also pose problems. Deflation and less than expected rates of inflation increase the burden of existing debt. Greece’s debt will become more of a burden if it rises in real terms. Low inflation also makes wage adjustment harder to achieve.

The ECB would (presumably) respond if the prospect of deflation became more likely. But would it be able to stave off falling prices through its version of quantitative easing? There are concerns that large-scale purchases of assets by the ECB might not be as effective as anticipated. Interest rates have already fallen and are unlikely to fall further. Moreover, the decline in borrowing costs for Greece and other sovereign borrowers may have already have factored in ECB intervention.

Draghi’s pledge in 2012 to do “whatever it takes” to protect the euro undoubtedly lowered concerns about a collapse of the Eurozone. But, as I have argued before, the confidence within the Eurozone inspired by the ECB’s powers could vanish, particularly if there were doubts about the ECB’s ability to actually accomplish whatever it takes to avoid deflation. Lower borrowing costs based on faith in the ECB will ease conditions in the Eurozone crisis countries. But they need to be backed up by improving economic fundamentals before they are seen as justified. Until then, purchasing sovereign debt is a high-risk proposition, no matter what the interest rates signal.

Birds of a Feather

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Policy coordination on the international level is one of those ends that governments profess to aspire to achieve but only realize when there is a crisis that requires a global response.  There are many reasons why this happens, or rather, does not. But in one area—monetary policy—central bankers have in the past acted in concert, and their activities provide lessons for the conditions needed to bring about coordination in other policy spheres.

Jonathan D. Ostry and Atish R. Ghosh suggest several reasons for the lack of coordination.  First, policymakers may only focus on one goal at a time, and ignore intertemporal tradeoffs. Second, governments may not agree on the size of spillovers from national policies. Finally, those countries that do not participate in policy consultations do not have a chance to influence the policy decisions. Consequently, the policies that are adopted are not optimal from a global perspective.

All this was supposed to change when the G20 became the “premier forum for international economic co-operation.” The government leaders agreed to a Mutual Assessment Process, through which they would identify objectives for the global economy, the specific steps needed to attain them, and then monitor each other’s progress. How has that worked? Most observers agree: not so well. Different reasons are advanced for the lack of progress (see here and here and here), but the diversity of the members’ economic situations works against their ability to agree on what the common problems are and a joint response.

There is one area, however, where there has been evidence of communication and even coordination: monetary policy. What accounts for the difference?  The linkages of global financial institutions and markets complicate the formulation of domestic policies. Steve Kamin has examined the literature on financial globalization and monetary policy, and summarized the main findings. First, the short-term rates that policymakers use as targets are influenced by foreign conditions. Second, the long-term rates that affect spending are also affected by foreign factors. The “savings glut” of the last decade, for example, has been blamed for bringing down U.S. interest rates and fuelling the housing bubble. Third, the financial crises that monetary policymakers face have foreign dimensions. Capital flows exacerbate volatility in financial markets, and disrupt the operations of banks (see here). Therefore, central bankers can not ignore the foreign dimensions of their policies.

The actions of monetary policymakers during the global crisis are instructive. In October 2008, the Federal Reserve, the European Central Bank, and several other central banks simultaneously announced that they were reducing their primary lending rates. The Federal Reserve established swap lines with fourteen other central banks, including those of Brazil, Mexico, Singapore, and South Korea.  The central banks used the dollars they borrowed from the Federal Reserve to lend to their own banks that needed to finance their dollar-denominated acquisitions. The Federal Reserve also lent to foreign owned financial institutions operating in the U.S.

While the extent of their cooperation in 2008-09 was unprecedented, it was not the first time that the heads of central banks operated in concert. There are several features of monetary policy that allow such collaboration. First, monetary policy is often delegated by governments to central bankers, who may have some degree of political independence and longer terms of office than most domestic politicians. This gives the central bankers more confidence when they deal with their counterparts at other central banks. Second, central banking has been viewed as a more technical policy area than fiscal policy and requires professional expertise. In addition, the benign economic conditions associated with the “Great Moderation” gave central bankers credibility with the public that manifested itself in the apotheosis of Alan Greenspan. Third, central bankers meet periodically at the Bank for International Settlements, and have a sense of how their counterparts view their economies and how they might respond to a shock. A prestigious group of economists have proposed that a group of central bankers of systemically significant banks meets under the auspices of the Committee on the Global Financial System of the BIS to discuss the implications of their policies for global financial stability.

All this can change, and already has to some extent. Monetary policy has become politicized in the U.S. and the Eurozone, and even Alan Greenspan’s halo has been tarnished. Policymakers from emerging markets were caught off-guard by the rise in U.S. interest rates last spring and argued for more monetary policy coordination.

Are there lessons for international coordination on other fronts? The conditions for formulating fiscal policy are very different. Fiscal policies are enacted by legislatures and executives, who are subject to domestic public opinion in democracies.  There is little consensus in the public arena on whether fiscal policy is effective, which can lead to stalemates. Finally, there is no common meeting place for fiscal policymakers except at the G20 summits, where there is less discussion and more posturing in front of the press.

The G20 governments enacted fiscal stimulus policies at the time of the crisis. Since then, the U.S. has been unable to fashion a coherent policy plan, much less coordinate one with foreign governments. The Europeans are mired in their debt crisis, and the G20 meetings have stalled. It is difficult to see how these countries could act together even in the event of another global crisis. Like St. Augustine’s wish for chastity, governments may want to coordinate their policies—but not quite yet.

Speaking Truth to Power

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When the full history of the European debt crisis is related, one important part of the story will be the uneasy relationship of the International Monetary Fund with its European partners in the “Troika,” the European Commission and the European Central Bank. The Fund and the Europeans came to hold different views on the nature of the crisis and how it should be handled soon after its outbreak in 2010. Their disagreements reflect the split in the Fund’s membership between creditors and debtors, and the inherent ambiguity of the position of an intergovernmental organization that serves principals with different interests.

Greece obtained $145 billion from the Troika in May 2010. Of that amount, $40 billion was provided by the IMF in the form of a three-year Stand-by Arrangement. This represented 3,200% of the Greek quota at the IMF, far above the usual access limits. Susan Schadler has drawn attention to the modification of IMF policy that was made in order to allow the agreement to go forward.

The IMF has criteria to be met in deciding whether to allow a member “exceptional access” to its resources. One of these of these is a high probability that the borrowing member’s public debt will be sustainable in the medium-term. At the time of the arrangement, the IMF’s economists realized that there was little probability that Greek sovereign debt would be sustainable within any reasonable timeframe. The IMF, therefore, amended the criteria so that exceptional access could also be provided if there were a “high risk of international systemic spillover effects.” There was little doubt that such effects would occur in the event of a default, but whether this justified lending such large amounts was questionable.

It soon became clear that the two of the other four criteria would not be met. Greece would not regain access to private capital markets while it participated in the Fund program (criterion #3). Moreover, there was little prospect of a successful implementation of the policies contained in the original agreement (criterion #4). By 2011, it was evident that the program with Greece was not viable. Talks began on a new program and a restructuring of the debt, which eventually occurred in 2012. Moreover, Ireland received assistance from the Troika in December 2010, as did Portugal in February 2011.

This was the background when newly-appointed Fund Managing Director Christine Lagarde, a former French finance minister, appeared at the annual gathering of central bankers and financiers at Jackson Hole, Wyoming, in August 2011. Ms. Lagarde voiced her concerns that her fellow Europeans were responding too slowly to the dangers posed by the sovereign debt crisis. (Lagarde also called upon U.S. policymakers to undertake steps to resolve the housing crisis.) But her recommendations for more vigorous actions went unheeded. Her call for a more accommodative monetary policy was ignored by outgoing ECB President Jean-Claude Trichet. And European bankers were displeased by her assessment of their capital base as inadequate and her proposal of public injections of capital if private sources were inadequate.

In retrospect, Lagarde’s judgments look prescient. Trichet’s successor at the ECB, Mario Draghi, came to a very different view of what that institution needed to do to maintain financial stability. The ECB lowered its key interest rate in November 2011, and the following month instituted a longer-term refinancing operation for European banks. European banks, however, are still seen as relatively frail.

The IMF subsequently reassessed the response to sovereign debt crises and reviewed the framework for debt restructuring. Its review found that “debt restructurings have often been too little and too late, thus failing to re-establish debt sustainability and market access in a durable way.” The report’s authors claimed that: “Allowing an unsustainable debt situation to fester is costly to the debtor, creditors and the international monetary system.” The policy review raised the possibility of more involvement of the official sector in debt restructuring.

But the development at the IMF of a proposal to write down unsustainable debt at an earlier stage of a crisis has aroused resistance from German and other policy officials. They see the suggestion of a standstill on debt repayments as an assault on the rights of bondholders. Any mention of delay or reduction of payments is viewed as the first step towards the evasion of borrowers’ responsibilities.

Such a position in the wake of the restructuring of the Greek debt is alarming. Other borrowers will suffer financing problems, and relying on exhortations to repay in full will not improve their circumstances. Moreover, ignoring the costs to the debtor of a (attempted) repayment is self-defeating. The Greek economy may have touched bottom, but even under the most optimistic scenario its debt/GDP ratio will not decline for years.

The IMF is the agent of 188 principals. To be credible, it must  serve the interests of all its members, not just its partners in a lending arrangement. Moreover, the IMF has established more credibility in this crisis than those who have consistently refused to acknowledge its extent. In seeking to improve the process of dealing with debt restructuring,  the IMF is fulfilling its mission to provide “…the machinery for consultation and collaboration on international monetary problems.” (IMF Article of Agreement I(i).) Its members should allow it to meet that mandate.

Assigned Readings: November 14, 2013

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Taking a historical perspective of economic changes, this paper argues that muddling through crises-induced reforms characterizes well the evolutionary process of forming currency unions. The economic distortions facing the euro include structural challenges in the labor and product markets, and financial distortions. While both structural and financial distortions are costly and prevalent, they differ in fundamental ways. Financial distortions are moving at the speed of the Internet, and their welfare costs are determined more by the access to credit lines and leverage, than by the GDP of each country. In contrast, the structural distortions are moving at a slow pace relative to the financial distortions, and their effects are determined by inter-generational dynamics. These considerations suggest that the priority should be given to dealing with the financial distortions. A more perfect Eurozone is not assured without successfully muddling through painful periodic crises.

International financial linkages, particularly through global bank flows, generate important questions about the consequences for economic and financial stability, including the ability of countries to conduct autonomous monetary policy. I address the monetary autonomy issue in the context of the international policy trilemma: countries seek three typically desirable but jointly unattainable objectives: stable exchange rates, free international capital mobility, and monetary policy autonomy oriented toward and effective at achieving domestic goals. I argue that global banking entails some features that are distinct from broad issues of capital market openness captured in existing studies. In principal, if global banks with affiliates established in foreign markets can reduce frictions in international capital flows then the macroeconomic policy trilemma could bind tighter and interest rates will exhibit more co-movement across countries. However, if the information content and stickiness of the claims and services provided are enhanced relative to a benchmark alternative, then global banks can weaken the trilemma rather than enhance it. The result is a prediction of heterogeneous effects on monetary autonomy, tied to the business models of the global banks and whether countries are investment or funding locations for those banks. Empirical tests of the trilemma support this view that global bank effects are heterogeneous, and also that the primary drivers of monetary autonomy are exchange rate regimes.

We analyse global and euro area imbalances by focusing on China and Germany as large surplus and creditor countries. In the 2000s, domestic reforms in both countries expanded the effective labour force, restrained wages, shifted income towards profits and increased corporate saving. As a result, both economies’ current account surpluses widened before the global financial crisis, and that of Germany has proven more persistent as domestic investment has remained subdued.

In contrast to earlier recessions, the monetary regimes of many small economies have not changed in the aftermath of the global financial crisis. This is due in part to the fact that many small economies continue to use hard exchange rate fixes, a reasonably durable regime. However, most of the new stability is due to countries that float with an inflation target. Though a few have left to join the Eurozone, no country has yet abandoned an inflation targeting regime under duress. Inflation targeting now represents a serious alternative to a hard exchange rate fix for small economies seeking monetary stability. Are there important differences between the economic outcomes of the two stable regimes? I examine a panel of annual data from more than 170 countries from 2007 through 2012 and find that the macroeconomic and financial consequences of regime‐choice are surprisingly small. Consistent with the literature, business cycles, capital flows, and other phenomena for hard fixers have been similar to those for inflation targeters during the Global Financial Crisis and its aftermath.

  • Much has been done since 2010 to reduce macroeconomic imbalances in the Euro Area periphery and to bolster economic and financial integration at the EU level
  • Stronger exports may now be stabilizing output after two years of contraction, but headwinds remain with fiscal adjustment continuing and bank lending constrained
  • Market sentiment, underpinned by OMT, has improved with better economic news
  • Challenges remain, however, including the need to restore full bond market access for Portugal as well as Ireland and agree further financing and relief for Greece
  • Italy remains at risk over the longer term, with a return to durable growth requiring deeper structural reforms that political divisions are likely to impede
  • Progress mutualizing sovereign and bank liabilities looks likely to remain limited, leaving Euro Area members vulnerable to renewed weakness in market sentiment