In the latest issue of The Economist (20 February, Disciplinary Measures) Daniel Gros of CEPS, Brussels, and Thomas Mayer of Deutsche Bank also advocate the kind of European Monetary Fund recommended by Giuliano Amato (see our previous post).
Their EMF would mimic the IMF in "having a professional staff remote from direct political influence and a board with representatives from euro-area countries." It "would conduct regular and broad surveillance of member countries"; "its main role would be to design, monitor and fund assistance programmes for euro-area countries in difficulties, just as the IMF does on a global scale". An IMF clone - so far. The main differences between the two Funds would concern funding, disbursements and sovereign default.
For its funding the EMF would borrow "in the markets with the full and joint backing of all its member countries", but "Only those countries in breach of set limits on governments’ stocks and annual deficits would have to contribute, giving them an incentive to keep their finances in order”. “Countries could, for instance, be charged an annual contribution of 1% of their “excess debt”” over the Maastricht limits of 60% of GDP, and of their excess deficit over 3% or GDP. Gros and Mayer reckon that by these rules the EMF would have accumulated €120 bn over the last decade; in 2009 Greece would have had to contribute 0.65% of GDP. A fine way of deterring moral hazard behaviour, but an additional burden both on the profligate country in need of assistance, like Greece, and on the club of delinquent countries (like Spain Portugal Italy Ireland) that share a similar predicament. Surely if the EMF had borrowed on international markets “with the full and joint backing of all its member countries” the richer and more disciplined countries could not ignore their commitments; its creditors would see to that.
Disbursements to member countries would be made up to the amount each has contributed in the past to the EMF – i.e. would depend strictly on earlier large scale financial indiscipline – conditionally on their fiscal adjustment programmes being approved by euro-area finance ministers, with tougher conditions (including EMF status of privileged creditor) applying to withdrawals above past contributions. Further finance would be tied to specific, authorized purposes.
Finally, in case of sovereign default the EMF would “offer all holders of debt issued an exchange against new bonds issued by the EMF”, requiring creditors to take a uniform “haircut” (=loss) in order to protect taxpayers. Nothing new here, we are only replicating old-style Brady bonds. “The EMF could, for example, tie its guarantees to the 60%-of-GDP Maastricht limit on debt, so that creditors of a country with a debt stock of 120% of GDP would face a 50% haircut”: this is a very neat and ingenious disciplinary mechanism. “The EMF would only exchange debt instruments that had been registered with it beforehand”. This is to say, cosmetic derivatives traded with Goldman Sachs would not be covered.
Certainly such a European Monetary Fund would be better than “muddling through on the basis of ad hoc interventions”, as Gros and Mayer say. Ten years ago Daniel Gros used to advocate unilateral euroisation by transition economies, relying on foreign banks to provide the necessary euro liquidity at all times; the EMF scheme is more realistic.
But what is the value added of this “in house solution” with respect to what is on offer from the IMF? A duplicate set of functionaries, duplicate surveillance and monitoring and associated reports, duplicate draft stabilization plans embodying the same deflationary policies. No sovereign encroachment by outside bodies, but a lot of sovereignty encroachment by European agencies in the form of offers that cannot be refused. “A euro-zone country that refused to abide by the decisions of the EMF could choose to leave the EU, and with it the euro, under article 50 of the Lisbon Treaty. But the price of doing so would be very great”. First, the Treaty's draftsmen were so keen not to encourage the notion that dissolving EMU was a feasible option that there are no rules at all for either exiting the euro-area or expelling a member. Second, raising the stakes (tougher conditionality) may raise the probability of winning a game, but at the cost of making the loss catastrophic (EU exit) if the game is lost.
Saturday, February 20, 2010
Thursday, February 18, 2010
The European Hermaphrodite
In an interview to Repubblica‘s financial supplement of 15 February Giuliano Amato proposes to “turn the current European crisis into an opportunity – by founding a European Monetary Fund”. Giuliano Amato was twice Italian Premier in 1992-93 and 2000-01, four times Treasury Minister, once Minister for Institutional Reform and Minister of the Interior; he is a distinguished academic, Professor of Constitutional Law, and has just been appointed Senior Advisor for Italy by Deutsche Bank. His generous proposal has vision and must be taken seriously.
Regional solutions are a step forward when global solutions are not there, but conditional financial assistance to governments experiencing imbalances in their external accounts or public finances is already being provided by the IMF. All EU and EMU members are both shareholders and clients of the IMF in any case. Giuliano Amato says “Those who are keen on the europeanisation of economies feel that something is lost if we are not capable of resolving our own problems ourselves”. Why does he endorse these views? If we set up a European Monetary Fund, should we then want to set up a European Health Organisation next to the WHO, a European Trade Organisation next to the WTO, a Bank of European Settlements next to the BIS?
Giuliano Amato does not regard the European Union as simply another regional organization, albeit of considerable scale. More than once he has defined the EU as a “hermaphrodite”, combining lasting traits of international organization with traits that used to belong exclusively to states. Therefore he believes that it was a mistake to build the single currency with a mere coordination of national economic and fiscal policy. A European Monetary Fund would give the single currency the instruments necessary to offset asymmetric shocks within the European Union. However, even someone sharing his hermaphrodite characterization of the Union might draw from it the diametrically opposite conclusion - that it should evolve more in the direction of a federal or unitary state than in that of a regional grouping (with its own regional Monetary Fund).
Apart from this, the proposal for a European Monetary Fund presumes that the operational criteria of this Fund would be different from those of the IMF, otherwise why bother? But if the EMF criteria were more severe than those of the IMF the Union cannot prevent its own members from applying for IMF assistance; if EMF conditions were less severe the Union might first try and negotiate with the IMF less stringent conditionality in general at least for its own members. It would only be worth setting up an EMF if, say, its conditions were more grounded in social and political consensus, more geared to what is left of the European Social Model, less US-centered and US-inspired.
Except that, in the financial crisis of 2008-2009 the IMF has been capable of providing the necessary leadership for implementing a global fiscal and monetary intervention against the crisis, while European institutions limped behind their various deflationary regional rules and traditional constraints.
Imagine a small group of tennis players (Giuliano Amato is a very fine tennis player), all fee-paying members and shareholders of a tennis club that works satisfactorily, who propose to found a second, exclusive club for the provision of tennis facilities identical to those already provided by the pre-existing club, simply to be able to call it their own. There would be no point - unless the game was played under different rules, but this possibility has not yet been illustrated.
Regional solutions are a step forward when global solutions are not there, but conditional financial assistance to governments experiencing imbalances in their external accounts or public finances is already being provided by the IMF. All EU and EMU members are both shareholders and clients of the IMF in any case. Giuliano Amato says “Those who are keen on the europeanisation of economies feel that something is lost if we are not capable of resolving our own problems ourselves”. Why does he endorse these views? If we set up a European Monetary Fund, should we then want to set up a European Health Organisation next to the WHO, a European Trade Organisation next to the WTO, a Bank of European Settlements next to the BIS?
Giuliano Amato does not regard the European Union as simply another regional organization, albeit of considerable scale. More than once he has defined the EU as a “hermaphrodite”, combining lasting traits of international organization with traits that used to belong exclusively to states. Therefore he believes that it was a mistake to build the single currency with a mere coordination of national economic and fiscal policy. A European Monetary Fund would give the single currency the instruments necessary to offset asymmetric shocks within the European Union. However, even someone sharing his hermaphrodite characterization of the Union might draw from it the diametrically opposite conclusion - that it should evolve more in the direction of a federal or unitary state than in that of a regional grouping (with its own regional Monetary Fund).
Apart from this, the proposal for a European Monetary Fund presumes that the operational criteria of this Fund would be different from those of the IMF, otherwise why bother? But if the EMF criteria were more severe than those of the IMF the Union cannot prevent its own members from applying for IMF assistance; if EMF conditions were less severe the Union might first try and negotiate with the IMF less stringent conditionality in general at least for its own members. It would only be worth setting up an EMF if, say, its conditions were more grounded in social and political consensus, more geared to what is left of the European Social Model, less US-centered and US-inspired.
Except that, in the financial crisis of 2008-2009 the IMF has been capable of providing the necessary leadership for implementing a global fiscal and monetary intervention against the crisis, while European institutions limped behind their various deflationary regional rules and traditional constraints.
Imagine a small group of tennis players (Giuliano Amato is a very fine tennis player), all fee-paying members and shareholders of a tennis club that works satisfactorily, who propose to found a second, exclusive club for the provision of tennis facilities identical to those already provided by the pre-existing club, simply to be able to call it their own. There would be no point - unless the game was played under different rules, but this possibility has not yet been illustrated.
Saturday, February 13, 2010
These Are Some I Printed Earlier
A hypothetical monetary dis-integration of the euro-area has been contemplated from time to time. Martin Feldstein (former economic adviser to Ronald Reagan and a president of the National Bureau of Economic Research) forecast “that the euro area will break up as member states voluntarily quit the euro area” even before the euro’s birth in 1999, and repeated such forecast recently. Wolfgang Münchau and Susanne Mundschenk discussed no less than eight such scenarios of Eurozone Meltdown in April 2009. Such conjectures have become common place with the rise of sovereign default risk for the so-called PIGS [Portugal Italy Greece Spain, the former Club Med, now with Italy replaced by Ireland - I wish economic commentators were politically correct], measured by interest spreads over German bonds, or CDS rates.
Just as monetary integration is expected to bring about net benefits, its mirror image monetary dis-integration is likely to involve net costs. A trade contraction among former fellow-partners of the euro-zone, due to higher transaction costs; an exchange rate risk; the expectation of higher inflation outside the euro-area; higher interest rates due to both such exchange rate risk and higher inflation; lower Foreign Direct Investment and lower portfolio investments – are a high price to pay for a sovereignty symbol and the ability to restore competitiveness (at the cost of higher inflation) through successive rounds of domestic currency devaluation. Neither weak nor strong eurozone members have an incentive, let alone an obligation, to dis-integrate.
But suppose a country like Greece decided that the inability to devalue while in the euroarea, and the gross political interference by euro monetary authorities in domestic economic matters like pensionable age and pension levels, nominal wages, fiscal budget and deficit and national debt, was intolerable and politically unacceptable to government and/or a rioting population. Exiting the euroarea - Münchau and Mundschenk argue - might be illegal, would take a long time because it would require democratic discussions in Parliaments and likely constitutional changes, and it could be frustrated by capital flight during the long period it would take. This is not the case. Any EMU member who wished to exit the euro-zone, let us say Greece, could do it de facto without saying or doing anything at all about the euro, simply by issuing nicely printed banknotes denominated in Greek Euro, initially valued at par with the old euro and subsequently floating against the euro, with a single decree stipulating that the new currency is legal tender in the payment of wages and taxes.
As long as the Greek euro can be used to pay taxes, parity can be kept at least for a while. The new Greek currency is issued through wage and salary payments to public employees and re-absorbed via tax receipts, the government getting a bit of a breathing space in between. Euro government receipts available for other government expenses are not affected. Having been decreed legal tender in the payment of wages (as well as taxes) shops and their suppliers will have an incentive to accept new Greek euro in payment instead of the old euro. The very existence of the new Greek euro will breed a lack of confidence in it; Gresham’s Law will raise the velocity of circulation of the new Greek euro with respect to the old euro, which sooner or later will exchange at a premium, in a market in which both can be traded freely. Workers would immediately claim higher wages in Greek Euro, and they would probably get them. Market prices for consumption goods and then production and investment goods would also soon be expressed in Greek euro; traders still pricing their goods and services in euro could be paid by converting the weaker Greek euro into stronger old euro, for both are convertible.
The euro would continue to be used in all extant inter-temporal transactions that had been stipulated in euro, both in the public and the private sector. All new transactions would be stipulated and settled in whatever currency is agreed by the transactors – except wages would normally be fixed and settled in the new currency, although indexation of Greek euro wage payments to the euro market exchange rate would be allowed. Imports and exports would be priced and settled in currencies agreed by traders.
The Greek euro monetary issues would give the government additional liquid resources, and to Greek producers the chance of devaluing labour costs thus acquiring additional competitiveness – as long as the price flexibility afforded by the new currency is exploited. In practice the euro would be at least partly de-monetised, thanks to Gresham’s Law, and used only in old intertemporal transactions, so that this could be argued to be a single currency system – though I would not press the point and, should this system be viewed as a dual currency system, I will stand by what I wrote in the previous post, that dual currencies are always a bad idea.
The only redeeming feature of the system envisaged here is that it could work. Unlike the dual currency system proposed by Michael G. Arghyrou and John Tsoukalas, and by Charles Goodhart and Dimitrios Tsomocos (see my earlier post). The Arghyrou&Tsoukalas new currency is not national but circulates in all countries of the euro-periphery, the exchange rate between the euro and the weak-euro is managed by the ECB (still mysteriously able to target price stability for both currencies despite weak-euro devaluation); price-fixing and wage-fixing are left indeterminate (nominally unchanged in terms of the weaker euro, considering that price stability is preserved in both currencies?) and so is the payment regime. And in the Californian Solution proposed by Goodhart&Tsomocos, the inability to use their new currency to pay taxes, and above all its inconvertibility, would make their IOUs as unattractive and useless as the old Transferable Rouble.
Another advantage is that there would be no need for parliamentary debates or constitutional changes, just a government decree whereby the Treasury – as Goodhart and Tsomocos envisage – issue their Greek euros in the form of their own IOUs. The time-lag involved between decision and implementation is that necessary to print the new banknotes. If these could be printed secretly beforehand, and stored safely, a country’s quasi-exit from the eurozone could take place at a stroke, from one day to the next. A quasi-exit, because there would remain the possibility, if and when the national IOUs should return to parity with the euro, of rejoining de facto the euro area, equally at a stroke. An amendment of the Growth and Stability Pact would be appropriate to cope with this unexpected development, and in the event of a final exit from the eurozone the country’s accounts with the ECB would have to be reckoned and settled, but all this could wait.
Still a bit messy and inelegant, though. Just a feasible scenario, explored so as to encourage finding better solutions. It is a good thing that these kinds of games, even as mental experiments, are strictly verboten in Frankfurt.
Just as monetary integration is expected to bring about net benefits, its mirror image monetary dis-integration is likely to involve net costs. A trade contraction among former fellow-partners of the euro-zone, due to higher transaction costs; an exchange rate risk; the expectation of higher inflation outside the euro-area; higher interest rates due to both such exchange rate risk and higher inflation; lower Foreign Direct Investment and lower portfolio investments – are a high price to pay for a sovereignty symbol and the ability to restore competitiveness (at the cost of higher inflation) through successive rounds of domestic currency devaluation. Neither weak nor strong eurozone members have an incentive, let alone an obligation, to dis-integrate.
But suppose a country like Greece decided that the inability to devalue while in the euroarea, and the gross political interference by euro monetary authorities in domestic economic matters like pensionable age and pension levels, nominal wages, fiscal budget and deficit and national debt, was intolerable and politically unacceptable to government and/or a rioting population. Exiting the euroarea - Münchau and Mundschenk argue - might be illegal, would take a long time because it would require democratic discussions in Parliaments and likely constitutional changes, and it could be frustrated by capital flight during the long period it would take. This is not the case. Any EMU member who wished to exit the euro-zone, let us say Greece, could do it de facto without saying or doing anything at all about the euro, simply by issuing nicely printed banknotes denominated in Greek Euro, initially valued at par with the old euro and subsequently floating against the euro, with a single decree stipulating that the new currency is legal tender in the payment of wages and taxes.
As long as the Greek euro can be used to pay taxes, parity can be kept at least for a while. The new Greek currency is issued through wage and salary payments to public employees and re-absorbed via tax receipts, the government getting a bit of a breathing space in between. Euro government receipts available for other government expenses are not affected. Having been decreed legal tender in the payment of wages (as well as taxes) shops and their suppliers will have an incentive to accept new Greek euro in payment instead of the old euro. The very existence of the new Greek euro will breed a lack of confidence in it; Gresham’s Law will raise the velocity of circulation of the new Greek euro with respect to the old euro, which sooner or later will exchange at a premium, in a market in which both can be traded freely. Workers would immediately claim higher wages in Greek Euro, and they would probably get them. Market prices for consumption goods and then production and investment goods would also soon be expressed in Greek euro; traders still pricing their goods and services in euro could be paid by converting the weaker Greek euro into stronger old euro, for both are convertible.
The euro would continue to be used in all extant inter-temporal transactions that had been stipulated in euro, both in the public and the private sector. All new transactions would be stipulated and settled in whatever currency is agreed by the transactors – except wages would normally be fixed and settled in the new currency, although indexation of Greek euro wage payments to the euro market exchange rate would be allowed. Imports and exports would be priced and settled in currencies agreed by traders.
The Greek euro monetary issues would give the government additional liquid resources, and to Greek producers the chance of devaluing labour costs thus acquiring additional competitiveness – as long as the price flexibility afforded by the new currency is exploited. In practice the euro would be at least partly de-monetised, thanks to Gresham’s Law, and used only in old intertemporal transactions, so that this could be argued to be a single currency system – though I would not press the point and, should this system be viewed as a dual currency system, I will stand by what I wrote in the previous post, that dual currencies are always a bad idea.
The only redeeming feature of the system envisaged here is that it could work. Unlike the dual currency system proposed by Michael G. Arghyrou and John Tsoukalas, and by Charles Goodhart and Dimitrios Tsomocos (see my earlier post). The Arghyrou&Tsoukalas new currency is not national but circulates in all countries of the euro-periphery, the exchange rate between the euro and the weak-euro is managed by the ECB (still mysteriously able to target price stability for both currencies despite weak-euro devaluation); price-fixing and wage-fixing are left indeterminate (nominally unchanged in terms of the weaker euro, considering that price stability is preserved in both currencies?) and so is the payment regime. And in the Californian Solution proposed by Goodhart&Tsomocos, the inability to use their new currency to pay taxes, and above all its inconvertibility, would make their IOUs as unattractive and useless as the old Transferable Rouble.
Another advantage is that there would be no need for parliamentary debates or constitutional changes, just a government decree whereby the Treasury – as Goodhart and Tsomocos envisage – issue their Greek euros in the form of their own IOUs. The time-lag involved between decision and implementation is that necessary to print the new banknotes. If these could be printed secretly beforehand, and stored safely, a country’s quasi-exit from the eurozone could take place at a stroke, from one day to the next. A quasi-exit, because there would remain the possibility, if and when the national IOUs should return to parity with the euro, of rejoining de facto the euro area, equally at a stroke. An amendment of the Growth and Stability Pact would be appropriate to cope with this unexpected development, and in the event of a final exit from the eurozone the country’s accounts with the ECB would have to be reckoned and settled, but all this could wait.
Still a bit messy and inelegant, though. Just a feasible scenario, explored so as to encourage finding better solutions. It is a good thing that these kinds of games, even as mental experiments, are strictly verboten in Frankfurt.
Wednesday, February 10, 2010
Dual Currencies Are Always A Bad Idea
Michael G. Arghyrou and John Tsoukalas advocate The Option of Last Resort for the solution of the current euro-area crisis: A Two-Currency EMU, on Economonitor of 7 February.
“The plan we propose involves the temporary implementation of a two-currency EMU, with both currencies run by the Frankfurt-based ECB. The core-EMU countries will continue to use the present currency, the strong euro. The periphery countries on the other hand, will adopt, for a certain period of time, another currency, the weak euro. Crucially, the bonds and external debt of the periphery countries will stay in strong-euro terms. Upon its introduction, the ECB will devalue the weak euro by a percentage enough to restore the competitiveness losses periphery countries have suffered over the last decade against their main trading partners, the core-EMU countries. This will give the periphery a competitiveness boost while it introduces extensive structural reforms. The ECB will implement monetary policy for the whole of the EMU with its primary objective being price stability for all its members, strong- and weak-euro countries. It will do so in much the same way it does now, the only difference being that the ECB will be setting two rather than one reference rates.”
A similar plan was advocated by Charles Goodhart and Dimitrios Tsomocos in the FT of 24 January: The Californian solution for the Club Med – except through the temporary introduction of a dual national currency, for Portugal by way of example, through an escudo IOU instead of a dual “weak-euro” throughout the euro-zone, just like the IOUs that California and Argentina’s districts used to cope with a fiscal crisis.
The Gresham-Copernicus-Oresme-Aristophanes Law
The trouble with any dual currency system – whether bi-metallic or bi-paper or mixed – is that either the rate of exchange between the two currencies is determined by the market, depending on what can or cannot be done with either currency and how, or their rate of exchange is managed by monetary authorities presumably at a rate other than would otherwise prevail in the market (or there would be no point in managing it). At a market-determined exchange rate, the introduction of a new currency simply increases the amount of liquidity in the system, without any other effect; nothing happens that could not have happened by expanding money supply in the old currency (as it can always be done with paper money). At any managed exchange rate different from the market rate, Sir Thomas Gresham (1519 – 1579), an English financier during the Tudor dynasty, rules: “Bad money [the currency overvalued with respect to the market rate] drives out good [the undervalued currency]”. The dual currency ceases to be dual. This law is one of the oldest economic discoveries: it was anticipated by Nicolaus Copernicus, even earlier by Nicole Oresme in the fourteenth century, and had been stated clearly by Aristophanes in his play The Frogs, around the end of the fifth century BC.
The chervonets precedent
In the past the introduction of an additional currency has been advocated, and at least once implemented, not to weaken a strong currency and restore competitiveness but to stabilize a rapidly depreciating currency suffering from hyper-inflation. Thus in 1922-24 Lenin introduced in the Soviet Union a new gold-backed convertible currency, called chervonets after Peter the Great‘s gold coinage, and circulating next to the overinflated rouble, or sovznak. Over time the sovznak was de-monetized and disappeared through hyperinflation, while the new currency and the government budget were stabilized.
In the case of the chervonetz-sovznak coexistence clearly the rate of conversion between the two currencies had to be floating and market-determined, for the new currency at an under-valued fixed rate would be displaced by Gresham‘s law, while an overvalued rate would be pointless and rouble-inflationary. But if the two currencies were exchanged freely in the market the old currency would gradually disappear through higher and accelerating rouble-inflation and hyperinflation, which is what I understand actually happened in 1922-24, leaving a single sound currency. The parallel currency implemented a slow motion currency-stabilisation through accelerating rouble inflation, instead of a single inflationary shock to reach immediate balance.
In 1988-89 George Soros, Wassily Leontief, Ed Hewett and Ivan Ivanov (Deputy Chairman of the State Foreign Economic Committee, GVK) launched their “Open Sector”project, with the participation of many Soviet, western and east-European economists (see Phil Hanson, "Foreign Advice", in M.Ellman and Kontorovich, The Destruction of the Soviet Economic System – An Insiders’ History, M.E. Sharpe, Armonk-New York, 1988, pp.238-255). It was a plan, initially surrounded by secrecy, for both wiping out monetary overhang and promoting foreign trade by introducing a new convertible currency inspired by the 1920s chervonets, paid to Soviet exporters and then circulating in parallel with domestic roubles. I took part in the project and went along for the ride, but never believed in it: what had happened with the chervonets would have happened with the parallel, convertible hard rouble: slow-motion stabilisation through rouble hyperinflation. Not a very effective or attractive measure, and it was shelved, like other radical plans, without being taken seriously into consideration.
No way to restore competitiveness
The introduction of the weak-euro or the IOU escudo would undoubtedly add liquidity that might reduce the danger of sovereign default, especially through the use of IOUs directly issued by sovereign debtors – at a price, i.e. the higher discount rate applicable to the IOUs. But seeing how the weaker new currency could restore competitiveness is rather nebulous.
The envisaged devaluation of the weak euro immediately after its introduction, “by a percentage enough to restore the competitiveness losses periphery countries have suffered over the last decade” presumes that the weak euro becomes legal tender in place of the old at par, and that traded goods prices quoted in weak-euro remain unchanged with respect to old euro prices. True, this happens to some extent with every devaluation, but here Gresham’s Law would demonetize the strong euro for all uses not specifically reserved to the old currency; producers and traders would be forced to re-consider their price policy in terms of the new weak-euro.
One inconsistency of this plan is worth stressing: “Crucially, the bonds and external debt of the periphery countries will stay in strong-euro terms.” But the weak-euro countries in order to benefit from greater competitiveness would have to price and invoice their goods in weak-euros, so how would they acquire the strong-euro they need to service their debts?
Easier euro-area enlargement?
Another claim made by Arghyrou&Tsoukalas for their two-currency EMU is totally bogus: “… our proposal will be beneficial for EMU’s enlargement: In the present circumstances, the young democracies of Central and Eastern Europe cannot realistically expect to join the EMU in the foreseeable future. A two-currency EMU will provide them a chance of joining the EMU at a reasonably close date, initially as members of the weak euro, thus maintaining internal popular support and the momentum of enlargement.”
Both the central parity with the Euro at which EMU candidates join ERM-II, and the final rate of exchange at which they replace their domestic currency with the euro, are negotiated by candidates with the EU monetary authorities. Joining a “weak-euro” or a “strong-euro” would happen at different parities, which could be tailored to the relative strength of weak and strong euro, without any competitive advantage for one or the other. This particular claim is nonsense.
National IOUs
The Goodhart-Tsomokos plan has some advantages over the weak/strong-euro scheme. For a start, the devaluation of the national IOU would be geared to the specific conditions of the country involved, rather than being a single-size for all “periphery countries”. Being a national scheme, it would not necessarily involve the ECB: “If the central bank does not want to do this, and under the Maastricht Treaty it could refuse, the Treasury could do this on its own.” And there is a mechanism for the national management of national IOUs and the euro: “… the government, whose taxes remain paid in euro, would be long in euro, whereas the Portuguese private sector would be long escudo, short euro. So, the government transfers its net long to the central bank and asks the central bank to manage the escudo/euro exchange rate, so that it is stabilised, say at a level that represents a 25 per cent internal devaluation, (the choice of number would need careful calculation).” “While managed, the exchange rate should not be pegged.”
But there are also serious additional difficulties with respect to the Arghyrou&Tsoukalas plan. “… escudo IOUs would be acceptable for all internal payments, except tax payments, between Portuguese residents, but not for any external payments between Portuguese residents and foreign residents. All public sector and private sector wage payments shift on to an escudo basis as do interest payments by a Portuguese resident to another resident. Portuguese residents’ deposits and borrowing with Portuguese banks shift to an escudo basis; others remain in euros.” “The escudo would be inconvertible, and non-residents would not be allowed to borrow it. After all, this would be but a humble state IOU, though written rather large and not a ‘proper’ currency; indeed its success would be evident in its disappearance within a defined horizon, say 4 years.”
Back to the drawing board
“It would be messy, and an unattractive dual currency mechanism.” Spot on, Charles. “But it could work; it has done so before now in other countries and circumstances.” You should remind us where and when (the chervonets/sovznak rate was floating and is not comparable to the managed IOU/euro regime). And you should explain how on earth, if external payments between Portuguese and foreign residents take place in euros, is Portugal’s external competitiveness going to be enhanced by the introduction of an inconvertible IOU escudo?
“The plan we propose involves the temporary implementation of a two-currency EMU, with both currencies run by the Frankfurt-based ECB. The core-EMU countries will continue to use the present currency, the strong euro. The periphery countries on the other hand, will adopt, for a certain period of time, another currency, the weak euro. Crucially, the bonds and external debt of the periphery countries will stay in strong-euro terms. Upon its introduction, the ECB will devalue the weak euro by a percentage enough to restore the competitiveness losses periphery countries have suffered over the last decade against their main trading partners, the core-EMU countries. This will give the periphery a competitiveness boost while it introduces extensive structural reforms. The ECB will implement monetary policy for the whole of the EMU with its primary objective being price stability for all its members, strong- and weak-euro countries. It will do so in much the same way it does now, the only difference being that the ECB will be setting two rather than one reference rates.”
A similar plan was advocated by Charles Goodhart and Dimitrios Tsomocos in the FT of 24 January: The Californian solution for the Club Med – except through the temporary introduction of a dual national currency, for Portugal by way of example, through an escudo IOU instead of a dual “weak-euro” throughout the euro-zone, just like the IOUs that California and Argentina’s districts used to cope with a fiscal crisis.
The Gresham-Copernicus-Oresme-Aristophanes Law
The trouble with any dual currency system – whether bi-metallic or bi-paper or mixed – is that either the rate of exchange between the two currencies is determined by the market, depending on what can or cannot be done with either currency and how, or their rate of exchange is managed by monetary authorities presumably at a rate other than would otherwise prevail in the market (or there would be no point in managing it). At a market-determined exchange rate, the introduction of a new currency simply increases the amount of liquidity in the system, without any other effect; nothing happens that could not have happened by expanding money supply in the old currency (as it can always be done with paper money). At any managed exchange rate different from the market rate, Sir Thomas Gresham (1519 – 1579), an English financier during the Tudor dynasty, rules: “Bad money [the currency overvalued with respect to the market rate] drives out good [the undervalued currency]”. The dual currency ceases to be dual. This law is one of the oldest economic discoveries: it was anticipated by Nicolaus Copernicus, even earlier by Nicole Oresme in the fourteenth century, and had been stated clearly by Aristophanes in his play The Frogs, around the end of the fifth century BC.
The chervonets precedent
In the past the introduction of an additional currency has been advocated, and at least once implemented, not to weaken a strong currency and restore competitiveness but to stabilize a rapidly depreciating currency suffering from hyper-inflation. Thus in 1922-24 Lenin introduced in the Soviet Union a new gold-backed convertible currency, called chervonets after Peter the Great‘s gold coinage, and circulating next to the overinflated rouble, or sovznak. Over time the sovznak was de-monetized and disappeared through hyperinflation, while the new currency and the government budget were stabilized.
In the case of the chervonetz-sovznak coexistence clearly the rate of conversion between the two currencies had to be floating and market-determined, for the new currency at an under-valued fixed rate would be displaced by Gresham‘s law, while an overvalued rate would be pointless and rouble-inflationary. But if the two currencies were exchanged freely in the market the old currency would gradually disappear through higher and accelerating rouble-inflation and hyperinflation, which is what I understand actually happened in 1922-24, leaving a single sound currency. The parallel currency implemented a slow motion currency-stabilisation through accelerating rouble inflation, instead of a single inflationary shock to reach immediate balance.
In 1988-89 George Soros, Wassily Leontief, Ed Hewett and Ivan Ivanov (Deputy Chairman of the State Foreign Economic Committee, GVK) launched their “Open Sector”project, with the participation of many Soviet, western and east-European economists (see Phil Hanson, "Foreign Advice", in M.Ellman and Kontorovich, The Destruction of the Soviet Economic System – An Insiders’ History, M.E. Sharpe, Armonk-New York, 1988, pp.238-255). It was a plan, initially surrounded by secrecy, for both wiping out monetary overhang and promoting foreign trade by introducing a new convertible currency inspired by the 1920s chervonets, paid to Soviet exporters and then circulating in parallel with domestic roubles. I took part in the project and went along for the ride, but never believed in it: what had happened with the chervonets would have happened with the parallel, convertible hard rouble: slow-motion stabilisation through rouble hyperinflation. Not a very effective or attractive measure, and it was shelved, like other radical plans, without being taken seriously into consideration.
No way to restore competitiveness
The introduction of the weak-euro or the IOU escudo would undoubtedly add liquidity that might reduce the danger of sovereign default, especially through the use of IOUs directly issued by sovereign debtors – at a price, i.e. the higher discount rate applicable to the IOUs. But seeing how the weaker new currency could restore competitiveness is rather nebulous.
The envisaged devaluation of the weak euro immediately after its introduction, “by a percentage enough to restore the competitiveness losses periphery countries have suffered over the last decade” presumes that the weak euro becomes legal tender in place of the old at par, and that traded goods prices quoted in weak-euro remain unchanged with respect to old euro prices. True, this happens to some extent with every devaluation, but here Gresham’s Law would demonetize the strong euro for all uses not specifically reserved to the old currency; producers and traders would be forced to re-consider their price policy in terms of the new weak-euro.
One inconsistency of this plan is worth stressing: “Crucially, the bonds and external debt of the periphery countries will stay in strong-euro terms.” But the weak-euro countries in order to benefit from greater competitiveness would have to price and invoice their goods in weak-euros, so how would they acquire the strong-euro they need to service their debts?
Easier euro-area enlargement?
Another claim made by Arghyrou&Tsoukalas for their two-currency EMU is totally bogus: “… our proposal will be beneficial for EMU’s enlargement: In the present circumstances, the young democracies of Central and Eastern Europe cannot realistically expect to join the EMU in the foreseeable future. A two-currency EMU will provide them a chance of joining the EMU at a reasonably close date, initially as members of the weak euro, thus maintaining internal popular support and the momentum of enlargement.”
Both the central parity with the Euro at which EMU candidates join ERM-II, and the final rate of exchange at which they replace their domestic currency with the euro, are negotiated by candidates with the EU monetary authorities. Joining a “weak-euro” or a “strong-euro” would happen at different parities, which could be tailored to the relative strength of weak and strong euro, without any competitive advantage for one or the other. This particular claim is nonsense.
National IOUs
The Goodhart-Tsomokos plan has some advantages over the weak/strong-euro scheme. For a start, the devaluation of the national IOU would be geared to the specific conditions of the country involved, rather than being a single-size for all “periphery countries”. Being a national scheme, it would not necessarily involve the ECB: “If the central bank does not want to do this, and under the Maastricht Treaty it could refuse, the Treasury could do this on its own.” And there is a mechanism for the national management of national IOUs and the euro: “… the government, whose taxes remain paid in euro, would be long in euro, whereas the Portuguese private sector would be long escudo, short euro. So, the government transfers its net long to the central bank and asks the central bank to manage the escudo/euro exchange rate, so that it is stabilised, say at a level that represents a 25 per cent internal devaluation, (the choice of number would need careful calculation).” “While managed, the exchange rate should not be pegged.”
But there are also serious additional difficulties with respect to the Arghyrou&Tsoukalas plan. “… escudo IOUs would be acceptable for all internal payments, except tax payments, between Portuguese residents, but not for any external payments between Portuguese residents and foreign residents. All public sector and private sector wage payments shift on to an escudo basis as do interest payments by a Portuguese resident to another resident. Portuguese residents’ deposits and borrowing with Portuguese banks shift to an escudo basis; others remain in euros.” “The escudo would be inconvertible, and non-residents would not be allowed to borrow it. After all, this would be but a humble state IOU, though written rather large and not a ‘proper’ currency; indeed its success would be evident in its disappearance within a defined horizon, say 4 years.”
Back to the drawing board
“It would be messy, and an unattractive dual currency mechanism.” Spot on, Charles. “But it could work; it has done so before now in other countries and circumstances.” You should remind us where and when (the chervonets/sovznak rate was floating and is not comparable to the managed IOU/euro regime). And you should explain how on earth, if external payments between Portuguese and foreign residents take place in euros, is Portugal’s external competitiveness going to be enhanced by the introduction of an inconvertible IOU escudo?
Sunday, February 7, 2010
Euro Girations
On 5 February 2010 the euro fell to US$1.36, the lowest level over the last nine months.
At first - roughly from August 2008 until March 2009 - the global crisis was accompanied, paradoxically, by a sharp appreciation of the dollar with respect to other major currencies including the euro. Faced with a global recession, worldwide investors run for cover and for safety and poured assets into the United States – the eye of the storm – investing mostly in US Treasury Bills. Then the dollar resumed its natural downward trend, out of concern for the rising budget deficit and the continuing worsening in the foreign investment position of the United States. By early September 2009 there were fears that the appreciating euro might soon overstep the US$1.55 mark past which Germany would cease to be even moderately competitive. But the euro recovery was short-lived, soon countered by worries about the worsening fiscal position of euro-zone member countries like Greece, Spain, Portugal, and Ireland (which replaced Italy in the derogatory PIGS acronym). Such worries included the possibility of Greece defaulting on its public debt, its subsequent exit from the euro-zone, domino effects on other heavily indebted high-deficit EU members both inside the euro-zone and outside (from the UK to Latvia), right down to the possibility of euro-zone dis-integration. At the same time there were widespread expectations of a bail-out – if need be – of troubled European economies, whether bilateral or pan-European, buttressed by IMF interventions, in order to prevent the feared catastrophic effects of country default.
All these perceptions – of likely sovereign default, of its catastrophic effects including default contagion, of forthcoming bail-out – were vastly over-inflated.
Sovereign debt differs from private debt in that sovereignty is a major obstacle to creditors impounding debtors’ gross assets to satisfy their rights, even if and when there are enough sovereign assets to match sovereign debt. Mostly, any impounding is purely symbolic, limited to aeroplanes and ships located outside the debtor country, and within the creditors’ reach.
Thus, in a sovereign crisis, debtors have the upper hand. The ultimate deterrent to sovereign default is the debtor’s fear of losing competitive access to international financial markets; this usually forces debtors and creditors to come to terms with default and agree forms of debt and/or interest reduction and re-scheduling. The ultimate incentive for outsiders to step in with a bail-out, providing on some terms (ranging from gift to expensive loans) the financial resources necessary for a debtor to meet outstanding obligations and avoid default, is the fear that sovereign default might seriously damage the financial position of creditors, in particular banks, in the outsider state considering bailing out the defaulting sovereign. A complex game develops: if it is confidently believed that a bail-out will be forthcoming, the bail-out itself may become unnecessary, but a change in such confidence may precipitate a default and brutally test bail-out credibility.
Here three qualifications are in order.
First, today the fiscal position of most countries in the world, in terms of both government deficit and debt, has significantly deteriorated due to the fiscal stimuli that have been mobilized to avoid a major depression on the scale of 1929-32, as well as due to their GDP fall and the related growth of social expenditure. A premature exit strategy by Central Banks and Government budgets may raise the probability of default rather than reducing it (see Olivier Blanchard’s warning in a recent interview with Les Echos Les Echos Olivier Blanchard).
Second, market expectations and credit rating agencies are based not on current parameters of deficit and debt, but on their current increments, which are extrapolated into an uncertain future; this intensifies – unduly and unfairly – the impact of current adverse trends even when levels of deficits or debts are still far from any reasonable danger threshold.
Third, before reaching the point of sovereign default there are financial discipline procedures (the Growth and Stability Pact for EU members, regardless of whether they belong to the euro-zone; IMF procedures for all) and conditional assistance that provide both the penalties and incentives to make much less likely the occurrence of sovereign default – although tough fiscal measures might trigger off a political crisis (see the Greek strikes in response to proposed cuts in nominal wages) and possibly a change of government and fresh opposition to austerity. Greece avoided the stringency of EU disciplinary procedures by falsifying official statistics, but is now being monitored all the more strictly after being found out.
What is not at all clear is whether EU institutions and member states, within and without the euro-zone, can be relied upon to provide financial resources to bail-out a fellow EU or euro-zone member. A small country’s default could be easily digested, but what should be the critical size, and how can moral hazard be avoided? We have noted in three previous posts, on European Bail-Outs , on A non-bail-out bail-out and on Sovereign Default , the dangerous ambiguity of the “Moscow rules” enshrined in EU Treaties. Apart from the legal obstacles to EU bail outs, voluntary assistance by individual euro-zone members to help their troubled neighbours – of a kind recently advocated by Le Monde for Greece – may also come up against legal hurdles (article 123 of the EU Treaty, http://openeuropeblog.blogspot.com/2010/01/another-twist.html). And in any case it is not clear whether the “exceptional circumstances” in which the Council can authorize assistance to a member-state would include a financial crisis: in an interview with Frankfurter Allgemeine Zeitung, German EU Law Professor Matthias Ruffert “completely rejects the idea that the financial crisis could credibly be defined as “exceptional occurrences beyond [the Greek government's] control”, saying: "state debt certainly cannot be counted among those [exceptional circumstances]."” Alternatively, reliance on the IMF is also problematic: paradoxically, the very suggestion that the IMF might step in to assist Greece ahead of European institutions has been interpreted as an indication that these last are not going to help, and made things worse instead of better.
However, suppose Greece did default. Bad news for its creditors, both domestic savers and the foreign holders of 73% of Greek public debt; bad news for the Greek government’s ability to re-finance the debt and fund the deficit; bad news for the Greek stock exchange and other stock exchanges, that all fell heavily on 4-5 February 2010 in response to the widening of Greek spreads. But would there be a domino effect on other defaults? Undoubtedly interest rate spreads and Credit Default Swaps would increase for all weaker countries, but additional defaults would not necessarily occur, and in any case not immediately, not simultaneously in different countries, and not in all countries. The euro exchange rate with other major currencies would weaken, but the very existence of the euro would not be at stake. Mr Trichet reminded us recently that the financial difficulties of Greece, representing 2.5% of the euro-zone GDP, could not possibly have a greater adverse impact than that exercised on the dollar by the financial difficulties of California, that represents 14% of US GDP.
The headline “Markets are starting to bet on Euro area disintegration” (Eurointelligence.com, 5 February) is not just wrong, it is plainly silly. Markets have been factoring in uncertainty about defaults and bail-outs, but the fall of European stock exchanges does not imply disintegration of the euro-zone by any stretch of the imagination.
Of course the euro-zone would ride the storm more smoothly and efficiently if three conditions were satisfied:
1) “a robust and transparent system of crisis management”, formally approved by national parliaments, involving conditionality to the point of some loss of sovereignty, in order to avoid moral hazard;
2) a reduction in internal imbalances, involving action both “in countries with large current account deficits, such as Greece and Spain, and in those with large surpluses such as Germany.”
3) a renewed effort “to construct a meaningful financial supervisory regime” (Wolfgang Munchau, in the FT of 1 February). But these are not conditions for eurozone survival, as Munchau claims.
The euro can survive just as it is – although official EU talk of “constructive ambiguity”, leaving vague and indeterminate what would happen in the worse case of Greece defaulting, while discouraging and talking down any involvement by the International Monetary Fund, creates the worst of all possible worlds in which a default could occur.
At first - roughly from August 2008 until March 2009 - the global crisis was accompanied, paradoxically, by a sharp appreciation of the dollar with respect to other major currencies including the euro. Faced with a global recession, worldwide investors run for cover and for safety and poured assets into the United States – the eye of the storm – investing mostly in US Treasury Bills. Then the dollar resumed its natural downward trend, out of concern for the rising budget deficit and the continuing worsening in the foreign investment position of the United States. By early September 2009 there were fears that the appreciating euro might soon overstep the US$1.55 mark past which Germany would cease to be even moderately competitive. But the euro recovery was short-lived, soon countered by worries about the worsening fiscal position of euro-zone member countries like Greece, Spain, Portugal, and Ireland (which replaced Italy in the derogatory PIGS acronym). Such worries included the possibility of Greece defaulting on its public debt, its subsequent exit from the euro-zone, domino effects on other heavily indebted high-deficit EU members both inside the euro-zone and outside (from the UK to Latvia), right down to the possibility of euro-zone dis-integration. At the same time there were widespread expectations of a bail-out – if need be – of troubled European economies, whether bilateral or pan-European, buttressed by IMF interventions, in order to prevent the feared catastrophic effects of country default.
All these perceptions – of likely sovereign default, of its catastrophic effects including default contagion, of forthcoming bail-out – were vastly over-inflated.
Sovereign debt differs from private debt in that sovereignty is a major obstacle to creditors impounding debtors’ gross assets to satisfy their rights, even if and when there are enough sovereign assets to match sovereign debt. Mostly, any impounding is purely symbolic, limited to aeroplanes and ships located outside the debtor country, and within the creditors’ reach.
Thus, in a sovereign crisis, debtors have the upper hand. The ultimate deterrent to sovereign default is the debtor’s fear of losing competitive access to international financial markets; this usually forces debtors and creditors to come to terms with default and agree forms of debt and/or interest reduction and re-scheduling. The ultimate incentive for outsiders to step in with a bail-out, providing on some terms (ranging from gift to expensive loans) the financial resources necessary for a debtor to meet outstanding obligations and avoid default, is the fear that sovereign default might seriously damage the financial position of creditors, in particular banks, in the outsider state considering bailing out the defaulting sovereign. A complex game develops: if it is confidently believed that a bail-out will be forthcoming, the bail-out itself may become unnecessary, but a change in such confidence may precipitate a default and brutally test bail-out credibility.
Here three qualifications are in order.
First, today the fiscal position of most countries in the world, in terms of both government deficit and debt, has significantly deteriorated due to the fiscal stimuli that have been mobilized to avoid a major depression on the scale of 1929-32, as well as due to their GDP fall and the related growth of social expenditure. A premature exit strategy by Central Banks and Government budgets may raise the probability of default rather than reducing it (see Olivier Blanchard’s warning in a recent interview with Les Echos Les Echos Olivier Blanchard).
Second, market expectations and credit rating agencies are based not on current parameters of deficit and debt, but on their current increments, which are extrapolated into an uncertain future; this intensifies – unduly and unfairly – the impact of current adverse trends even when levels of deficits or debts are still far from any reasonable danger threshold.
Third, before reaching the point of sovereign default there are financial discipline procedures (the Growth and Stability Pact for EU members, regardless of whether they belong to the euro-zone; IMF procedures for all) and conditional assistance that provide both the penalties and incentives to make much less likely the occurrence of sovereign default – although tough fiscal measures might trigger off a political crisis (see the Greek strikes in response to proposed cuts in nominal wages) and possibly a change of government and fresh opposition to austerity. Greece avoided the stringency of EU disciplinary procedures by falsifying official statistics, but is now being monitored all the more strictly after being found out.
What is not at all clear is whether EU institutions and member states, within and without the euro-zone, can be relied upon to provide financial resources to bail-out a fellow EU or euro-zone member. A small country’s default could be easily digested, but what should be the critical size, and how can moral hazard be avoided? We have noted in three previous posts, on European Bail-Outs , on A non-bail-out bail-out and on Sovereign Default , the dangerous ambiguity of the “Moscow rules” enshrined in EU Treaties. Apart from the legal obstacles to EU bail outs, voluntary assistance by individual euro-zone members to help their troubled neighbours – of a kind recently advocated by Le Monde for Greece – may also come up against legal hurdles (article 123 of the EU Treaty, http://openeuropeblog.blogspot.com/2010/01/another-twist.html). And in any case it is not clear whether the “exceptional circumstances” in which the Council can authorize assistance to a member-state would include a financial crisis: in an interview with Frankfurter Allgemeine Zeitung, German EU Law Professor Matthias Ruffert “completely rejects the idea that the financial crisis could credibly be defined as “exceptional occurrences beyond [the Greek government's] control”, saying: "state debt certainly cannot be counted among those [exceptional circumstances]."” Alternatively, reliance on the IMF is also problematic: paradoxically, the very suggestion that the IMF might step in to assist Greece ahead of European institutions has been interpreted as an indication that these last are not going to help, and made things worse instead of better.
However, suppose Greece did default. Bad news for its creditors, both domestic savers and the foreign holders of 73% of Greek public debt; bad news for the Greek government’s ability to re-finance the debt and fund the deficit; bad news for the Greek stock exchange and other stock exchanges, that all fell heavily on 4-5 February 2010 in response to the widening of Greek spreads. But would there be a domino effect on other defaults? Undoubtedly interest rate spreads and Credit Default Swaps would increase for all weaker countries, but additional defaults would not necessarily occur, and in any case not immediately, not simultaneously in different countries, and not in all countries. The euro exchange rate with other major currencies would weaken, but the very existence of the euro would not be at stake. Mr Trichet reminded us recently that the financial difficulties of Greece, representing 2.5% of the euro-zone GDP, could not possibly have a greater adverse impact than that exercised on the dollar by the financial difficulties of California, that represents 14% of US GDP.
The headline “Markets are starting to bet on Euro area disintegration” (Eurointelligence.com, 5 February) is not just wrong, it is plainly silly. Markets have been factoring in uncertainty about defaults and bail-outs, but the fall of European stock exchanges does not imply disintegration of the euro-zone by any stretch of the imagination.
Of course the euro-zone would ride the storm more smoothly and efficiently if three conditions were satisfied:
1) “a robust and transparent system of crisis management”, formally approved by national parliaments, involving conditionality to the point of some loss of sovereignty, in order to avoid moral hazard;
2) a reduction in internal imbalances, involving action both “in countries with large current account deficits, such as Greece and Spain, and in those with large surpluses such as Germany.”
3) a renewed effort “to construct a meaningful financial supervisory regime” (Wolfgang Munchau, in the FT of 1 February). But these are not conditions for eurozone survival, as Munchau claims.
The euro can survive just as it is – although official EU talk of “constructive ambiguity”, leaving vague and indeterminate what would happen in the worse case of Greece defaulting, while discouraging and talking down any involvement by the International Monetary Fund, creates the worst of all possible worlds in which a default could occur.
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