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, 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” (, 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.


Ron said...

Uncertainty about bail-outs may have some advantages. As Alan Greenspan used to say, "keep the markets guessing...".

D. Mario Nuti said...

It may be advantageous to "keep markets guessing" trends in policy instruments such as the interest rate, or exchange rate policies. But there is nothing to gain when you keep markets guessing the rules of the game.

Antonio Lettieri said...

Two o three things still about Greece and the confusing position of the EU.
When the EMU was established, it was clear that it was not a “perfect monetary union”, given the lack of a unified labour market and a common fiscal policy. It was inevitable in this framework to incurring in more or less hard problems in the relationship between the Member states. So the establishment of the Monetary union in this framework was a political choice. And it was convenient for countries, such as Italy, which found an anchor of stability in the euro; as well as for Germany, which could occupy the center of a large economic and monetary area, dominated by the new currency, which indeed was a natural metamorphosis of the old DM.
Now that the global crisis has exacerbated the initial problems and a number of countries are at risk, Brussels and Frankfurt can’t wash their hands under the pretext of combating the "moral hazard”. If the was a hazard it was, first of all, political at the EMU establishment. A domino-process of defaults would threat the disintegration of the Monetary Union. The solution can’t be found in a simple (and hypocritical) technocratic approach. The budget problems, in the middle of a global crisis which hits, to begin with, powerful countries such as US and Britain, needs to be tackled on the basis of political choices, avoiding what Krugman calls the “budget hysteria”.

chilosi said...

Apparently the present crisis depends on the fact that no fiscal budget constraints were forced when times were better on the countries whose fiscal imbalances put now the Eurozone into trouble. The stability pact was stillborn. Nobody has been asked to pay the fines for violating it even in times of relative plenty (at least in relation to the present conjuncture), and one may doubt whether if the fines were asked they would have been paid. Counterfeit and creative national accounting have been largely tolerated for political reasons. Only Ireland, to my recollection, was reprimanded, not because of its national finances, which were in order at the time, but because its prices were catching up to its relative development level (by the Balassa Samuelson effect). Some other, more automatic, sanctioning procedures could have been more practical (such as an automatic suspension of the representatives of the violating country to the membership of the Economic and Financial Council, unless, say, a qualified majority of the other members were to vote to the contrary, or the prohibition for the ECB to take advantage of the securities of the violating countries in its open market operations, up to the blocking of the disbursements from the EU budget). It is also conventional wisdom that the stability pact was too rigid, and this did justify its neglect: to prospect some form of collective decision procedure for modulating it in practice according to circumstances could have been better to the point. Now that the period of relative tranquility is over, the cracks are showing up. The best way to mend them is for the countries in trouble to reform themselves in such a way as to re-establish the faith of the markets in their solvency. Then the issue of helping them to have a softer landing could be faced. These are not the best times for fiscal consolidation, but that some kind of trouble was eventually in store could have foreseen. In the meantime the weakening of the Euro could be a welcome by-product.

chilosi said...

As to the comparison between Greece and California, it is interesting what is reported in an article published yesterday on the site of the Wall Street Journal by Marco Annunziata (

"...the comparison between Greece and California goes exactly to the heart of the problem. First of all, California's fiscal problems are nowhere near as serious as Greece's. In 2008, the latest year for which official U.S. Census Bureau data are available, California ran a budget deficit of $46 billion, or some 2.5% of California GDP; Greece recorded a deficit of 7.7% of GDP, which rose to an estimated 12.7% of GDP last year. California's debt amounted to a paltry 7% of its GDP at end-2008; in Greece it stood at about 100%, ready to escalate to over 110% in 2009. With a debt-to-GDP ratio of 7%, you almost certainly do not have a debt sustainability problem; with a ratio over 100%, you could."

D. Mario Nuti said...

I agree with Tonino about the political nature of the EMU project. The common currency should have been the very last stage of European integration, the "crowning" of full integration, after the achievement of political, defence and foreign policy integration. Instead the euro was a way to drive "la finalité politique" forcing the implementation of the missing aspects of integration. A currency which is not backed by a state, a government, an army, is naturally handicapped.

If the crisis of the weaker euro-zone members deepened, I believe "Brussels and Frankfurt" would act - though not as efficiently as if crisis procedures had been in place. The IMF would have to be involved, never mind the loss of face in Europe, and Greece would be squeezed very hard. But I am not convinced that even in case of unassisted default "A domino-process of defaults would threat[en] the disintegration of the Monetary Union."

D. Mario Nuti said...

Yes, Alberto, if the strict and mechanistic discipline of the so-called Growth and Stability Pact (the greatest euphemistic misnomer of Eurospeak) had been enforced, today financial markets would have more confidence in the euro and in the state of public finances in the weaker members of the euro-zone and of the EU. Though I am not sure that strict GSP enforcement would not have destroyed more income and employment than has been jeopardised or lost from financial indiscipline.

As to the relative assessment of the burden of deficit and debt in Greece and California, the data you approvingly quote neglect that Californians are also burdened - in addition - by their own share of the total US monster deficit and debt, while the Greeks only have to cope with their own.

Antonio Lettieri said...

I agree Mario. The domino effect will be avoided, since it serves no one, starting with Germany and France.The fact remains that without a clear (political) position of the Union, the financial problems for the involved countries become more complicated,under the attak of the market speculation; meanwhile the Union's credibility is going to be further downgraded within, as well outside, the area.